Tax Law

The First Student Loan Forgiveness Lawsuit Has Been Filed

The plaintiff faces state income taxes if his loans are forgiven.

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Graduate Student Loan Icon – Student Loan Graphics for Education Financial Aid or Assistance, Government Loans, and DebtIt was only a matter of time before someone filed a lawsuit in an attempt to block President Joe Biden’s student loan forgiveness proposal.

The plaintiff is Frank Garrison, an attorney working for the Pacific Legal Foundation (PLF). PLF is a 501(c)(3) organization as its tax returns are publicly listed on its website. PLF also happens to be the firm representing Garrison in this lawsuit. He received a Pell Grant so he qualifies to get $20,000 in loan forgiveness under Biden’s proposal.

His argument for blocking the proposal is the one we’ve all heard before: the president cannot unilaterally forgive student loans on a massive scale with major economic impact without congressional approval. He also claims that the proposal should have gone through the formal notice and comment procedures pursuant to the Administrative Procedure Act.

What is interesting about this lawsuit is how Garrison tries to establish standing to sue: by claiming that he would be harmed due to state income taxes as a result of forgiveness.

As an employee of a 501(c)(3) charitable tax-exempt organization, Garrison has been enrolled in both the Income Driven Repayment and Public Service Loan Forgiveness (PSLF) programs. According to the lawsuit, all of his federal loans will be forgiven in just over four years so long as he stays in PSLF. When the loans are forgiven, the forgiven amount is tax free by law both at the federal level and with Indiana.

When it comes to the president’s loan forgiveness proposal, it will be tax free at the federal level. But Indiana is one of six states that do not conform with the federal law that gives tax-free status. So when the loan is forgiven, the debtor will have to include the $20,000 forgiveness as taxable income and pay a state income tax of $1,000.

He claims that since his loan forgiveness would be automatic per the government’s announcement, he will be forced to accept the forgiveness and then be forced to pay the resulting state income tax. Thus, he would have suffered harm. He would be better off not accepting forgiveness and finishing the PSLF requirements so he can get all of his federal loans forgiven tax free.

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While his claim is interesting, there is a problem: He can opt out of the forgiveness program and avoid the harm of having to pay $1,000. The Department of Education has claimed that 8 million borrowers will get automatic debt relief based on income information already on file. But the latest information states that forgiveness applications will be available in early October. This can either mean that there is conflicting information that needs to be clarified, or those that apply will get automatic forgiveness without having to go through additional steps to prove their income.

Also, it appears that Indiana’s tax law allows the exclusion of cancellation of debt income if the debtor is insolvent. Being insolvent basically means that a taxpayer’s total liabilities exceeds their total assets at the time of forgiveness. If Garrison is insolvent at the time his loans were forgiven, then any income due to cancellation of debt can be excluded from his tax return.

While Garrison’s effort is a valiant one, it may end up being futile. By the time the lawsuit gets to a judge, forgiveness applications will be out, and he can simply decline to apply for forgiveness and avoid the harm he is claiming he will suffer. On the other hand, if the issue is important enough, a court may somehow find standing and let the case be heard on its merits.

Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at stevenchungatl@gmail.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.

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