Debt Settlement vs. Bankruptcy: Choosing Between the Best “Worst” Option
Debt settlement and bankruptcy are often compared as two equal alternatives. Debt settlement is, however, often a “false alternative,” not at all an option offering the equivalent legal protections and legal benefits that a Federal court-ordered bankruptcy discharge does.
Debt Settlement: The Ups & Downs
There are instances in which debt settlement can be a better option than bankruptcy. If an individual has only one or two larger-sized debts that are the primary source of his or her financial concerns, has a large lump of cash available to make a settlement offer with, and doesn’t mind suffering the taxable consequences of a charge-off of the debt, debt settlement may be something worth attempting at least initially before turning to the possibility of a Chapter 7 or Chapter 13 bankruptcy—depending upon who the creditor is and what their policies regarding settlement may be.
You will note that that instance has quite a few qualifications bundled in before debt settlement begins to look like a good idea. Let’s unpack them a bit:
Qualification Number 1: Debt settlement will only address a single debt at a time.
A Chapter 7 or Chapter 13 bankruptcy is nearly always a better option if you have more than one or two debts to deal with. Why? Bankruptcy is something of a “nuclear option.” It will discharge all of your debts all at once (other than few, such as delinquent child support payments and recent tax debt, which are singled out as “non-dischargeable” by the US Bankruptcy Code, the Federal statute governing the bankruptcy process). Debt settlement may sound more palatable, but, ultimately, you will spend time and money and fees of one sort or another, depending on whether you are hiring someone to negotiate a settlement for you, dealing with just one, single debt while the rest of your debts go unaddressed. While your credit report continues to deteriorate as you channel your limited resources at a single creditor, potentially neglecting others.
Qualification Number 2: Debt settlement requires a settlement.
I am always surprised when people I speak with are themselves surprised that settling a debt actually requires a cash settlement. This happens often, as if merely chanting the phrase “debt settlement” at a creditor will make them forgive someone’s debt completely. Not so. In order to settle a debt, you need to have a lump sum of cash available to settle it out. Payable upon demand. Don’t have a big lump sum of cash, but your creditors are threatening to sue you for collection and garnish your wages? It is likely time to take a hard look at bankruptcy, which will stop all collections efforts, including garnishments and lawsuits, cold the moment that they are filed, discharging ALL debts, for generally a lower fee than would be required to settle a single larger sized debt. It’s a cost-benefit analysis in the end. Bankruptcy is simply excellent at providing the most bang for your buck—and with the legal force of the Federal Courts behind you.
Qualification Number 3: Taxable Consequences
When you settle a debt out, the total amount you owe essentially is split into two portions: one “settled” portion, the amount of the settlement you pay on the debt, and one “forgiven” portion. So you pay your settlement, get a good release in place, and the creditor agrees not to attempt to collect from you any further and to report the debt as settled and closed to the credit bureaus. Is that the end of the debt settlement story?
Not quite. That other “forgiven” portion is still out there. The creditor will charge off that portion, which most people inaccurately interpret as “to forgive.” In fact, the charge-off is simply a writing off of lost business income for the creditor’s own taxable liabilities as regard the Internal Revenue Service or the Michigan Department of Treasure, or whatever other taxing authority they are subject to in their home jurisdiction. When a creditor charges off a debt, it reports the debt to the IRS, etc., as lost business income and gets a tax write-off for it.
They are then required by Federal tax law to issue you a 1099 for that charged-off amount because the IRS does consider charged-off debt to be “forgiven” debt, and it considers forgiven debt to be a form of personal income. You will receive a 1099 for the “forgiven” balance of the debt just as if you’d worked as a contract employee for the creditor in that year.
So you will pay twice with a debt settlement: once when you make the lump cash settlement, and again in a subsequent tax year when you have to pay your tax-bill, assuming you don’t have the ability to absorb the tax hit for income you didn’t actually earn. And they have a few years to issue the 1099, whenever it suits them. You may think all is well and good for 2 years following your settlement and then get that 1099 in the mail, seemingly out of nowhere.
The discharge of debt in Chapter 7 or Chapter 13 bankruptcy is an entirely tax-free event. You will never have to pay taxes on a 1099 received for debt discharged in bankruptcy.
Qualification Number 4: Debt settlement requires the creditor to want to settle the debt.
This is something else that people discussing the debt settlement alternative to bankruptcy with me are, surprisingly, often surpised to learn. While some creditors will work a debt settlement negotiation out with something vaguely resembling good faith, other creditors could care less whether you settle the debt out or not. Particularly if the debt collector is an attorney who can simply sue you, get a default judgment, and garnish your wages or bank account. Debt settlement requires that you approach the creditor hat-in-hand and, essentially, ask them to do something nice for you.
For them, the response is a matter of playing the odds. Is what you’re offering a better deal than they could get if they just sued you? Is what you’re offering more than what they would lose hiring a high-school drop-out to call you at work and harass you for $8/hour? Do they have an “internal policy” that is rigid, unwavering and unwelcoming to reasonable discussion? Is it possible to even figure out who or where the amorphous company calling you at all hours of the night really is in order to negotiate a settlement? Are they calling from Belize or from the middle of a Native American reservation someplace? Do they really even own the debt, and will sending a check to this random collection agency really ensure that no one ever tries to collect the debt from you again?
You can see that nicer-sounding phrase “debt settlement” carries with it a great deal of uncertainty that even an experienced attorney can have difficulty unraveling. Nobody likes the idea of “bankruptcy,” but a Chapter 7 or Chapter 13 bankruptcy will deliver a guaranteed, legal resultwithout any need to negotiate anything with a creditor at all.
Qualification Number 5: Who Is Doing the Debt Settling?
The final debt settlement qualification worth mentioning is that most “companies” who offer to settle your debts are offering services of dubious benefit at the very least and possibly in violation of multiple Federal Trade Commission guidelines and even criminal law at the very worst.
It’s one thing to settle a debt out yourself. You can always try picking up the phone and asking a creditor if they will accept a settlement of this or that debt. If you’re not an experienced lawyer such as the attorneys of The Hilla Law Firm are, you will have to take the creditor’s word for it that the debt settled after you mail your check or that the release they send you to sign does anything to protect you at all. But you can try it. It doesn’t cost you anything if you do it yourself.
You can also hire a licensed attorney with a legal obligation to provide you service of value for the money you pay him or her to help with the negotiation. The Hilla Law Firm, PLLC has indeed successfully settled debts out favorably for some few clients that actually met the various criteria described here.
However, in a sadly large number of cases, debt settlement “services” are offered by companies who really provide no bona fide service whatsoever, who cost you money, who further damage your credit report, and who push you, ultimately, straight into the bankruptcy you hoped to avoid in the first place.
The basic debt settlement company business model works like this: You sign a contract with a debt settlement company that requires you to pay $X per month to them. The contract provides that, out of each monthly payment you make, they will keep some amount as a fee for their “service.” When you have lumped up in your account with the company a sufficiently large lump of cash—after their monthly fee deductions–they will then pick up the phone and try to work out a settlement with one of your creditors.
This is something that you can do yourself without any need for their “service.” Further, by the time they get around to making that call, a number of months have passed during which you have been making no payments to your creditors because you have been channeling all of your available income to the debt settlement company’s payment. Your credit report is by this time shot. Maybe they settle the debt out for you, maybe they don’t. You are possibly by this point being sued for collections by one or more of your other creditors, possibly being garnished, and you have no way of knowing whether they really fought the good in fight in attempting to settle a debt out, or if they just picked up the phone and took “yes” or “no” for an answer. There is no downside for them: they are not attorneys with licenses and ethical obligations, largely. They are fly-by-night outfits who come and go and have earned their profit off of your monthly fees.
But, in the meantime, think carefully about your options. One of them may not really be a real option at all.
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