Perhaps the biggest problem with debt-settlement programs is the potential tax consequences. You see, after you have paid a creditor “pennies on the dollar” to settle your debt, the creditor is able to take a tax loss on the remaining balance. The creditor tells the IRS that it has “cancelled the debt.” Unfortunately, the IRS considers a cancelled debt part of your income and you must pay taxes on this “income.”
Getting rid of cancellation of debt income is a tricky issue. If you filed bankruptcy before the debt as cancelled, the debt is discharged by your bankruptcy is not income for tax purposes. Bankruptcy debtors who receive a 1099-C on a discharged debt should inform the IRS that the debt was discharged by filing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. Consult your tax professional for more information.
If the debt is canceled before you file bankruptcy (as in a debt settlement agreement), the cancelled debt is part of your income. While you cannot discharge fresh taxes in bankruptcy, you may still be able to file bankruptcy and avoid incurring the tax debt. The most common way to do this is to convince the IRS that you were insolvent when the debt was cancelled by the creditor.
You qualify for this income exclusion if, on the date that the debt was cancelled, your liabilities exceeded your assets. If you were “partially insolvent,” you must pay some taxes on the debt. For instance, if your total liabilities (including $2,000 of canceled debt) are $7,000, and you have $5,000 in total assets, you must report the $2,000 of the canceled debt as income:
$2,000 Cancelled debt
$5,000 All other debts
$5,000 Total assets
$2,000 Amount of debt imputed as income for tax purposes
As you can imagine, the IRS is skeptical when a tax payer claims insolvency. However, filing bankruptcy soon after receiving the 1099-C may be good evidence of your insolvency.
Cancelled debt income adds insult to injury. If you have debts you cannot pay, speak with an experienced bankruptcy attorney and discuss strategies for discharging the debt. If you have received a 1099-C and you are facing a large tax bill, bankruptcy may still be able to help.