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Tuesday, October 26, 2010

Look Before You Leap: Debt Settlement

(Any reader who is an imamother commentor, feel free to post my advice on any of the recent threads discussing debt settlement. . . . Disclaimer: This post is informational only and does not constitute personalized tax advice, just a summary of potential issues to be aware of).

There have, sadly, been numerous recent posts on imamother from families in untenable financial situations, often accompanied by plenty of debt, usually credit card debt. The "solution" offered by others is to settle the debt. You don't even need a company. . . you can do it yourself! is the advice. Some offer their success stories of negotiating debt down to pennies on the dollar. And, it it worked well for them, it should be something you should try too, right?

Well, maybe not. The decision whether to settle debt isn't just another solution for the amateur to test drive, like asking a credit card company to lower your rate or engaging in juggling debt from one credit card with a promotion to the next. . . . . nor is it particularly advisable to the leave it to the "professionals", i.e. those debt settlement/consolidation companies that have sprung up like weeds with all sorts of incredible claims that could work for you too. (I've noted many companies advertise heavily in the frum world).

Take my advice: before pursuing this route, consult a tax advisor/CPA who is familiar with the issues at hand. Just like in any other profession, the initials alone do not an expert make.

In short, debt settlement, unlike bankruptcy, can be a taxable event. In bankruptcy, unsecured debt is forgiven, although student loans and taxes owed still remain. In a debt settlement, there may well be a taxable event that one needs to prepare for. In such a case, the debt needs paid off as negotiated, and come tax time, an unfamiliar tax document called the 1099-C (Cancellation of Debt) will arrive in the mail and a new debt may be incurred, this one to good ol' Uncle Sam, as well as the State and Locality of residence. The taxable amount will, of course, be taxed at the marginal rate and could eliminate valuable tax credits. This could make the settlement not quite the bargain assumed.

The short of the long is that the amount shown on the 1099-C is taxable up to the net worth of the taxpayer. And, there is the rub. While some professionals in the debt settlement business will tell you ". . . relax about paying taxes on canceled debt balances. That should be the least of your concerns if you're upside down financially. Don't let the misguided criticisms of financial writers (who haven't done their homework) discourage you from looking into one of the most popular and flexible options for achieving debt-freedom," you might define insolvency from a different standard than the legal standard.

(See Pub. 4681) When a taxpayer is deemed insolvent, there is no tax incurred. Where a taxpayer is solvent, tax is incurred on the amount of the debt settlement up to the amount of solvency. The insolvency worksheet (p. 6) assists the taxpayer in determining their Net Worth. Assets include just about everything, from the home to jewelry. Liabilities include all debts owed, from the house to the babysitter.

I can easily envision situations where a debtor may see no way out from their mountain of debt, see settlement as a great option, and end up in a pickle come tax time. This especially could be true where equity exists in a home or business. So, tread carefully. And feel free to point to this very, very incomplete synopsis when others recommend debt settlement. For some, it might smell like roses; For others, like rotten eggs.


JS said...

You raise an important issue (though I think the post is a bit confusing as written). But, the basic point is that old standby, "if it sounds too good to be true, it usually is."

Given the complications of tax and finance, it behooves everyone to consult an expert in the area before doing something like this.

As you mention, debt forgiveness is considered income (26 usc 61(a)(12) and section 108 also).

The real heartbreaking situation which you hint at, is someone discharges their debt, incurs a large tax, and then becomes insolvent due to the tax - in such a situation you're screwed. You can't get out from a tax burden, even in bankruptcy. The irony is that if the person reversed the process by discharging the debt in bankruptcy it would likely be tax-free.

Orthonomics said...

Cleaned up the post. It is probably still confusing. And it should be! The point of the post is that debt settlement isn't for amauters. It is an area of tax law that is not familiar to the general public. The form is not once I ever dealt with in a tax class. If I had to read up on the subject just to gain a passing familiarity, I expect there are those who get blindsighted. Hence the necessity of consulting a professional, even if some person in cyberspace managed to settle their debt without assistance and feels great!

Miami Al said...

Chapter 7 is WAY HARDER to qualify for "high earners," and high is not that high. Chapter 13 is just not realistic for Orthodox Jews... The austerity measures certainly don't preclude living a Torah observant life, but they do preclude living an "Orthodox lifestyle" -- these are VERY different things.

That said, if you owe real money, and are making the payments, and plan to pay it back, better to settle for a fraction. Yes you pay income tax on the difference, but otherwise, you have the pay the difference.

If I owe 100 and settle for 20, and pay 25% tax on the 80 I save, that's 45... That's way better than paying 100. If you can't afford it and can go Chapter 7, you can probably pass the insolvency test, I looked at the form, it wasn't that complicated.

That said, you should not use debt settlement, because the business is a con and it is run by swindlers and conmen.

They will charge you a fee for entering, and a monthly fee. Some of the monthly fee is kept as profit, the rest in their "account" for settling.

So you owe $100, you send them $5/mo, each month they take $2.50 as profit, and have $2.50 set aside for you to pay the creditor. Once they have $20, they start offering settlements.

If you kept the cash to settle and kept calling them up to negotiate every few months, you'd likely come out FAR ahead of using these services.

Orthonomics said...

Miami Al--Before settling, you have to know what the cash requirements are for paying the debt. Also, what is the chance of a layoff? Trading unsecured high-interest debt in for permanent debt can be risky. There are a lot of factors to consider if you aren't plain insolvent.

Miami Al said...

If bankruptcy is under consideration, you are 100% correct. If it is not, you are just moving unsecured high interest theoretically dischargable debt into unsecured, low interest, non-discharable debt. That said, the IRS has an settlement program. So if you are truly bankrupt by the process, you might settle your $100 in debt for $20, owe the IRS $25, and settle with the IRS for $5.

Also, if you are paying it off, it's taxable...

If I pay off $100 in debt, I need to make $100 in post-tax income. So I needed to pay taxes on that $100 ANYWAY, the difference is, with settlement, some of the principal goes away.

Zach Kessin said...

From what I have heard on Dave Ramsey, you are best of avoiding the debt settlement companies. They have huge fees and don't do squat.

That being said if you owe on your credit cards and are behind they will often take a settlement. (They would rather get 20% now then 100% never).

a few points

1) Get it in writing.
2) Don't let them access your bank account, send them a money order.

Listen to Dave Ramsey! (Yes I drank the Dave Ramsey cool-aid)

Anonymous said...

This is an important post. A very clear, simple message needs to be put out there: "Do not use a debt consolidation/ credit counseling service that charges a fee or asks you to give them the money for them to make the payments on your behalf. Use only non-profit debt/credit counseling services,and check reliable sources to determine if they are legitimate, such as the Better Business Bureau or the AG's office consumer protection bureau. Whether you negotiate your own debt relief plan or use a service, be on notice that any debt forgiveness may be treated by the IRS as taxable income so check with a tax professional and plan accordingly."

Anonymous said...

All credit counseling agencies are "non profit" but none of them are. They are all structured as dual company setups. The non-profit fulfills the obligation to be non-profit, and the associated marketing company is for-profit. The board of the non-profit are friends and family of the owners. They take all the profits out for "client acquisition fees" and "employee leasing fees." The thing about debt consolidation:

1. If they charge you a "first pay" it means that the first payment goes to them as profit. A $50-$75 service fee isn't a big deal, and they are supposed to waive it if you ask.

2. If you are concerned about your credit score, the FICO system treats credit counseling as a Chapter 13 Bankruptcy, so if you are in a 5 year payment plan, it's another 7 years after that before your credit recovers.

That said, it will get you into a payment plan to get out of debt with lower interest rates and payments.

Anonymous said...

Anon 10:47 - That is not entirely true. There are some true non-profits that do not charge or collect any fees that provide advice and counseling.

Miami Al said...
This comment has been removed by the author.
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