Can You Claim Insolvency for Credit Card Debt Settlements?

Debt settlement, or debt negotiation, lets debtors pay off outstanding credit card accounts or other debts for less than the actual balance owed. The debtor negotiates with the creditor to pay a percentage of the debt, typically in the form of a lump sum payment or several smaller payments. The creditor then forgives the remaining amount of the debt. Depending on the creditor, the age of the debt and the amount of cash you have to settle with, you might be able to reduce your debt by anywhere from 25 percent to 75 percent.

The Internal Revenue Service (IRS) has specific rules about reporting forgiven debt. A creditor must complete IRS Form 1099C to report the cancellation of a debt if the forgiven amount exceeds $599. The creditor must also issue a copy of the 1099C to the debtor for tax filing purposes. If you receive a 1099C, you must report the amount of forgiven debt as income on your taxes, unless you plan to claim insolvency. If you believe you were insolvent at the time the debt was forgiven, you will need to complete IRS Form 982 to determine what amount of debt can be excluded from your income.

Insolvency means the value of your total debts or liabilities exceeded the total fair market value of your assets. The IRS allows debtors to exclude forgiven debt from their taxable income up to the point of insolvency. For example, assume that your debts total $50,000 and your assets are valued at $35,000. Your creditors forgive $20,000 of outstanding debt. According to the IRS rules, you can only exclude $15,000 of the debt from your income since this is the point to which you're insolvent. The remaining $5,000 will have to be reported as taxable income.

In addition to the tax implications associated with credit card debt settlement, there are several other things you should consider. First, you should negotiate with your creditor to have the debt listed on your credit as paid in full, rather than settled or charged-off. While a settled debt is not as damaging to your credit as bankruptcy, it can potentially cause your credit score to suffer. Second, if you're thinking of using a debt settlement company to negotiate on your behalf, you should be aware that a number of these companies operate fraudulently in order to scam unsuspecting consumers. Finally, if you settle a debt but don't receive a Form 1099C, you must still report the forgiven debt on your taxes to avoid additional IRS penalties.