In a recent issue of the L.A. Times, Liz Weston compared bankruptcy and debt settlement as ways to deal with overwhelming debt.  Her column was good, but given the limited space she had, it was a bit brief.  In this post I will expand on her discussion.


I.  Debt Settlement


The idea behind debt settlement is pretty simple:  You ask the creditor to accept less than you owe in full satisfaction of the debt.  You can do the negotiation yourself, or you can hire someone to negotiate on your behalf.

If the creditor agrees to lower the balance, you pay the reduced amount, either in one lump sum, or in a stream of payments.  Unless you have a friend or relative to help you, the lump sum approach isn’t too likely because if you had the lump sum the creditor would assume you could get more and would demand more.


      A.  Pros Of Debt Settlement


  • You get a resolution to your debt problem ― at least with that particular creditor.
  • You don’t have a bankruptcy on your credit reports.


     B.  Cons Of Debt Settlement


          1.  The Free-Rider Problem


A creditor may be reluctant to believe you when you claim to be unable to pay.  Indeed, the creditor may ask for documentation of your income, expenses, assets, and liabilities to determine what you really can afford to pay.  And if the creditor learns that you have other debts, it may tell you to pay it in full and let the other creditors take the hit.  This is known as the free-rider problem.


          2.  The Demand To Liquidate Assets


If you own your home, or have other valuable assets, such as a retirement account, the creditor may demand that you take out a second mortgage, borrow from your 401(k), or liquidate assets to pay.


          3.  The Tax Hit


If the creditor agrees to accept less than full payment, then it will write off the unpaid portion for tax purposes.  It will then issue a Form 1099-C to you, and send a copy to the taxing authorities.  It will do this to lower its taxable income, and thus lower its tax liability.

When that happens, the written off liability will be credited to you as income ― sometimes known as cancellation of debt income, or imputed income from discharge of indebtedness ― and you will owe income tax on that phantom income.  Thus, the tax liability will be part of the cost of the debt settlement.

By the way, you might wonder why the forgiven debt counts as income.  There are three ways to view it.

First, the creditor’s forgiving the debt was, from your perspective, economically equivalent to you earning the money and paying the creditor.  Thus, you had a taxable event.

Second, when the creditor forgave you the debt, you received an economic benefit in the amount of the forgiven debt.

Third, if you had paid the creditor, the money would have been taxable income to the creditor.  When the creditor forgave the debt, it not only didn’t have that income on which it would have been taxed, it reduced its adjusted gross by the amount it wrote off, meaning that the taxing authorities lost revenue.  They make up that revenue by taxing you on the forgiven debt.


          4.  Inability To Make The Payments


Suppose the creditor agrees to accept a reduced amount through a stream of payments, but you lose your job and become unable to make the agreed upon payments.  When you stop making the payments you breach the contract.  The creditor may elect to sue you as a prelude to levying funds from your bank accounts, garnishing wages once you find another job, and recording a lien against you and your assets.

In sum, debt settlement doesn’t always solve the problem.  If it did, we wouldn’t have bankruptcy.


II.  Bankruptcy


There are two ways to deal with your debt problem in bankruptcy.  The most commonly used one is a Chapter 7 bankruptcy, which discharges the debt without you making any payments to the creditor.

Not only does this wipe out the debt, it avoids the tax hit because of a provision in the Internal Revenue Code (emphasis added):  “Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—the discharge occurs in a title 11 case.”  26 U.S.C. § 108(a)(1)(A).  (Title 11 is the Bankruptcy Code.)

If your income is too high ― in a way that can be made precise ― to qualify for Chapter 7, you can use one of the reorganizing chapters:  Chapter 11 and 13.  In those chapters you propose a plan to repay some of what you owe based on (a) what you can afford, and (b) the value of certain of your assets.

But isn’t that just like debt settlement?  Sort of.  But there are two very important differences.

First, outside of bankruptcy you have to convince the creditor to accept your offer.  In a Chapter 13, once the judge confirms the plan the creditor has to accept its terms.  You have the power of the United States federal government behind you to enforce the terms.

Second, as with Chapter 7, there is no tax hit for the same reason as in Chapter 7.

You might have noticed that I suddenly focused on Chapter 13.  What about Chapter 11?  You can certainly reorganize under Chapter 11, but unlike in Chapter 13, in Chapter 11 the creditors get to vote on the plan.  Therefore, unless there is a very good reason to file a Chapter 11, you are better off in either a Chapter 7 of Chapter 13.


     A.  Pros Of Bankruptcy


Based on the foregoing discussion, bankruptcy can get rid of debt entirely, or else make repaying it manageable, and there is no tax hit on the discharged debt.


     B.  Cons Of Bankruptcy


Bankruptcy stays on your credit reports for ten years, though you’ll be able to get credit and loans as soon as you get your discharge.  However, it may take a while to get the interest rates down and the available balances up.

And some people feel a bit uncomfortable about going into bankruptcy.  If you’re one of those people, it might help to know the following:


          1.  Bankruptcy In The Bible


Nationwide bankruptcy was mandatory every seven years in ancient Israel because of this passage:

At the end of every seven years thou shalt make a release.  And this is the manner of the release: Every creditor that lendeth aught unto his neighbour shall release it; he shall not exact it of his neighbour, or of his brother; because it is called the LORD’S release.

Deut. 15:1-2

Who am I to argue against God who didn’t want people to be debt slaves?


          2.  Bankruptcy In The Constitution


The Bankruptcy Code was enacted pursuant to the U.S. Constitution, article I, section 8, which gives Congress the power to “establish uniform Laws on the subject of Bankruptcies throughout the United States.”

Thus, you can view bankruptcy as your constitutional right.


          3.  Faces Of Bankrupts On Our Currency


Most of our paper currency has the visages of people who went bankrupt.  This includes several presidents.

The list of notables who went through bankruptcy and later became fabulously successful include Walt Disney before he successfully made vermin cute, Milton Hershey before he made his name synonymous with chocolate, and Henry Ford before he found success making and selling cars.

Bankruptcy isn’t for everyone, and ultimately, of course, you must make the decision.  Look five years down the highway of life.  Will you be debt-free, except perhaps for a home mortgage?  If the answer is “Yes,” then you don’t need bankruptcy.  If the answer is “No,” then you really ought to consider filing for bankruptcy protection.

And if you’re a debtor in the Central District of California who is considering using bankruptcy to deal with your debts under Chapter 7, 11, or 13, call an attorney who is a board-certified bankruptcy law specialist to represent you.


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