What are the tax consequences of debt settlement?

Your financial situation is desperate, unpaid bills are piling up and the phone will not stop ringing with calls from your creditors. You finally notice one of the numerous debt settlement offers floating around that claims it can eliminate your debt for less than half of what you owe. This sounds great. You have never really paid attention to the offers before, so you focus on the ad and think to yourself, wow this seems perfect, and a much better option than the bankruptcy I was considering.

For many consumers who are facing bankruptcy, debt settlement may seem like a very reasonable alternative. At first glance, the process appears quite simple: the debt settlement company negotiates past due balances with creditors and eventually agrees to a reduced lump sum amount which upon receipt will be viewed as payment in full. Done and done.

Ironically however, and what many consumers do not realize about debt settlement is that consumers who can actually afford the advertised debt settlement programs are the ones who will also suffer the greatest consequences as a result of the settlements.

In other words, if you were thinking about bankruptcy protection as your best financial relief, but are now feeling persuaded to settle your debt through a third party settlement company you should at least be aware of the looming tax consequences that can result.

There is at least one major hang-up with debt settlement in terms of taxes: the IRS views forgiven debt from debt settlement as taxable income. You will likely owe income taxes on the debt that was erased through your settlement. Yikes.

This tax burden can be crushing and leaves many consumers in a worse position than they were in the first place. Imagine a consumer’s income tax rate is 25% and they have successfully eliminated $10,000 in debt through a debt settlement company. The $10,000 of forgiven debt now equates to $2,500 in taxes owed to the IRS for the year.

So while the creditors may have written off the debt, the IRS will not dismiss the tax liability on the funds they consider to be income. Insolvency is the exception to this rule, but only protects a consumer to the point of their insolvency. That is to say consumers whose liabilities outweigh their assets can file IRS form 982 which will petition the IRS to waive the taxes owed. If they are determined to be legally insolvent, the debt can be protected from income taxation, but only up to the amount of they were determined to be insolvent. Even those deemed insolvent are not completely protected from IRS taxation with debt settlement programs.

Bankruptcy however, will offer complete protection from the income tax burden that would otherwise exist through a debt settlement process. With bankruptcy there is no limit on the amount of forgiven debt that can remain free of income tax. By law, when debts are forgiven through a bankruptcy, none of the eliminated debt is considered to be taxable income.

In light of the tax issues alone, bankruptcy protection oftentimes proves to be a better option than debt settlement for many facing financial hardship. Where a debt settlement program may leave an unmentioned lingering tax burden, a bankruptcy will often provide a complete financial fresh start.

For consumers racked with unpaid bills, debt settlement programs may seem like a tempting alternative to bankruptcy, but understanding the future tax implications should be crucial to making this decision. A free consultation with a good bankruptcy attorney can be the best place to start.
If you live in New York, are considering bankruptcy relief or have questions about the taxes consequences of debt settlement, please contact the Law Office of William Waldner for a free bankruptcy consultation. We only practice Bankruptcy Law and are always here to help.

The following posts offer more information on how to deal with debt:

How to wipe out credit card debt

Read This Before You Starting A Debt Consolidation Program

Call 212-244-2882 to arrange a free bankruptcy consultation today. Mention this blog post when scheduling by referencing the promotional code: DBT212 to receive the required 3 bureau credit report, and required credit counseling course, both free with any signed retainer agreement.

This article is intended for educational purposes only. By reading this article no attorney-client relationship has been created.