Debt Settlement And Income Taxes

Debt Settlement And Income Taxes
Debt Settlement And Income Taxes

A very large number of people find themselves owing thousands of dollars to credit card companies and as a result, searching for viable options to successfully eliminate their debt in order to avoid a bankruptcy filing. Debt settlement has become a very popular alternative to bankruptcy among scores of individuals – especially since the bankruptcy laws changed back in October 2005. As you may know, debt settlement is a process which enables debtors (consumers) to negotiate a reduced pay-off balance (normally 50% or less) with their creditors. When the agreed-upon settlement amount is paid, the remaining balance is forgiven, and no further debt is owed.

When creditors agree to settle an account for less than what is actually owed, they are required by the IRS to report any forgiven debt over the amount of $600 on Form 1099. The potential of facing a tax liability resulting from debt settlement can be unnerving to a good many people, including consumers, as well as some debt counselors. On the other hand, an equal amount of people have difficulty understanding this train of thought, and feel that the possible tax consequences of debt settlement shouldn’t play a major role in whether or not one should choose debt settlement to free themselves from debt.

If you should owe taxes on the amount of your forgiven debt, it’s simply due to the fact that you saved a significant sum of money. Because of this it seems that it would be common sense to realize that the total amount of money you paid to your creditor, in addition to the income tax liability, would still be a great deal less than what you would end up paying if you were to continue making the minimum monthly payments on your accounts each month. As a matter of fact, it’s more than likely that the interest you would end up paying to a creditor over a period of years would easily exceed the taxes for which you may be liable, as a result of settling your debt.

There’s also a strong likelihood that you may not be required to pay taxes on your forgiven debt if you’re able to prove that you were “insolvent” at the time you settled your debts. In order to be classified as insolvent it is required that have a negative net worth, meaning your liabilities must exceed your assets.

Now, if this is not the case, and you don’t qualify for an insolvent classification, obviously you may owe at least something to the IRS. If you believe this to be so, it’s important to talk with a tax professional so that you may obtain proper advice pertaining to your particular situation. If you simply don’t know where you stand regarding the insolvency rule, it’s a good idea to carefully review IRS Publication 4681 for additional information.

Have a Federal Tax issue you are dealing with, such as cancellation of debt or insolvency? The Neighborhood Christian Legal Clinic – Low Income Taxpayer Clinic can consult with you to provide advice regarding your IRS tax issues, and/or potentially act on your behalf for FREE if you qualify for assistance (come to a clinic intake session)!


Jim Floyd is the Staff Enrolled Agent at the Neighborhood Christian Legal Clinic – Low Income Taxpayer Clinic.

As an Enrolled Agent, Jim is a federally-licensed tax practitioner with unlimited rights to represent clients before the Internal Revenue Service. This means he is unrestricted as to which taxpayers he can represent, what types of tax matters he can handle, and which IRS offices he can represent clients before. Enrolled agent status is the highest credential the IRS awards.

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