Most people who come into my office asking about bankruptcy want to get an understanding of the bankruptcy alternatives before pulling the trigger on a bankruptcy filing. Debt settlement is the most common alternative people ask about.
How debt settlement works (in theory).
In theory, debt settlement works like this: your original creditor sells the debt to a debt collector for 10 cents on the dollar (or even less sometimes), and the debt collector starts calling you, writing you, calling you at work, calling your relatives, etc. asking for payment. Because you are aware of the fact that the debt collector did not pay 100% of the face value of the debt to your original creditor, it is possible for you to settle the debt with the debt collector for less than you owe but more than they paid, creating a win-win situation for everyone involved. For example, if the debt collector purchased a $10,000 debt for $1,000 and if you settle that debt with the debt collector for $2,500, you are better off because you only have to pay back 25% of what you owed, and the debt collector is better off too because it just made a 150% return on its investment. This is how it should work.
Then the IRS steps in and complicates the debt settlement process.
One unforeseen consequence of debt settlement is that after you settle the debt for less than you owed you are supposed to report the discharged debt on your income tax return as income for the year. To further encourage you to report the settled debt on your taxes, the creditor is supposed to issue you an IRS Form 1099-C, which reports the canceled debt to the IRS.
This creates big problems for unwary settlers of debt for a couple of reasons:
- Working off of the example above, you thought you were settling $10,000 of debt for $2,500. But, at the end of the year if you have to pay taxes on the canceled $7,500 portion of the debt and if you are a 25% tax bracket payer, the IRS is going to stick you with a bill for $1,875 bill at tax time.
- Suppose you don’t have the $1,875 at tax time? Well, now you’re going to pay interest and penalties on the unpaid tax bill.
- Even worse, because this is income tax debt, you cannot discharge the tax liability in bankruptcy until 3 years after it came due have elapsed.
Don’t get me wrong. Settling $10,000 of debt for $4,375 is a pretty good deal, but you should understand that you have two entities to pay to settle, not just the owner of the debt.
Also understand that Form 1099-Cs are not issued every single time a creditor writes off debt. You could get lucky and dodge this bullet. However, do not think you are out of the woods just because you settle debt in one year and have not received a 1099-C by the time you file your taxes. 1099-Cs can be issued years after the fact, so you have the unpleasant uncertainty of waiting for this bomb to drop some time in the future.
The beautiful thing about discharging debt in bankruptcy is that you do not have to pay income tax on the written-off portion of the debt. Even if the creditor sends you a 1099-C after bankruptcy, it is a relatively easy process to tell the IRS that you will not be including that written-off debt in your income by attaching a Form 982 to your tax return.
Bankruptcy is a better option for many people.
I usually decline to engage in the settlement of debts on behalf of my clients. I find that in most situations, an attorney would have to charge you too much to engage in the settlement negotiations, and a professional debt settlement negotiator is a better, more economical choice. I can recommend a good debt settlement negotiator in Crystal Lake. Ray of Hope Negotiations does good work, doesn’t rip people off, and I trust them (and, no, I haven’t been bribed by Gary for the recommendation).
What I can help you with, however, is filing bankruptcy. If your debts are too large to negotiate or if you do not want to deal with the uncertainty of being issued a 1099-C, bankruptcy is a great option for many debtors. Contact me to schedule a free consultation to discuss whether bankruptcy is right for you. The initial consultation is free, and I try to make it a low-pressure environment.