By Garrett Sutton, Esq.

People in debt should, and often do, explore every option before filing for bankruptcy. One option is to settle your debts for less than owed. The company owed takes a partial payment and forgives the rest of the debt. And that forgiveness of debt may just bring the IRS knocking on your door.

I know that it sounds crazy and wrong, but the ‘forgiveness of debt is income’ issue does kind of make sense in a strange way. Suppose you borrowed $10,000 from a company and now you need to pay it back. You are struggling and the company in an unusual burst of magnificence lets you off the hook. They tell you, “You don’t have to pay the $10,000 you owe us.” As a result, you are suddenly $10,000 richer. It is as if you ‘earned’ the $10,000. Can you see where the IRS comes in here? If you earn $10,000, the IRS wants a piece of that. And so when you “earn” $10,000 by having a loan forgiven they want to get a piece of that, too. Accordingly, forgiveness of debt is income, and you can expect the IRS to tax you on it.

To further understand the IRS position it helps to think like a thief. What if a worker arranged with his boss to not receive a salary, but a ‘loan’? A year later the boss forgives the loan because the worker just happened to help him out. The worker maintains he didn’t really earn anything, he just had a loan forgiven. He further maintains he doesn’t owe taxes. Well, if this worked, we’d all do it. And for that reason alone, the IRS taxes it.

If you settle a debt for less than you owe, or if the creditor writes it off, the lender may send the IRS a 1099-C which is used to report “discharge of indebtedness income.” In fact, creditors are required to do this if the forgiven debt exceeds $600. You normally will be sent a copy of this too, but if you’ve moved it may not reach you. The IRS expects you to pay taxes on this “income.” If, however, you qualify for an exclusion or exception, you may be able to get out of paying taxes on some or all of that income.

You’ll be using Form 982 plus instructions from the IRS to walk you through this process. But it can be confusing. Just take a look at the title of that form, “Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).” So I recommend you work with a tax professional who can guide you through it.