Q:  Should I try to negotiate my debt with my creditors or set up a debt repayment plan with a credit counseling agency instead of filing for bankruptcy?

A:  I recommend looking into all available methods to repay your creditors before resorting to bankruptcy relief. However, regardless of the proposed method, get all the facts. Often, people try to repay their creditors through repayment plans but wind up in bankruptcy anyway for various reasons.

You will only find out if a creditor is willing to negotiate the debt or terms of repayment if you ask. You must take the initiative to contact all your creditors directly. Before calling, figure out what repayment terms are favorable (i.e. settlement of what percentage of the balance, reduction of interest rate, amount of monthly payments, and number of payments) but also exactly what repayment terms you can afford as a bottom line.

You will find that some creditors are willing to negotiate, and others are not. Some companies refuse to negotiate. Most payday loan companies fall in this group. Credit counseling agencies also generally cannot help with payday loans. The unwillingness of some creditors may squash your hopes of getting out of debt. If you must have complete cooperation from creditors, then contacting the creditors directly is not likely to be effective.

Credit counseling agencies and debt consolidation companies offer debt repayment programs. They also make many promises. Historically, they have hit-or-miss success and bad reputations. Some research on your part will be required to find a reputable company. Look for agencies approved by the government, national consumer advocacy groups, and/or the Better Business Bureau.

Q:  What is the most important consideration in debt settlement or negotiation?

A: It is imperative that you understand the treatment of forgiven debt by the Internal Revenue Service. The IRS treats the forgiveness of debt outside of bankruptcy as taxable income. The forgiveness of debt is considered "phantom income". Essentially, an individual receives a benefit that he or she did not pay for. That benefit is therefore considered income and taxed by the IRS.

In debt settlements, creditors issue a Form 1099 for the amount of the debt forgiven so it can write off the debt forgiven as a loss. The Form 1099 is sent to the IRS and a copy should be sent to debtor personally. The debt forgiven must be listed as income on the tax return for the year that it was forgiven unless an IRS exception applies.  The resulting tax liability will depend upon one’s adjusted gross income and deductions.

Most people are unaware of these tax consequences and consequently do not include the debt forgiven as income. The IRS will remind people though by sending an assessment notice and demand for payment. In this demand, the IRS will have, of course, included penalties and interest.   Needless to say, the assessed tax liability generally comes as a complete and unwelcome surprise.

The tax liability created from a debt negotiation cannot generally be discharged in bankruptcy.  For this reason, debt negotiations or settlements may not be the best available option.

Furthermore, the IRS currently recognizes three exceptions which may prevent a tax liability on forgiven debt from arising.  The exceptions are limited and include:

*Debt discharged under title 11 (in a bankruptcy); 

*Non-business insolvency (where liabilities exceed assets);

*Mortgage deficiency on a primary residence.  See Mortgage Forgiveness Debt Relief Act of 2007, enacted December 20, 2007.   

Specific rules apply so consult with your tax professional for more detailed information.  Your tax professional can help determine if an exception applies and if Form 982:  Reduction of Tax Attributes Due to Discharge of Indebtness (and Section 1082 Basis Adjustment) should be filed with the IRS to cancel out 1099s sent by creditors.

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