We often hear the phrase “Too good to be true”. Well, unfortunately when it comes to debt settlement, that statement may be truer (and costly) than you might think. Many people are traveling under the mistaken assumption that if they are able to work out a settlement with a creditor offering to pay less than the total amount owed on the debt, then the balance of the debt will be “forgiven” or “cancelled”.
Tax Consequences of Debt Settlement
If you are attempting to reach a settlement with a creditor, generally the creditor will mention that “there may be tax consequences with regard to the settlement of this debt.” Additionally, they may send a letter regarding the terms of the settlement and somewhere within the contents of the letter, you will see the above statement. What in the world does the creditor mean?
The best explanation I can provide is an example of someone that called me some time ago and presented this scenario:
“I have just gotten a notice from the IRS that I now owe a substantial amount in taxes!”
As we continued talking (I had previously met with this person for a free consultation), I found out that this person who had a $20,000.00 debt owed on a credit card had worked and worked with the creditor to reach a settlement and withdrew from his retirement to pay the settled amount (example: $20,000.00 owed, $10,000.00 was paid to the creditor for settlement of the debt, thus $10,000 was “forgiven”). Many months later, the IRS had received a 1099 form from the creditor for the “forgiven” part of the debt. So the $10,000.00 amount that was “forgiven” was counted to this person as income and taxes would be owed on the “income” (which was actually the “forgiven” debt). As this particular person was ineligible for filing chapter 7 straight bankruptcy, the person was going to have no other choice but to pay the IRS directly or through a chapter 13 case.
If this person had already filed a chapter 7, we would have been able to direct the person to the IRS website to fill out a form, include the bankruptcy case number as evidence of his insolvency and file it with the IRS. Or if the tax return is not due or has not been filed, as long as the bankruptcy is filed BEFORE the tax return, any indebtedness owed to the creditor is thereby discharged and the same form can be attached to the tax return (In these type cases, it is very important to obtain proper legal advice in order for the “forgiven” portion of the debt to be discharged.)
Contact one of our offices near you so that you can meet with an attorney to discuss this issue if you are trying to reach settlements with creditors to find out if getting debts “forgiven” by a creditor will be “too good to be true” for you.