Los Angeles Bankruptcy Law Monitor : Los Angeles Bankruptcy Lawyer & Attorney : Christine Wilton Law Firm : Southern California Chapter 13 & Chapter 7 Bankruptcy, Foreclosure

Debt settlement requires that you negotiate with creditors to settle debts for less than what you owe. Once an agreement is reached, you pay the agreed amount and your liability for that debt goes away. What these debt settlement companies don’t tell you is that you will also receive a 1099 tax form they filed with the IRS. Now that the debt is gone, you’ve got a tax bill for that settled debt. So, not only have you paid to get rid of the debt, you owe income taxes too.

Too often, hiring a debt settlement company to help you negotiate with creditors can cost in the thousands of dollars. What happens is that they set you up on their payment plan and then the debt settlement company begins taking your money first for their fees and never paying a dime to your creditors until their fees have been paid in full.  Many consumers end up in litigation with their creditors and these companies do nothing to assist consumers until they've been fully paid.

Here’s an example: Say you owe $5000.00 to credit card and you’ve done well and negotiated this debt down to $500.00. You must pay $500.00 to get rid of the debt. At year’s end you will receive a tax bill for $4500.00 and you must pay income tax on that amount; perhaps another 15% depending upon your tax bracket. You’ve paid a total of $1175.00 to settle that account. Simply follow this plan until each credit account has been eliminated and you get the picture.  Add to that cost, the fees for hiring a debt settlement company and you have nothing left.

Bankruptcy, on the other hand, effectively eliminates all debts, without any income tax liability. Usually, you are charged a flat fee for services. Once you’ve received your discharge, your debts are gone forever. Isn't that your goal? So, you pay nothing to your creditors, have no income tax liability and pay one flat fee to file your bankruptcy case and your debts are permanently eliminated.  There's no sense in foregoing a free consultation with a bankruptcy lawyer because you can generally keep your cash and belongings and still eliminate your debts.

Your credit score is the last thing you should be thinking about during any financial crisis. Besides your credit score only measures how well you manage DEBT and isn’t that what you’re working so hard to get out of? We have generally found that most people who file for bankruptcy have their credit score actually increase because the debts are gone. Soon after, you’ll receive offers for credit because the creditors know that you cannot file bankruptcy for another 8 years, making you a prime candidate for high interest credit cards. But why would you want to create debt ever again?
 

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I know what you've been told because I have heard it all too.  The government wants you to do your very best to avoid bankruptcy at all cost.  Bankruptcy is bad; or at least, a harsh remedy to dealing with debt, and should be your last resort.  We have all bought into this 'agreement reality' and it couldn't be further from the truth.

I assert, bankruptcy is a powerful tool that should be considered in your overall financial plan that includes eliminating debts.  Adrian Lapas, over at Bankruptcy Law Network explained the pitfalls of debt settlement by warning of 1099 tax bills for canceled debts; and even creditor's unwillingness to negotiate a settlement at all.  Oh, and I'm really tired of discussing your credit  score because it's already been adversely affected by your not making your payments on time. In fact, filing bankruptcy might actually improve your credit score once all that bad debt is cleared from your credit report. 

I've had clients come to me after signing up with these debt settlement companies and spending nearly $10,000 on fees, only to find themselves in lawsuits with their creditors that these companies warned them about and would not help them with.  Remember that if you negotiate your settled debts, you're still paying money toward them and you'd better have some cash saved up to pay it in full if they accept your offer.  Also, you must be prepared for that 1099 tax bill at the end of the year because you'll wind up paying taxes on that can celled debt.

Bankruptcy not only eliminates the debt without any payments from you, it will eliminate your liability entirely and you won't owe taxes on the debts that were discharged in the bankruptcy.  That's where bankruptcy as a tool, is more efficient and not only a powerful tool, but a cost saving device for you as well.

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I've had several clients come to me after working with debt settlement companies that have provided no service at all, except to take my client's money.  These debt settlement contracts usually provide that the debt settlement company will set up a trust account with your name on it and take their fees and payments first.  Then, when there's enough money in the account, they will begin to negotiate with your creditors.  When you agree to the settlement of the debt, the debt settlement company gets even more money.  To say that they nickel and dime you into further debt is being nice.  I would like to think of it as unconscionable; that's the legal term.

Bruce Weiner, a New York bankruptcy lawyer, points out the pitfalls of working with debt settlement companies in his recent blog, "1099-C and Forgiveness of Debt:  Another Reason to Be Wary of Debt Settlement Companies," and "Wall Street Journal Says, 'Beware of Debt Relief Offers,'"  that these companies make false promises and don't deliver.  Their marketing campaigns invade every inch of the media and they serve to disseminate bad information on a viral level that only confuses the general public and causes many to go further into to debt than needed to avoid the stigma of bankruptcy.

1. Debt Settlement Companies can be scams; and
2. Debt Settlement Companies can cause you to have to pay income taxes on settled debts.

Debt Settlement companies are, generally, not lawyers and cannot give legal advice about your debts, including advising you not to pay your debts.  They cannot stop lawsuits or wage garnishments; or foreclosure on your home.  The automatic stay, is an injunctive statute that stops all attempts to collect a debt from you the moment you file for bankruptcy.  DON'T GET SCAMMED!

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The only reason you should negotiate directly with your creditors, is to avoid bankruptcy.  Remember that working with debt settlement companies is both costly and detrimental to your finances and will likely land you in my office filing for bankruptcy.  If you want to avoid bankruptcy, work directly with your creditors for an agreement on what your debt is worth.  If they even think you're about to file for bankruptcy, they will most likely make some kind of offer.  However, settling debts to avoid bankruptcy comes with a price;  Income Taxes!

Beware that if you settle, or negotiate a debt to avoid bankruptcy, you could end up getting a tax bill.  while the IRS is forgiving settled debt where mortgages are concerned; the California Franchise Tax Board is not because their program has expired.  So, in California, you'll wind up owing state income taxes, if the debt you settled relates to a secured mortgage in a short sale.

But what about your credit cards?  Unsecured debt negotiations and settlements will be taxed by both the state and federal agencies.  So, unless you're prepared to pay taxes on the amount that will be written off by your creditor, then, like Cathy Moran said in her blog, Should I Settle Some Debts Before Bankruptcy, your money could be put to better use, like saving for retirement.

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