I often meet with debtor’s deciding between whether they should settle their debts or file bankruptcy.
One of the important things to consider when settling your debt is whether you were going to also incur tax consequences for the amount of debt forgiven. If you owe $10,000 and settle for $3,000, not only do you pay the $3,000 immediately, but the $7,000 difference is considered debt forgiveness income. In other words, your taxable base just went up by $7,000.
Now there might be exceptions to avoid this taxable consequence. For instance, if the debt is disputed, the debtor might be able to avoid the tax hit. However, ordinarily, if the amount of debt forgiven is over $600, the creditor will issue a 1099 to the debtor at the end of the year.
The debtor will now have incurred tax income in the amount of debt that was forgiven; therefore, in settling for $3,000, the debtor could now have to pay income taxes on $7,000 worth of income.
The debtor can potentially avoid the tax hit if he is officially insolvent. IRS form 982 is the insolvency form you fill out with your taxes to determine if you qualify for insolvency. Before settling a debt, it is recommended the debtor discusses with his accountant whether he will will qualify for insolvency if he gets a 1099.
If the debtor does not settle the debt and files bankruptcy, the debtor will avoid the income tax consequences regardless of whether he gets 1099, if he gets a discharge in the bankruptcy case. This is because bankruptcy is automatic insolvency. Therefore, while the debtor who settles debts outside of bankruptcy may qualify for insolvency, the debtor files bankruptcy and gets a discharge will qualify for insolvency.