One of the worst alternatives to Chapter 7 or 13 bankruptcy is debt management or debt settlement plans, sometimes called credit counseling. But, please don’t confuse this with the credit counseling certificate requirements for bankruptcy. Most people are aware of the claims and advertisements of these debt management agencies. But, are their claims true or are the schemes? NACBA has published a report showing real case studies.
The biggest problem with debt settlement or management agencies is that their efforts result in forgiveness of debt that results in a tax liability becaues the forgiven debt is taxable. So, when the debt is forgiven, the banks turn in a 1099 A or 1099 C and you pay taxes on the forgiven debt. So, even if you complete the plan, you lose.
Conversely, if you file bankruptcy and a bank turns in 1099 by mistake, then, you check a box on 1099 for being insolvent and filing bankruptcy. Then, you have no additional tax debt.
The Fallacy of Debt Management or Debt Settlement Plans
“Sign up for debt management and we will settle your debts for 50%.” Yes, debt settlement and debt management attempt to settle debts for 50% but they have a very high failure rate. People often have to file bankruptcy anyway after paying into debt management. The truth is, debt settlement is so profitable that many services operate or paid for by credit card companies themselves.
However, Chapter 7 normally repays 0% to creditors and rarely fails. Additionally, Chapter 13 often pays less than 50%. Think about that!
⎆ Some of the misleading “promises” they make.
“All the creditors work with us.” False! Debt management or settlement counselors attempt to negotiate lower rates of interest or payments but not all creditors accept it. Bankruptcy uses court orders from a federal judge that can strips liens and mortgages and eliminate debt. You are not reduced to begging with creditors. In fact, a federal court order has contempt powers if the court order is not obeyed.
“We will pay your creditors.” False! They normally pay themselves first. Then, payments are given to creditors at the end of plans. Often the only person paid is the debt settlement company if you don’t complete the plan.
“Debt management is better for credit than bankruptcy.” False! Both bankruptcy and debt settlement will tank your credit scores if you file. After the bankruptcy discharge, most people can buy a car within a year or home within two years at normal rates. It takes time when repaying your debt on time to build a high FICO score and eventually it can be repaired.
If you are considering whether to file bankruptcy or use debt management, understand that paying your debt in part, unfortunately, leaves you with a 1099 and an IRS tax debt that is often worse than owing the debt itself.
⎆ Bankruptcy vs. credit counseling.
Please don’t confuse this with the requirement to complete a “credit counseling” class before and after filing bankruptcy. However, “debt management”, sometimes called “credit counseling”, is an answer to very few situations. The absolute truth is that over 90% of credit counseling agency plans fail.
⎆ Why debt management plans fail when bankruptcy is successful.
1. Beware of the debt management 1099 C trap.
First, when you pay credit cards through a credit counseling or debt management plan, the banks turn in 1099 C. In other words, you pay taxes as income for the amount of the debt you are forgiven as income. Conversely, if your debt is discharged in bankruptcy there are no tax consequences!
If you do a short sale on a house in foreclosure and the bank is not paid all the money, you get a 1099 C. You also get a 1099 C if there is a balance left on the mortgage after your property forecloses or sells in a short sale.
Reporting forgiveness of debt on the IRS 1099 C is a requirement for creditors that settle or write off over $600. For example, if you settle your $10,000 debt for $3,000 you get a 1099 C for $7,000 and a tax bill of about $2,000 – $3,000. If you don’t declare this income you also get non-reporting and negligence penalties.
There are two exceptions to the 1099 C forgiveness of debt. The first is you are insolvent when the debt is written off (bankrupt). The second is you file bankruptcy before the debt is written off and the 1099 C is issued, there is also no income to declare. If you file bankruptcy after the 1099 C is issued you still have to declare that as income.
There is a third exception for real estate. This is the Mortgage Forgiveness Act of 2007. It applies to the homeowners of residential real estate only who wrote the debt off from 2007 to 2012.
2. Debt management is difficult to complete.
For one thing, people rarely complete credit counseling. Often, half or more of the money paid is kept by the debt agency. In Chapter 13, if you make most of your payments and can’t finish, you may get a hardship discharge. But if you don’t make all the credit counseling payments you still owe the debts.
Most people find themselves unable to finish credit counseling plan payments. All it does is trash their credit and waste their time. With credit counseling agency plans you must complete all of the payments … on time or their plans fail. But, by planning and filing bankruptcy, you can convert Chapter 13 to Chapter 7 if Chapter 13 doesn’t work.
3. Debt management has no power over creditors whatsoever.
Although credit counseling agencies promise that they can force credit card companies to settle accounts for pennies on the dollar, it is simply untrue. Rather, in some states, credit card companies accept credit counseling payments and still sue for the complete amount later. That’s because these states have no accord and satisfaction rules.
Conversely, only the bankruptcy court can force banks to take pennies on the dollar and many bankruptcy plans offer 10% or less on the dollar. Credit counseling agencies and debt management plans simply cannot do that.
4. Debt management is often a fly-by-night scam.
Some credit counseling agencies take payments from customers and then file bankruptcy themselves (see the 2004 story on Ameridebt and the FTC investigation of the industry on the FTC website.) What the credit counseling agencies do is pay themselves from what you pay them before they pay your creditors! Credit counseling agencies often take up to 50% of what you pay them as a “fee”. This leaves thousands of people still in debt and with their money gone.
Credit counselors often advise people that by paying 50% of what you owe that you can “repair your credit record.” However, if you partially repay your debts your credit will be just as bad as if you file bankruptcy. Both credit counseling plans and bankruptcy are rated as an I-9 unpaid charge off on your credit file.
If you are thinking about filing bankruptcy, don’t delay because timing is crucial. I am here to help you. So, contact my office right away to start the conversation. Nick C. Thompson, Bankruptcy Lawyer: 502-625-0905.