Debt settlement or a debt management plan is an out-of-court alternative to bankruptcy. In a debt settlement, the creditor and debtor get together and negotiate a lump sum payment or payment plan that satisfies both sides. In a debt management plan, the debtor and creditor agree to a repayment plan and some creditors offer hardship programs for customers with financial difficulty.
DON’T ATTEMPT DEBT SETTLEMENT WITHOUT AN EXPERIENCED ATTORNEY
It is best to get advice from a Certified Specialist in bankruptcy law before you attempt a debt settlement or debt management plan. Debt settlement can be a heated and stressful process. Debt settlement requires organization, planning and patience. The Internal Revenue Service (IRS) treats forgiven debts as income and will expect you to pay income tax on the forgiven amount (see below). There are other hidden dangers that so-called debt settlement companies or some lawyers won’t tell you about. A Certified Specialist in bankruptcy law can guide you with comprehensive legal advice and experience.
A debt settlement plan should not be undertaken without a comprehensive review of your debt problems, your assets and your other legal options. Getting solid legal advice and considering all your options will reduce your stress and put you in control of your future. In addition, working with a skilled attorney will protect you from dishonest debt collectors working for your creditors with shady repayment schemes or illegal collection practices.
RED FLAGS – IS DEBT SETTLEMENT A GOOD IDEA?
Debt settlements are a great deal for the outfits who offer them, including lawyers. They advertise miracle results, maybe charging you hefty upfront fees, and often have a lucrative contingency fee on the tail end that you have to pay. Caution—lawyers can make a lot more money doing settlements than filing someone’s bankruptcy case. That helps explain why there is so much advertising done by lawyers and others promoting debt settlements. Never mind what is in the client’s best interests, and never mind that they usually never work out as promised.
In almost all cases, debt settlements are simply a bad deal for the client. There are very few clients that will benefit from doing debt settlements. As lawyers practicing bankruptcy law in Los Angeles with more than 34 years of experience, our firm will provide debt settlement services, but only in those very rare instances where it provides a tangible benefit for our client.
So if debt settlements are not such a good idea, why not? Here are a few issues to consider before jumping into a debt settlement:
- Income Taxes. A big drawback with debt settlements is that some people will owe income taxes on the amount of debt that is forgiven. Suppose someone owes $10,000 to a bank, and we get the bank to settle with our client for just $4,000, forgiving $6,000. Some people will owe income taxes on the $6,000 of debt that has been forgiven.
- More Tax Talk. The tax codes normally treat the amount of a forgiven debt as if it was ordinary income, earned in the tax year that the debt was forgiven, and then assess income taxes on it. The philosophy behind this is that money you borrowed but don’t have to repay gives you the exact same financial benefit as if it was money that you actually earned.
- A Little Tax Loophole. There is a narrow exception to this rule. If the taxpayer can prove financial insolvency at the time of the debt forgiveness, taxes won’t be owed. Proving insolvency to the IRS may be difficult. The IRS will look at the value of all your assets. Many people have home equity and retirement savings that the IRS will count as assets. You might feel broke, but on paper the value of your assets might be more than the amount of your debts, and thus you are financially solvent and not immune to the tax consequences of debt settlement.
- Bad Credit. Debt settlement does not save your credit, and it does not restore good credit to people who already have bad credit. Having good credit means that you always pay the full amount you are supposed to pay, and you always pay it on time. In almost all cases, a lender will not compromise over a debt unless the debt is already seriously delinquent. Why would they give a discount to someone who always pays on time? If you are current on the debt payment but want to get it settled for less than you owe, you probably won’t have any success. If you let your debt get delinquent to the point where a lender is willing to settle, you have ruined your credit. It may take many years for it come back, if ever. Paying less than the amount you owe to settle a debt gives you a lousy credit reputation, and your credit report may reflect that for the next 7 years.
- Often, No Real Benefit Can be Acheived. Of course it would be foolish to intentionally let good credit turn bad because you want to try and get debt settlements. Let’s say you owe $10,000 on a credit debt that is current and in good standing. You let it go delinquent for the next 12 months, hoping that things will get to the point where you can get a very favorable settlement. Six to twelve months of delinquency is about where the chances of a settlement become realistic. Most credit cards will immediately jump to 30% or more interest after the first month that the card is in default, and there will also be accruing late fees every month (and there can also be over monthly limit fees tacked on). After one year, the debt will probably have grown to $18,000. If you then settle for 50%, you must pay the bank $9,000. You might also pay fees of $2000 to a lawyer or a debt settlement company, and perhaps you pay $1500 in income taxes on the amount of debt forgiveness. To settle that $10,000 debt, you might spend $12,500—and you ruined your credit.
- No Easy Monthly Payments. Most lenders require payment in a lump sum when they settle with you. They usually will not settle at a discount and let you make monthly payments. They already had that arrangement with you, and it didn’t work. And in cases where payment plans might be available, your credit will continue to be damaged monthly during the term of the payment plan. You will not be “rebuilding” your credit standing and establishing a good (new) payment history.
- Bankruptcy May Work Better, and No Tax Owed on Discharged Debts. Most clients who would like to make debt settlements are actually perfect candidates for bankruptcy. If you are insolvent, you won’t owe taxes on debt forgiveness, but you will be paying out a lot of money, often 50% of what you owe, sometimes less, but sometimes more. Why pay out that money and still have bad credit? Just think to yourself the other things that you could do with that money. Under Federal tax law, you do not owe income tax on debts that you discharge in bankruptcy.
- The Ideal Settlement Candidate. The ideal debt settlement candidate walks into our offices with debts that already have a longstanding delinquency, and has valuable assets that might be worth too much to protect in a bankruptcy case, perhaps money from a recent inheritance or some other windfall. Such people are few and far between. Most people with a serious debt problem will find their best solution by filing bankruptcy.
The promoters of debt settlements have made heavy investments in advertising. These promoters will only make money if they convince you to enter into a debt settlement. So of course they always recommend a debt settlement or repayment plan outside of bankruptcy. This is true even where a bankruptcy filing is clearly the best remedy for the client.
Take the time to have your financial situation analyzed by a Certified Specialist in bankruptcy law and to consider all of the consequences of a potential debt settlement. At the same time, consider your other options and get sound legal advice.