One of the alternatives to a Chapter 7 or Chapter 13 bankruptcy is a debt management or settlement plan, sometimes called credit counseling. They work similarly. Most people have heard the claims and advertisements. But are the claims true? NACBA has published a report showing real case studies.
Both debt settlement and management result in a forgiveness of debt that results in a tax liability. Forgiven debt is taxable. If the debt is forgiven, the banks turn in a 1099a or 1099c and you pay taxes on the forgiven debt. Even if you complete the plan you lose. If you file bankruptcy and a bank turns in a 1099 by mistake you check a box on the 1099 for being insolvent and filing bankruptcy and there is no tax.
“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 high failure rate. People often have to file bankruptcy anyway after paying into debt management. Chapter 7 normally repays 0% to creditors and rarely fails. Chapter 13 often pays less than 50 percent. Debt settlement is so profitable that many services are operated or paid by credit card companies themselves.
Here are some of the common “promises”:
- “All the creditors work with us.” Debt management or settlement counselors attempt to negotiate lower rates of interest or payments but not all creditors will 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. A federal court order has contempt powers if the court order is not obeyed.
- “We will pay your creditors.” They normally pay themselves first. 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.” 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 a home within 2 years at normal rates. It takes time 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 only leaves you with a 1099 and an IRS tax debt that is often worse than owing the debt.
An income tax form called the 1099 C forgiveness of debt is reported as income to you in the year the debt was written off. A creditor is required to issue an income tax IRS 1009 C to any person that settles a debt or has a debt written off in excess of $600. Try to settle a debt for less than payment in full and have an income tax bill. If you use a debt management firm to settle your debts don’t be surprised when the 1099 C comes in the mail.
If you do a short sale on a house in foreclosure and the bank was not paid all the money look out for a 1099 C. You get a 1099 C if there was is a balance left on the mortgage after your property foreclosed or sold by short sale. The mortgage company will issue you a 1099 C for the difference.
Reporting forgiveness of debt on the IRS 1099 c is required to be issued by any creditor that settles or writes off over $600. If you settle your $10,000 debt for $3,000 you will get a 1099 c for $7,000 and and a tax bill of about $2,000 – $3,000. If you don’t declare this income you will 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 apples to the homeowners of residential real estate only who had the debt written off from 2007 to 2012.
Bankruptcy vs. “Credit Counseling”
You are required to have a “credit counseling” class before and after filing bankruptcy. But this is an evaluation to determine whether you should file bankruptcy and a later class. Debt management, sometimes called credit counseling, is an answer for some situations.
When you pay credit cards through a credit counseling or debt management plan, the banks turn in a 1099. You are taxed as income for the amount of the debt you are forgiven as income. If your debt is discharged in a bankruptcy there are no tax consequences!
- Over 90% of credit counseling agency plans fail. People rarely complete credit counseling. Often, half or more of the money paid is kept by the debt agency. In a 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. Many people find themselves unable to finish credit counseling plan payments, their credit is trashed and their time wasted. With credit counseling agency plans you must complete all of the payments … on time or their plans fail. You can convert a Chapter 13 to a Chapter 7 if a Chapter 13 does not work.
- Although credit counseling agencies promise that they can force credit card companies to settle accounts for pennies on the dollar. The truth is that no credit counseling agency can force banks to accept 50 cents on the dollar. In some states, credit card companies can accept credit counseling payments and still sue for the complete amount later. These states have no accord and satisfaction rules. Only 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 can’t do that.
- Some credit counseling agencies have taken payments from customers and then filed bankruptcy themselves. (see the 2004 story on Ameridebt and the FTC investigation of the industry on the FTC website). Credit counseling agencies pay themselves from what you pay them. Credit counseling agencies often take up to 50% of what you pay them as a “fee”. This has left thousands of people still in debt and their money taken.
- Credit counselors often advise people that by paying 50% of what you owe that you can “repair your credit record.” If you partially repay your debts your credit will be just as bad as if you had filed bankruptcy. Both credit counseling plans and bankruptcy are rated as an I-9 unpaid charge off on your credit file.