Offering a settlement to end a debt lawsuit helps the defendant in the case avoid a possible court judgment. Settlements usually take place out of court and can result in significant savings for the defendant. For example, a debt collector collecting on an unpaid credit card debt may settle for as little as 20 percent of the balance, although the range is usually 20 to 70 percent, according to SmartMoney. Whatever the percentage, tax consequences could add significantly to the overall cost of the settlement.
Considerations
The Internal Revenue Service usually treats savings realized through debt settlement as income. A defendant settling a $15,000 credit card debt may pay only $3,000 through the settlement, but in most cases the IRS would consider the $12,000 in savings as income.
Exceptions
Not all settlement activity presents tax consequences. People file lawsuits for numerous reasons, such as disputes over property lines. Tax consequences during settlement usually becomes an issue when the plaintiff in the case, such as a credit card company, agrees to cancel debt as part of the agreement.
IRS Form
The IRS usually requires that debtors file a special form for all debt settlement resulting in savings of $600 or more. Creditors and debt collectors agreeing to settlements send debtors an IRS 1099 form in January. The form, titled "1099-C, Cancellation of Debt," outlines the financial terms of the settlement. Debtors who fail to include the form with their tax return are subject to penalties. Creditors and debt collectors send the forms in January, with a copy sent to the IRS.
Exemptions
Debtors who have more debts than assets at the time of their settlement are eligible for an IRS exemption and do not have to report debt settlement savings as income. Having more debts than assets means a person is financially insolvent. A tax adviser can help a defendant determine insolvency according to the IRS guidelines.
Decisions
Debt settlement is usually a good deal for the defendant even with tax consequences. A 1099 filing could result in a higher tax bill, but a defendant paying $3,000 to settle a $10,000 credit card debt is likely to realize a savings overall even after the tax consequences. Allowing the case to reach a judge and receiving a possible settlement could lead to a court judgment for the entire amount.
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