If you miss payments on a credit card, medical bill, or some other type of unsecured debt, chances are good that at some point you will receive an offer to settle the debt for a lump sum. The settlement offer may state that you can repay the debt for only 50 cents on the dollar. These types of offers usually require that the debtor make a lump sum payment to the creditor. If you have the money to spend then this may seem like a great offer, and depending on your financial situation it may in fact be a good deal.
However, before settling your debt, calculate the actual cost to you of accepting the agreement. The creditor may not tell you that the portion of the debt that is cancelled will be reported to the IRS as income. This means that you will have to pay taxes on the cancelled debt. That isn’t the worst part though. The cancelled debt may cause you to jump a few tax brackets which could mean that you have to pay a higher tax rate on your entire income. Once the actual cost of settling the debt is calculated you may find that there is little savings.
Bankruptcy is different in that debts discharged in bankruptcy are not considered income for the purpose of calculating tax liability. Creditors sometimes file a 1099C on discharged debt. However, when this happens the debtor can file a form 982 with the IRS. Doing so will cause the 1099C to not be treated as income, and as a result the 1099C will not affect tax liability. This is a great benefit to bankruptcy debtors. Without this advantage bankruptcy would be much less effective as a tool for discharging and reorganizing debt.