Settling your debts in full is a good thing. It can keep you out of bankruptcy, get rid of those pesky collectors, help your credit and let you regain discretion of where your paycheck goes. So when the creditor who you allegedly owe $10,000 offers you a settlement of $2,500, you just saved $7,500, with no strings attached, right? Not necessarily, but why? The answer is taxes.
In the above scenario, you just saved $7,500, but the IRS considers it income. If the amount is over $600, then the creditor is required to send you a form 1099-C. How can it be income? The IRS considers debt forgiveness as income. So how can you get out of increasing your taxable income base by $7,500 with this settlement?
A couple approaches come to mind. The first approach is that if the amount or nature of the debt is at all in dispute, insist that any settlement is on a disputed debt. Also, make sure the language of the settlement agreement states so. If the debt is disputed, it is not debt forgiven and therefore not income. Even if the debt is not considered disputed, you might be insolvent according to the IRS. If a debtor is insolvent, there are no taxable consequences to the settlement. To declare this a non-taxable event due to insolvency, fill out IRS Form 982 and submit it with your taxes.
For those of you on the fence about filing bankruptcy, you might have just made the connection about the problem with settling your debts at the expense of increasing your taxable base. Your income taxes that are not at least three years past due (among other considerations), are non dischargeable. That credit card bill you just settled on the other hand, was dischargeable. So you just possibly exchanged dischargeable debt for non dischargeable debt, on top of paying $2,500.
This is not to say, don’t settle. The point is there are consequences and factors you might not have fully thought about, especially for those who might go the bankruptcy route. Therefore, it is a good idea to discuss any potential settlement with your attorney and/or accountant, before agreeing to anything and sending in that check.
And don’t forget that whenever you settle a debt, make sure before you make a payment that you get in writing from the creditor that it is settled in full accord and satisfaction.