The 1099-C Issue: Potential Tax Liability in Debt Settlement and Bankruptcy

When you owe debts that you cannot pay most will look to one of two options – debt settlement or bankruptcy. What many don’t realize is that in some circumstances there is the potential for additional tax liability even if you pay off most of your debt.

This potential tax liability comes in the form of a 1099-C.

Here’s how it works…if you owe a debt and the creditor cancels or forgives any of the amount owed they are required to send you an IRS form 1099-C for the forgiven amount.  Then, you have to add this amount onto your gross income when you calculate how much tax you owe the government at the end of the year.

For example, if you owe $20,000 on a credit card and enter into a settlement where you agree to pay $13,000 as payment in full then the credit card company would be required to issue you a 1099-C in the amount of $7,000 (the forgiven amount).  Then, when you went to prepare your tax return you would have to add an additional $7,000 onto your gross income and potentially end up pay additional taxes on that amount.

To me this law has always seemed to have the effect of kicking someone when they are down.  The reason you are seeking a settlement is because you are not in a position to pay the debt.  Now, you finally get your creditors to work with you and there is the IRS standing there with its hand out.

1099-C and Bankruptcy

What about bankruptcy?  I mean bankruptcy would seem to be the ultimate in debt forgiveness as almost all of your unsecured debts are completely eliminated.

Well, there is an exception in the law when it comes to bankruptcy.  You will not receive a 1099-C for debts discharged in a chapter 7 or chapter 13 bankruptcy.  If you do, you need to bring this to the attention of your bankruptcy attorney and your CPA.

Can a Credit Card Company Choose Not to Issue a 1099-C?

I work with a lot of clients on debt settlement.  Many of my clients will want as a term of the settlement that the creditor not issue them a 1099-C.  I have asked but in general most creditors will not agree because they believe they can’t agree to this – after all, the law says that they have to issue the 1099-C on forgiven debts.

If you are working through debt settlement you need to take into consideration that you will likely be issued a 1099-C on amounts that are forgiven by the creditor in your settlement arrangement.

Is There Any Way Around the 1099-C?

If you are working on settling your debts and know that you will be receiving 1099-C’s next year during tax season then it is a good year to spend some extra cash and hire a CPA to assist you with your tax return. There are exceptions to the rule on 1099-C liability and you may qualify.  For example if you are insolvent at the time when the 1099-C is issued then you will not be required to pay tax on the amount in the 1099-C.

The IRS defines insolvency as when a person’s liabilities (debts) exceed their total assets.  So if you have more debt than assets you may be considered insolvent by the IRS and thus would qualify for one of the exceptions to the rule when it comes to 1099-C tax income.

The 1099-C is a “no fun” part of debt settlement (and as I write that I guess there really is no “fun” part of debt settlement) but often it ends up being a secondary consideration in your overall debt settlement strategy and many times the tax liability can be avoided all together.