Debt settlement can be an effective way of reducing your debt load to a manageable level. Rather than filing bankruptcy, debt settlement allows you to negotiate a payment for at least some of your debt. Unfortunately, settlement can have additional financial ramifications, since the creditor that agrees to reduce your debt usually has to report that amount to the Internal Revenue Service.
Debt Settlement
Debt settlement occurs when your creditor agrees to accept as payment-in-full a payment that is less than the total amount you owe. Typically, you will have to make a lump-sum payment to the creditor in exchange for the reduced total balance. Since it can be difficult to personally negotiate a reduced balance with a creditor, some debtors hire debt settlement companies to negotiate on their behalf. Debt settlement firms tend to charge high fees and are not always entirely successful at settling the balance due. But often they may be able to negotiate with your creditor more successfully than you can.
Once your creditor accepts a settlement proposal and you make your agreed-upon payment, the debt is considered to be paid in full. The creditor will issue you an IRS Form 1099-C at the end of the year indicating the amount by which it reduced your debt. This form also goes directly to the IRS.
Taxation of Canceled Debt
The Form 1099-C your creditor sends you after the completion of a debt settlement plan is more than a simple notification. The IRS considers canceled debt listed on a 1099-C to be taxable income. You must report this amount to the IRS as part of your gross taxable income when you file your taxes. As a result of this taxation, the settlement deal you or your representative firm negotiated with your creditor may not be as good as it originally seemed. For example, if you are in the 30 percent tax bracket and you settled your debt down to $5,000 from $20,000, you may owe $4,500 in taxes from that settlement.
Bankruptcy
While debt settlement may be a way to avoid bankruptcy, the taxation of your canceled debt may be a huge negative compared to bankruptcy. If you discharge your debts in a bankruptcy case rather than through a settlement, your unpaid debt is not taxable. While both forms of debt elimination damage your credit report, a bankruptcy may remain for up to 10 years, while debt settlement and other negative accounts generally last seven years.
Insolvency
Insolvency is another way to avoid taxation of your settled debts. While your creditor must still send a Form 1099-C to the IRS showing the amount of your canceled debt, you can file Form 982 to avoid taxation if you are insolvent. For IRS purposes, insolvency means you owe more debt than you have in assets. If the amount of your canceled debt exceeds the amount by which your debt exceeds your assets, you may still have to pay tax on a portion of your settlement.
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