Tax Consequences of Debt Settlement

When financial difficulties strike, individuals often find themselves seeking solutions to manage their debt burden. Debt settlement is one such option that can provide relief by negotiating with creditors to pay a reduced amount to settle the debt. However, it’s crucial to understand the potential tax implications associated with this process.

Understanding Debt Settlement:

Debt settlement involves negotiating with creditors, typically credit card companies or personal loan providers, to accept a reduced payment to settle the debt. You can handle debt by yourself and just negotiate directly with your creditors. Or there are many different companies that offer these kind of services; there are local and national companies that can review your situation and come up with a potential plan or recommendation to deal with the debts. This often includes monthly payments to save up funds to pay for the settlement amount and for the fees associated with the settlement.

A common example of a debt settlement situation we see is: if you owe $20,000 on a credit card, you might negotiate to settle the debt by paying $12,000 instead. On its face, it looks like this settlement will result in a savings of $8,000. However, there are more factors that impact this settlement.

Tax Consequences and Form 1099-C:

When a creditor agrees to settle a debt for an amount lower than what you owe, the forgiven amount is considered income for tax purposes. The creditor is required to report this forgiven debt to both you and the IRS using Form 1099-C. For example, if your creditor forgives $8,000 of your debt, you likely will receive a 1099-C reflecting that amount. This means that your taxable income will usually increase by that amount, unless you qualify for an exception. This taxable event really results in decreased savings that you achieved through the settlement.

It is also important to consider the tax consequence as part of your potential savings. It is not necessarily a reason not to settle, but it is a factor to consider when determining if you are getting a good settlement. Additionally, it is important to review all related expenses of the settlement process to understand you’re full out of pocket.

Imagine a borrower with a $15,000 debt owed to a credit card company. Through negotiation, the borrower manages to settle the debt for $7,000. Consequently, the credit card company issues a Form 1099-C for the forgiven amount of $8,000 ($15,000 – $7,000).

Now, let’s examine the tax implications based on different tax brackets. If the borrower falls into the 12% tax bracket, they would owe an additional $960 in taxes ($8,000 x 0.12). However, if the borrower is in the 22% tax bracket, their tax liability would increase to $1,760 ($8,000 x 0.22). This tax burden adds to the overall cost of the debt settlement process.

Taking into account the use of a lawyer or debt consolidation company, if the borrower is charged a 10% fee of the total debt ($15,000 x 0.10 = $1,500), their actual out-of-pocket expenses would include the fee and the taxes paid. In the 12% tax bracket scenario, the total out-of-pocket cost would be $2,460 ($1,500 fee + $960 taxes). In the 22% tax bracket scenario, the total cost would be $3,260 ($1,500 fee + $1,760 taxes).

So your total savings is really the difference between the original debt and the settlement amount plus any costs. Comparing these costs to the original debt of $15,000, the borrower’s savings in the 12% tax bracket scenario would be $5,540 ($15,000 – [$7,000+ $2,460]), while in the 22% tax bracket scenario, the savings would be $4,740 ($15,000 – [$7,000 + $3,260]). While the result is still net savings of 30% to 40%, it isn’t as high as it originally seemed.

This detailed example emphasizes that while debt settlement can lead to substantial savings, understanding the tax implications, fees, and potential savings is crucial for making an informed decision. Seeking advice from professionals can help borrowers navigate the complexities and make the best choices for their financial well-being.

Similarly, since there are additional costs to any settlement, we usually advise debt settlement often makes the most sense when you can settle the debt yourself and do not have to pay a third party. Since third party fees eat into any profit, it can be substantial savings when you do not need to pay a settlement company or lawyer to handle the negotiations. Settlement fees often charge 15% to 25%. The higher the fee, the more likely there will be little overall savings. In our example above, we only used fees of 10%; if the fees were 20%, the savings in the overall settlement would be substantially less.

The biggest issue we see with debt settlement and the tax consequences is that most debt settlement companies do not advise on how much it could be. The standard line we hear from many debt settlement companies is that there are potential tax consequences and you should speak to a tax advisor if you can concern. While, most debt settlement companies are not lawyers or even financial adviser, so they likely cannot provide accurate calculations for tax issues, they often remain vague about the potential tax bill and do not encourage anyone to follow up. Sometimes, the tax issue is not even brought up during a financial review, but only put into the language of the contract.

Insolvency Exception

The IRS provides some relief through the insolvency exception, which can help mitigate the tax burden arising from forgiven debt. If you are insolvent at the time of debt settlement (your liabilities exceed your assets), you can exclude the forgiven debt from your taxable income up to the extent of your insolvency. For instance, if your total debts are $50,000 and your assets are worth $30,000, you’re insolvent by $20,000. If your forgiven debt is $10,000, you can exclude that amount from your taxable income. This calculation does have certain exceptions. As a result, it is crucial that you use an experienced tax preparer to properly calculate the exception and file the proper paperwork, if it applies to you.

With this exception, you still have to declare the 1099-C on your income, but then the IRS knows to disregard that additional amount; as result, under these circumstances there would be no tax consequences on debt settlement.

Prior to settling any debts, you likely should talk to your tax preparer or a tax advisor about whether this exception applies to you. If it does, you do not need to be as concerned about the potential tax consequences playing a factor in your overall debt settlement analysis.

Bankruptcy Exception:

For those who file bankruptcy, forgiven debt resulting from the discharge of indebtedness may be excluded from taxable income. This basically means any debt settled or cancelled due to bankruptcy is not reported as income. Bankruptcy is a complex legal process that involves filing a petition, but it can provide significant relief from both debts and tax liabilities. This tax benefit can provide substantial savings, depending on your income bracket and amount of debt. This benefit can result in significant savings for someone dealing with debt; it also is a important factor for anyone already struggling with tax debt.

Often with bankruptcy, a creditor will not even issue the 1099-C since the debt was cancelled under the bankruptcy code. However, if a creditor does issue a 1099-C, then you just have to file the Form 982 with your taxes and check that the debt was due to “Discharge of indebtedness in a Title 11 case.” No need for calculations; there is basically a presumption of insolvency if you have filed for bankruptcy. Similarly, it is also possible that a 1099-C is issued during a Chapter 13 plan for a debt, and if so, the same process applies.

Debt settlement can provide a much-needed lifeline to individuals facing overwhelming debt. However, it’s vital to be aware of the tax consequences associated with forgiven debt, as well as potential exceptions like insolvency and bankruptcy. Considering the pros and cons, it’s recommended to seek advice from financial advisors or legal professionals before embarking on the debt settlement journey. Remember, understanding the implications can empower you to make informed decisions about your financial future.

Attorney Ashley F. Morgan is a Virginia debt lawyer. Her primary focus in practice is bankruptcy and debt issues, including tax issues. It is important to her that her clients are making the best decision for their situation; she regularly advises her clients about the pros and cons about bankruptcy and debt consolidations given their specific circumstances. She wants you to under stand the pros and cons of all your options, not just bankruptcy. She has recommended debt settlement in various situation, but only when the client understands the full situation, including the tax consequences of the settlement.