Let's face it; no one wants to file a Chapter 7 or Chapter 13 bankruptcy. And it is this fact that the debt settlement and debt consolidation companies prey upon. We see it and get asked about it time and again. We meet with a potential client who informs us that they have been making payments to a debt settlement company for months, and the only thing that has been "eliminated" is the money in their bank account (through the payment of the debt settlement company's fee). They're still receiving harassing phone calls from their creditors, their interest rates have been increased to default rates, interest on the debt continues to accrue, and they're potentially now getting sued in court by their creditor(s). So what good was it signing up with a debt settlement company? Unfortunately....probably not much good.
Most Debt Settlement Companies Are Scams.......
For purposes of this discussion, let's dismiss, for the time being, the fact that many of these "debt settlement" companies are out-and-out scams who will end up doing nothing for you but take your money. In fact, back in May of 2009, the Attorney General of New York, Andrew M. Cuomo, launched a nationwide investigation into debt settlement companies, and determined that upwards of 82% were found to be scams of one degree or another. But what about those companies that are not scams?
Debt Settlement Is Not Law And Can Have Tax Consequences........
Well, the theory of "debt settlement" hinges on a position of leverage. The first instructions a debt settlement company will give you is to stop paying your credit cards. The theory is that this will create a position of leverage with your credit card companies for negotiating your balances down (as much as 50% they will tell you). It essentially goes like this: once you stop paying them, the debt settlement company contacts your credit card company and tells them that if they want to receive any money at all, they must agree to reduce your overall balance.
The problem with this: They don't have to agree! This process is pure negotiation...it is not the law! The other problem is that, even if your credit card company does agree to accept 50% of your overall debt in satisfaction of the whole amount (say for instance $10,000 in satisfaction of $20,000), this process involves legal debt forgiveness or cancellation, which, under the current Tax Code, has tax implications. Your credit card company will send you and the IRS form a 1099-C, which you will be required to report on your tax return.
You see, the government doesn't really care how you got out of debt, and they look at this scenario as if someone paid you the other $10,000, and that is how you got out of debt. And, of course, if you're receiving money (even theoretically), the government wants their share, so that forgiven or canceled amount is taxable as income to you just like your income from your job. It is this firm's opinion that many debt settlement companies do not even tell people about these tax consequences.
Bankruptcy Is Law And Generally Does Not Have Tax Consequences...........
As everyone knows, or will now know, bankruptcy is law. In fact, it is Federal Law (with a little bit of state law mixed in). Therefore, there are no negotiations with your credit card companies based upon a theory of leverage. Unlike debt settlement negotiations, a bankruptcy filing tells your credit card companies what is going to happen. Bankruptcy, unlike debt settlement, is not looking for their agreement.
Additionally, as compared with debt that is legally forgiven or canceled through debt settlement negotiations, debt that is discharged in a Chapter 7 bankruptcy or Chapter 13 bankruptcy is generally not taxable as income under the current Tax Code. It's as simple as that!