If you have engaged in debt settlement or received other cash settlements, you should receive a 1099 form from the Internal Revenue Service -- in most cases. The form allows the reporting of income from settlements on federal tax returns. Taxpayers receive the forms from debt collectors or other parties in January. Failure to report the information can lead to significant tax penalties.
Considerations
Settling debts for less than the full amount is an effective debt management strategy. SmartMoney reports that credit card companies and debt collectors often settle delinquent credit card accounts for 20 to 70 percent of the balance. A 20 percent settlement on a $20,000 credit card debt allows the debtor to pay off the account for just $4,000 -- an initial savings of $16,000. However, the IRS will treat the $16,000 as income -- and require a 1099 form for reporting purposes. The result could be a higher tax bill for the taxpayer.
Exceptions
Debt settlement usually results in the issuance of Form 1099-C, Cancellation of Debt. The IRS requires the form for any debt settlement resulting in a savings of $600 or more. However, the agency alows exceptions for people who were insolvent at the time of the settlement. Insolvency means the taxpayer had more debts than assets.
Other Settlements
Income from other types of settlements, such as payments from insurance companies, are usually reported on IRS Form 1099-MISC, for miscellaneous income. Reporting of this type of income can also lead to a higher tax bill, but the overall situation is much different than debt settlement because the recipient receives real income from the settlement.
Strategy
Carefully plan debt-settlement transactions to prevent tax problems. A tax adviser can review a list of the your debts and assets and determine whether you qualify for insolvency -- a very important consideration if you plan to settle a large amount of debt -- for example, $10,000 or more.
Timing
If you are not insolvent, settle debts early in the year if possible. Settling in December means facing the tax consequences in April, just four months later. However, settling in January gives you until April of the next year -- 15 months later -- to pay the tax bill. If you are receiving other types of settlements, immediately meet with their tax adviser or accountant to plan for the tax implications.
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