Most of our clients in financial distress strive to avoid the filing of bankruptcy out of the shame that they feel. Because the client does not want to file for bankruptcy, we are often approached about settling debts instead.
While we certainly applaud the desire of clients to attempt to repay their creditors and settle their obligations, and while there may be reasons that a person would actually be better off settling debts rather than filing for bankruptcy (the client has too many assets), the simple fact is that a client may put themselves in a considerably worse financial hole due to the potential tax consequences of forgiven debt.
Under the federal Internal Revenue Code, when a debt you owe is forgiven, the amount of the debt that is forgiven is generally considered income to the person and it must be included on their tax returns as ordinary income. We call this “cancellation of debt” (COD) income.
However, while the general rule is that you include COD income, there are two very important “exclusions” – (1) where you are insolvent, and (2) where you filed for bankruptcy.
The easiest exclusion to consider is if the debt was “forgiven” because of a discharge in bankruptcy. If a debt is discharged in bankruptcy, any resulting COD income is excluded in full. Bankruptcy wouldn’t be very beneficial if, in forgiving your debt, you were suddenly faced with a huge tax bill because you had to include all the forgiven debt as income on your tax return – Ouch!
The other major exclusion is the “insolvency” exception. In general, if your debts exceed your assets, you are insolvent. You can exclude an amount of COD income to the extent that you are insolvent. For example, if you have $200,000 in debts, and $175,000 in assets, you are insolvent to the extent of $25,000 – that is how much your liabilities exceed your assets. But let us say you just negotiated a debt settlement that resulted in forgiven debt of $40,000. Since you are only insolvent by $25,000 then you can only exclude $25,000 of the resulting $40,000 in COD income, meaning you will have to pay taxes on the $15,000 of COD income that you couldn’t exclude.
The obvious difference is that while the bankruptcy exception excludes COD income in full, the insolvency exception may exclude it in full (depending on how the insolvency numbers work out), but it may not as well.
If the client is not insolvent at all, then none of the COD income is excluded and the client faces a large potential tax bill (which is generally not dischargeable for at least 3 years).
For clients who have assets, the question then becomes whether those assets can be protected in bankruptcy from the reach of creditors so that all the debt can be forgiven with no immediate tax consequence. If assets cannot be excluded, then one must consider which alternative (debt settlement vs. bankruptcy) will result in the least amount of loss based on assets and the amount of tax that may have to be paid. It may be that one still comes out financially better in bankruptcy even though some assets may be lost to a bankruptcy trustee in the process.
Deciding whether to settle debts or whether bankruptcy is the right answer is a complex issue. Settling debt can avoid bankruptcy – but the cost may be a huge, nondischargeable tax bill instead. Potential clients should not assume that settling debt is always the best route and that it may result in even bigger problems if the taxman cannot be paid.
