If you find yourself deep in debt, and are exploring your options to get out, the odds are you’ve considered both bankruptcy and debt settlement. Most consumers don’t realize that debt settlement carries with it significant tax consequences. In order to help you make a more educated decision, there are three rules you should be aware of.
Rule #1: Settling Debts Outside of Bankruptcy Has Tax Consequences
This is a rule that consumers frequently overlook: the IRS taxes forgiven debt as income. Let’s say you successfully negotiate a reduction in your Visa bill from $50,000 down to $10,000. You write the credit card lender a check for the $10,000 and they agree to release you from the obligation to make further payments.
You’ve settled. Credit card debt gone!
Your Balance sheet is improved, or is it? Here’s the rub. After the settlement, your credit card lender will report the amount of debt they have agreed to forgive to the IRS using a tax form called a 1099-C. The 1099-C alerts the IRS to the settlement you reached with your credit card lender. From there, the IRS expects you to pay income tax on that extra $40,000. Your credit card bill may have gown down, but your tax bill just went way up.
Rule #2: The IRS Rarely Agrees to Settle Tax Debts
You see tax settlement companies come and go, but they all offer the same thing: “we’ll settle your tax debts for pennies on the dollar.” In most cases this is simply not true. When the IRS agrees to settle a tax bill, it is known as an Offer in Compromise. Offers in compromise are rarely approved. Make no mistake, the IRS only agrees to write off large chunks of a tax bill if they see no possibility of getting money out of you ever again. This means you can’t work or are elderly. When you hire a tax resolution company to “settle” tax debt, what they’re usually doing is setting up an installment plan for you. In some cases, this adds value, but be very careful who you hire.
Rule #3: Debts Discharged in Bankruptcy Are Not Taxed
This is a big one. In contrast to debts forgiven through a debt settlement, debts discharged in bankruptcy are not taxable. If you get $1,000,000 of debt forgiven in settlement, you will be taxed on that amount as additional income. If you get $1,000,000 discharged in bankruptcy, your tax bill doesn’t go up one cent. The exclusion from debt discharged in bankruptcy from your income tax bill is codified in the Internal Revenue Code section 108(a)(1)(A) which provides:
Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if
the discharge occurs in a title 11 case (a bankruptcy case)
Conclusion: Debt Settlement Has Tax Consequences
For many consumers, bankruptcy is the absolute last resort and maybe that’s a good thing. However, settling debts with your credit card lender only to find yourself in hot water with the IRS makes little sense. The bottom line is this: it is never a bad idea to meet with your accountant as well as a bankruptcy lawyer before deciding on the appropriate course of action.