Sometimes it pays to come to an agreement with a creditor that allows you to pay your debt off at a discount. That way you don’t need to file bankruptcy.
But sometimes debt settlement is a bad idea compared to bankruptcy.
First of all, I have had numerous clients that have come to me after paying thousands of dollars to a debt settlement company having accomplished nothing. Some of the debt settlement companies use the monthly money you pay to the debt settlement company to only pay the most aggressive companies – sometimes only the ones that have sued.
But one of your goals was to avoid being sued. Hopefully, you can avoid this problem by hiring a good debt settlement company instead of one that rips you off.
Another problem with debt settlement is that you might have to pay taxes.
Let’s assume you (or your debt settlement company) negotiates a reduced payoff of a debt. It is very likely that the creditor will issue a 1099-C. This is a notice to the IRS of the forgiven debt. The forgiven debt is income.
Only financial institutions are required to file the 1099-C. So if you’re settling with a creditor that is not a financial institution the creditor may not file the 1099-C. I. That case it would be up to you to tell the IRS that you paid a debt off for less than the full amount.
For example, let’s say you owe Mastercard $10,000 and they agree to accept $5,000 in full and final payment of the account. Great, you’ve saved $5,000. But you now have $5,000 of income that is reported to the IRS.
Fortunately, if you are insolvent when this happens you are not taxed on this income. But you must explain this to the IRS when you file your tax return. If you are insolvent you need to explain this to the IRS on your tax return. You can fill out IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness or attach a detailed letter to your tax return explaining the calculation of your total debts and assets.
You are insolvent when, and to the extent, your liabilities exceed the fair market value of your assets. So it is possible none of your forgiven debt is taxable or it is possible that all or only a portion of it is counted as income
There is another exception to the rule that debt relief income is taxed. If the debt is disputed and you pay something to settle the debt you are not taxed. But it must be a legitimate dispute. Therefore if you do decide to pay a debt at a discount it may be critical that you and your attorney document the fact that you disputed the debt.
Do not ignore a 1099-C. Failure to address the 1099C will result in a tax assessment by the IRS for any amount over $600 plus penalty and interest. This will likely occur 12-18 months after you file when IRS matches up the info reported to them with what is on your tax return. Have a tax professional do your return and they can help you determine how much of the 1099-C is taxable.
Ok so let’s assume you’ve avoided being ripped off by a bad debt settlement company. You’re insolvent so you have no tax problems. You’ve avoided bankruptcy. But you’re broke because you’ve given all your money to the creditors in accordance with the debt settlement plan. Please consider whether it might have been better to have filed for bankruptcy.
If you plan your bankruptcy properly you can keep a considerable amount of assets. Talk to someone that knows about how these actions effect on your credit rating. You might be surprised about the effect of all this on your credit rating. Paying off the debts at a discount might not be any better for your credit rating than filing bankruptcy.