Possible Tax Consequences of Debt Settlement

People want to pay their debts.  If there is one thing I have learned over the last 11 years of practicing law is that people generally want to pay the debts that they have incurred.  People usually hire me when they simply can’t.  And in almost every bankruptcy consultation I do clients ask me to discuss different debt settlement options before we talk about bankruptcy options.  People want to do all they can to pay the debt (often to their detriment).

And even though debt settlement may be the preferred route for many people it is important to understand that the amount you agree to pay the creditor as part of a settlement may not be total amount you end up paying on the debt.

This is because the I.R.S. requires that the creditor issue you a form 1099-C for any amounts over $600 that they forgive or settle.  If you receive a 1099-C this means that you have to treat the amount forgiven as income on your next tax return.

For example, if you have a $10,000 debt that the creditor agrees to settle for $6,000, they will then issue you a 1099-C for $4,000 and you would be required to treat that $4,000 as income on your tax forms and pay taxes on that $4,000.

While it is better and cheaper to pay taxes on $4,000 than to actually pay $4,000 it nonetheless needs to be something you are considering at the time you agree to settle a debt.

Most junk debt buyer cases that I deal with are for less than $10,000 – in fact estimates are that 95% of junk debt buyer cases in Arizona are for less than $10,000.  This means that while you may incur some additional tax liability due to debt settlement, if you can get a good deal on your settlement it still may be worth it.

However, if you are getting sued by a debt buyer for a large amount of money you could be looking at a significant tax liability if you enter into a settlement agreement.

The point of this article is really to make sure you that you understand that possibility when heading into a debt settlement so that there are no surprises when next April rolls around.