Debt Negotiation – Applying the Insolvency Rule to a 1099-C Tax Liability

Insolvency Rules

If I enroll into a Debt Negotiation program to settle my debts with my creditors, will I have to pay tax to the IRS?

This is a daily question I am asked during my consultations with consumers.  The answer is that it depends on your situation. Before I review a few situations to illustrate when you may or may not be required to pay a tax on forgiven debt, let me make it very clear that I am NOT a Tax Attorney and I cannot give you specific tax advice.  Please first verify everything with your personal tax professional.

1099-C Debt Negotiation

1099 debt forgiveness

The question about paying taxes on a forgiven debt revolves around a creditor issuing a form 1099-C for a cancellation of a Debt. Say you owe $10,000 and are unable to pay the entire balance.  The creditor agrees to accept $5,000 as payment in full and offers a Debt Reduction of $5,000. The creditor then may issue you a 1099-C showing that you had $5,000 of debt forgiven that may be reported by you as taxable income. Think about it like this. Normally when you borrow money you do not pay tax on it because you have to pay the money back.  It is not income.  However, if you do not pay the money back, then it is essentially a gift which then could become taxable to you.

A lot of consumers have some unjustified fears about this potential tax ramification of Debt Negotiation. First let me make it clear from a financial standpoint, that paying taxes on an amount of debt that is forgiven is always cheaper than paying back the entire debt plus interest.  For instance, if a creditor forgave a $9,000 debt, you may have to pay $3,000 or so to the IRS depending on your situation. Isn’t $3,000 cheaper than $9,000 plus interest?  So even if you found yourself in a circumstance where you had a tax liability, you are still saving quite a bit of money.

Lets now examine when you may or may not have a tax liability when you have consumer debt forgiven by a creditor.

The Insolvency Rule (IRS publication 908)

Most Debtors find that there is actually a big “loop hole” called the insolvency rule that allows them to NOT have to pay any taxes on the forgiven debt. According to the IRS, if you are “insolvent” at the time of the debt forgiveness, (which most consumers are if they are enrolled in a debt negotiation program) then you have no tax liability on the debt reduction up to the point that you are insolvent.

Taxes on forgiven debtLet me put that in English for everyone.  If your debts outweigh your assets then you are insolvent.  So if you have a negative net worth then the IRS lets you slide and does not require you to pay taxes on the forgiven debt.  As an example, if you where 100K upside down on your house, had 50K in credit card debt and only 40K in assets then you would be insolvent by 110K and you would not have to pay taxes on any of the settled credit card debt..

Most consumers find that if they are so far upside down financially that they have to look into a debt negotiation strategy, that they are also insolvent and therefore not liable for additional taxes on the amount of debt forgiven.  As always though, check with a qualified Tax consultant about your specific situation, and ask if the Insolvency Rules would apply to you.

For further information please see IRS Publication 4681.  It covers rules and applications of canceled debts in detail and provides a form to help determine whether or not you qualify under the IRS Insolvency Rules.

About Damon Day

As a Debt Coach and a Financial Advocate, I have saved my clients Millions of Dollars by exposing the debt relief scams that other consumers fall victim to. I work directly for my clients to create custom debt relief strategies based on their own unique circumstances. Consumers who speak with me first, come out far ahead of those who don't, every single time. Guaranteed. +Damon Day

3 Responses to “Debt Negotiation – Applying the Insolvency Rule to a 1099-C Tax Liability”

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  1. Jeff (1 comments) says:

    So the point is that if you are forgiven any debts by ANY amount, you get taxed as if it was earned income? Gotta love the Internal Revenue Service. Always trying to get every last penny from you.

  2. Damon Day (116 comments) says:

    Hello Jeff,

    Well yes, it is true that you will be taxed on earned income if your assets are greater than your liabilities at the time of settlement. While I certainly have a lot of beefs with the nonsensical way that the IRS does a lot of things, in this instance, what they do makes sense from an accounting perspective.

    Based on your site, I am sure that you know this but for the benefit of my readers let me explain further. Lets say I loan you 1,000 dollars. You receive 1,000 but do not pay income tax on it. It is assumed that I have already paid the income tax before having it as disposable money to lend to you. If you pay me back, then I have no tax liability on the money you paid me because it was just repayment of money that I already paid tax on.

    However, if you are unable to pay me, and I forgive the 1,000 dollar debt, then I am going to write off that 1,000 dollar loss on my next years tax return and have it offset 1,000 in current income that I will not have to pay tax on. Therefore the IRS loses out on the ability to collect tax on 1,000 that I earn this year. Well if they can’t collect it from me, they are going to look to the person that received that 1,000 to collect it from.

    So on the borrower side, if I forgive that 1,000 dollars, then you would receive 1,000 dollars in income, since you are not going to pay it back. Since the IRS lost the ability to collect the tax on that 1,000 from me, they are going to go to the person on the other side of the accounting equation to collect their tax.

    So from an accounting perspective, the IRS is simply looking to regain the revenue it lost from me writing off the debt. That is actually fair. And it really is more than fair when you consider, if the debtor is in fact insolvent than the IRS lets the debtor slide and is not able to collect any revenue on that transaction. In other words, the lender gets a tax break, and the borrower receives tax free money.

    Further, even if the borrower is solvent and is required to claim the 1,000 as 1099 earned income, in many cases the borrower can be in a lower tax bracket than the lender. So if I get to take a 1,000 deduction at the highest federal tax rate, and the borrower only has to pay taxes on that 1,000 at the lowest federal tax rate, the IRS is still out the difference.

    To recap, I am certainly not defending the fact that the IRS is in every facet of our lives and they TAX the living you know what out of everything. All I am doing is pointing out that in this specific example, from an accounting perspective, it does make perfect sense that they would want to tax the borrower on a forgiven debt. And to the IRS’s credit, if the borrow is insolvent they will let it go and just not collect any revenue.

    Most consumers that are in a position to require that a debt be forgiven are insolvent, so usually when a consumer receives a settlement from a creditor, they are not likely to owe a tax. Again, you always want to consult with a tax professional to help determine if you will be taxed on the forgiven debt.

    .-= Damon Day´s last blog ..Debt Settlement – FTC could put 84% of Companies out of Business! =-.

  3. Kevin (2 comments) says:

    This is very different from UK.