Why is the Department of Education Dragging its Feet on Debt Relief for Disabled Veterans?
By John R. Brooks | December 13, 2018
Hundreds of thousands of student borrowers, including 42,000 veterans, qualify to have their student loans cancelled because of a total and permanent disability (TPD). Yet few eligible borrowers take advantage of this benefit, in part because they have to actually ask for it. The Department of Education (ED) knows who these disabled borrowers are and could automatically discharge their loans today, but it has refused to do so even in the face of years of Congressional pressure. Instead, more and more disabled borrowers go into default or see their disability benefits offset to pay back their loans. This is bad enough for most disabled borrowers, but is particularly cruel to disabled veterans, whose inability to afford their student loans is precisely because of their service to the country. ED claims it can’t automatically discharge this debt for tax reasons, but that is simply not the case.
TPD discharge has been around since the beginnings of the student loan program in 1965, but until this year was hampered by the tax treatment of discharged debt. As a general rule, discharged debts create gross income for tax purposes, since the discharge is economically equivalent to receiving, say, a cash windfall and using it to pay off the debt. So, for example, a cancelled $10,000 credit card debt would be treated as $10,000 of income, with resulting federal tax bill as high as $3,700 (because the top marginal tax rate is 37 percent). But there are a number of exceptions to this tax treatment, such as for taxpayers who are insolvent or bankrupt. For student loans, the exceptions are confusing and depend on the reason for the debt discharge. The tax code provides an exception for Public Service Loan Forgiveness, but not for forgiveness under the other Income-Driven Repayment programs. The Higher Education Act (but not the tax code, which will be important later) provides an exception for loan discharge due to school closing, but there is no exception for discharge due to false certification of loan eligibility or “borrower defense to repayment” (fraud, essentially). And until recently there was also no exception for discharge due to death or disability.
Without that exception to the tax treatment of cancelled debt, one can understand ED’s reluctance to push TPD discharge. For example, in 2017, Army veteran Will Milzarski, who suffered traumatic brain injury, PTSD, and hearing loss during combat in Afghanistan, was hit with a $70,000 tax bill after his $223,000 in student loans was cancelled under TPD discharge. That’s painful for a borrower (and bad politics for ED).
But the Tax Cuts and Jobs Act (TCJA) changed all that. As of January 1, 2018 (and until January 1, 2026), the tax code excludes from gross income student debt cancelled by reason of death or disability, a change added in large part to answer ED’s objections to automatic discharge. So no problem anymore, right? ED can now go ahead and automatically discharge the student loans of disabled borrowers without fear of causing more problems or backlash—problem solved. Well, not quite. Because ED is now claiming that there is still a state tax problem. It says that just because the federal tax law doesn’t tax this discharged debt, it may still be the case that a state’s tax law does. But for several reasons, this is not a serious argument.
State Tax is Highly Unlikely to Apply
First, let’s note that even if state income taxes did apply, they would be small fraction of what the federal tax liability would have been, and an even smaller fraction of the loan itself. The top federal tax rate is 37 percent, but state tax rates top out at 13.3% (in California), and run more like 3 – 5 percent for a more typical state and loan balance. In other words, the risk is that a borrower would have to pay, say, 5 percent of the loan balance in state taxes, compared to 100 percent of the balance to ED—not a horrible trade-off. The cancellation of Will Milzarski’s $223,000 student debt led to a $70,000 tax bill, but only $8,000 of that was owed to the state of Michigan.
That is still a substantial amount, however, which is why it is also important that state taxes are very unlikely to apply, because state tax law overwhelmingly follows federal tax law. The exclusion from gross income for TPD discharge was written into the federal tax code, and of the 42 states (including DC) with an income tax, 37 almost entirely conform their state tax codes to the federal tax code, and the other 5 still have close connections to the federal tax code. Many of the 37 states have “rolling” conformity, so any change in federal law is immediately and automatically incorporated into state law. Others update their tax law on a “static” basis, so it might take a year or two for state law to catch up. A few states have elected not to conform to some aspects of the TCJA, but according to an analysis by Senate Democrats, at most 10 states present a possible issue today, and that number will shrink fast as more states conform.
ED could—today—automatically discharge the student loans for disabled veterans and others who live in the other 41 states (including DC) with absolutely no state tax consequences. If it were truly concerned about state tax consequences for those in the other 10 states, ED could tailor the process, such as by waiting for those states to update their laws, providing an opt-out choice for those borrowers, or working with state tax authorities to clarify whether they will assert taxation.
But it is not clear why ED would be truly concerned, since it has been down this road before.
No State Tax Issues in the Corinthian Colleges Discharge
In 2015, after the Department shut down the for-profit Corinthian Colleges chain, ED announced that the loans of students who had attended one of the Corinthian schools would be forgiven, under either closed school or borrower defense discharge theories. Following pressure from Sen. Elizabeth Warren and others, the IRS ruled that it would not assert taxation of these forgiven balances, since at least one of three exemptions was likely to apply: the closed school exemption in the Higher Education Act, the insolvency exemption in the tax code, or fraud exemptions in the case law.
Later, in conjunction with a similar forgiveness of debt for former students of American Career Institutes (ACI), the IRS further ruled that tax regulations did not require creditors—both ED and private lenders—to issue information returns, the 1099-C forms that normally accompany debt forgiveness. That is tantamount to ordering that state taxes not apply. State tax law piggybacks on federal information reporting even more than it does on federal tax base definitions—without a form, it is unlikely for a state tax authority even to know what’s going on, or for a borrower to know that reporting is necessary. It would have been practically impossible for states to tax the loan forgiveness.
And no one made a peep about states taxes, as far as I can tell. No one was worried about state taxes applying when the loans were cancelled, no state complained of being deprived taxes when the IRS said 1099-Cs were not required, and I have not found evidence of any state attempting to assert taxation. Maybe some state cases and rulings will crop up down the road, but so far it is just not an issue.
This is particularly striking, since state taxes would have been more likely to apply to the Corinthian and ACI discharges than to TPD discharges after the TCJA. The Corinthian and ACI discharges relied in part on exemptions that are not in the federal tax code, and so would not have been automatically included in state tax laws. The exemption for closed school discharge in particular is only in the Higher Education Act, not the tax code. If officials were not worried about state tax law conformity for Corinthian and ACI, they definitely should not be worried about it for TPD.
ED’s Reluctance to Help Veterans
It’s hard not to notice that ED has been dragging its feet all along in helping disabled veterans in particular. In April 2016, ED announced a program to proactively identify and offer debt forgiveness to disabled borrowers by doing a computer match with the Social Security Administration (SSA), which administers the bulk of federal disability benefits. It sent letters to 387,000 individuals, with a combined loan balance of $7.7 billion, who only had to sign and return the letter to have their debts discharged. (As of July 2018, only 19,000 borrowers had done so, according to the GAO.)
But the SSA’s database does not include disabled veterans receiving benefits from the Veterans Administration (VA). ED announced in December 2016 a plan to do a similar computer data match with the VA, but did not actually start contacting disabled veterans until April 2018. At that point, according to a FOIA request made by Veterans Education Success, ED contacted over 42,000 disabled veterans, 25,000 of whom were already in default on their loans. As of May of this year, only about 8,500 had signed and returned the letter requesting discharge.
The lack of uptake by veterans is disappointing, but not surprising. Many may have been confused about the tax consequences or not realized that the tax law had changed, they may have been wary of something that sounds similar to common scams, or a disability (e.g., blindness) may even have prevented them from effectively receiving the notice or responding to it. This low uptake, for veterans and other disabled borrowers, is precisely why automatic discharge is so vital.
Members of Congress have repeatedly pressed ED to do more for veterans in particular. Since 2016, at least 20 Senators, Republican and Democrat, have written to ED and the VA to urge more attention to the student loans of disabled veterans, and to automatic loan discharge in particular. In 2017, Senate committee reports for both the VA appropriations bill and the National Defense Reauthorization Act directed ED to automatic the process for debt relief and other benefits. But ED continues to drag its feet. Just last month, a Department spokesperson told UPI in response to questions about automatic discharge for veterans that “the last thing we want to do is cause unintended consequences—like impact future federal student aid or create a state or local tax liability—for men and women who have given so much.” But if this isn’t a real reason to prevent automatic discharge, then what is going on?
ED has been criticized in the past for thinking too much like a bank, and not enough like a student aid agency. The solvency and financial stability of the loan program may take on too much weight in officials’ minds relative to the needs of individual borrowers. This may flow from the good intention of trying to keep the student loan program safe from opportunistic political attacks, but it can go too far. ED estimates about $8.7 billion in loan balances could be affected by TPD discharge, for both veterans and non-veterans. That’s not insignificant and would likely cause further pressure on subsidy rates already being pushed up by Income-Driven Repayment. But Congress has spoken, both in statute and otherwise, that totally and permanently disabled borrowers must be relieved of their student debt obligations.
Policymakers Need to Act
Taken together, ED’s arguments for inaction don’t pass muster and likely reflect historical bias against loan cancellation, not any true legal barrier to helping veterans and other disabled borrowers. To ensure that disabled veterans and other borrowers are given the benefits they deserve, policymakers should take the following simple steps:
First, ED should use its computer data matching systems with the SSA and VA to immediately identify disabled borrowers in the 41 states that already exclude TPD discharge from state taxes and automatically cancel any remaining student debts.
Second, the IRS should extend its ruling from Corinthian and ACI to TPD discharge, and state that ED and any private creditors are not required to issue 1099-C forms. As a practical matter, that will resolve the state tax issue in every state.
Third, if ED believes it necessary to resolve the issue further, it should work with the tax authorities in the 10 states where the law is unclear to issue rulings to confirm that they will not assert taxation.
ED could begin with step one today and thereby start giving over 400,000 disabled borrowers the relief that they need, that they deserve, and that they are owed under the law.
John Brooks is Professor of Law at Georgetown University Law Center. His research focuses on tax law and policy, social insurance, and the federal student loan program. Follow him on twitter @jakebrooksGULC.