Debt settlement vs. Bankruptcy: When forgiven debt is taxable income

March 20, 2012

empty pockets image: bankruptcy or debt settlement?When individuals struggle with debt, two relief options considered are bankruptcy and debt settlement. As independent law firms, it is important to advise both small business owners and individual clients of the potential income tax ramifications of each choice. Since many debtors view bankruptcy as a last resort, they believe debt settlement is a better decision. What they don’t know, however, is debt settlement can result in an unexpected tax liability.

When a debt is settled for less than what is owed, the debtor pays pennies on the dollar, the lender forgives the remaining unpaid balance, and the parties consider the debt resolved. However, any amount forgiven in excess of $600 can trigger a lender-issued 1099-C, Cancellation of Debt. The 1099-C reports to the Internal Revenue Service the amount that has been forgiven. All type of forgiven debt is subject to 1099-C reporting, including those related to credit cards, student loans, mortgages, and stockholder debt.

Upon receipt of the 1099-C, the debtor is shocked to learn that the forgiven amount is taxable income. If the forgiven debt is significant enough, the debtor may now find they’ve now got a new problem — a huge tax debt owed to the IRS.

However, debt eliminated pursuant to a bankruptcy is not taxable income. Simply put, had the debtor chosen bankruptcy as the mechanism for debt relief, none of the debt — regardless of amount eliminated — would be reported as income.

Despite the debt being discharged in a bankruptcy, the lender might still issue a 1099-C to the debtor. It’s important the bankrupt debtor does not ignore the receipt of a 1099-C. Instead, the debtor must file IRS Form 982 with their tax return. Form 982 explains to the IRS that the debtor is not including the cancelled amount in income because the debt was forgiven as a result of a bankruptcy filing.

The important thing to remember is 1099-Cs cannot be ignored. If the debt is settled, the forgiven amount must be included in income, unless otherwise eligible for exclusion. For the bankrupt debtor, Form 982 must be filed.

If the 1099-C is ignored, the IRS will first send inquiry letters to the taxpayer, asking why the amount was not included in their income and advising of the proposed tax, penalties and interest due. If not explained, the IRS will finalize the amount due and begin collecting on the debt, including setting off of any refunds and garnishing wages.

It is important to know that each debtor’s situation differs from the next, and the information contained in this article is subject to a variety of other factors, exceptions and exclusions. For more information, consult IRS publication 4681, “Canceled Debts, Foreclosures, Repossessions and Abandonments (for Individuals)” or contact a tax professional or bankruptcy attorney for help.

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