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Debt Relief – Insolvency – Bankruptcy Information » Debt Relief, Insolvency » The Effects of Debt Settlement on Tax Liability

The Effects of Debt Settlement on Tax Liability

Article by Otto Wynn

(The author of this article is not a tax attorney, CPA, or enrolled agent, and this is not to be considered tax advice. If you need tax advice, you should consult someone who is certified in this arena.

Did you hear about Bill Gates? He decided to give away all his shares of Microsoft and start working at a car wash in Seattle. When Larry King asked him why he decided to do it, Gates admitted that he was losing too much money on the taxes. You see—by making $ 7 an hour, he would be in the lowest tax bracket, and if he could manage to make less than $ 19,000 a year, then he would not have to pay any taxes at all! Back when he was making a $ 1 billion annually, he was left with $ 500 million after taxes every year. So Gates thinks he can make more money this way.

As preposterous as the above example sounds, it’s exactly the same logic employed by consumers who fear the tax implications of debt settlement. For one, most people enrolled in debt negotiation programs don’t have to pay taxes on their savings as is (more on this later). Secondly, why in the world would it ever even deter you from enrolling in a debt settlement program anyway? It’s literally the equivalent of someone turning down a million dollar salary for minimum wages because of the favorable tax implications. Consider the following scenario.

Frank owed $ 20,000 at 19% interest when he enrolled in a debt settlement program. When it was all said and done, Frank was able to reduce his debt down by 45% and in the process he saved $ 9000 off the balance alone. Unfortunately, each of his creditors reported his savings to the IRS and he was forced to tack on $ 9000 to his $ 40,000 annual income. So he was taxed like he made $ 49,000, which put him in the 30% tax bracket and meant he had to come up with $ 2700 on April 15th. Regrettably, Frank did not have the money, so he got on a payment plan with the IRS, who charged him their current interest rate, which happens to be 8 percent annually. In the end, Frank paid off the IRS in 1 year for $ 2916. This means that Frank in actuality only saved about $ 6,000 off the balance. So would Frank have been better off continuing to pay the minimums instead of settling his debts? Let’s see. He saved $ 6,000 off the balance alone and roughly $ 40,000 in interest charges, which brings his net savings to $ 46,000. It’s pretty clear that it was still in Frank’s best interests financially to do debt settlement.

It does not end here. Most debt settlement candidates never have to pay taxes on the debt anyway. The IRS exempts anyone who was technically insolvent at the time their debt was settled from having to pay taxes on the savings. So the next question is, what does it mean to be insolvent? According the IRS, someone is insolvent when their assets (what you own) exceed their liabilities (what you owe), and it should come as no surprise that when someone is at the point when they’re seeking debt relief, they’re probably in debt up to their eye balls and therefore are insolvent. If you owe more than the value of your assets, then all you have to do is fill out IRS form 982 along with your tax return illustrating this fact. All told it will probably take you a couple hours to do this, and if you saved $ 46,000 like Frank in our example, then it’s the equivalent of making $ 23,000 an hour. Unless you’re Bill Gates, it’s probably worth it.

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