Common Misconceptions Regarding Debt Settlement


Interviewer: Generally, what are some of the common misconceptions about debt settlement?

Andrew Campbell: Well that depends upon whether someone is dealing with credit card debt or student loan debt

A lot of people with high credit card debt get targeted. In fact, they’re often sent offers in the mail from these debt settlement companies.

The problem is that what people don’t realize is that it’s not such a great idea. Let me explain what I mean.

There are several problems with debt settlement. First is how much you are charged. When I say charged I don’t simply mean how much the debt settlement company charges you. I mean the total cost for their services.

To account for the total costs you have to understand how debts are handled by the IRS.

There Are Tax Consequences to Debt Settlement

There are tax consequences to debt settlement and many people don’t know this.

The IRS defines gross income as income received from any source. If you have an obligation – say you have a $10,000 credit card debt. They’re going to need to make a lump sum offer to that credit card company.

A debt settlement company knows that they’re going to need to make a lump sum offer to that credit card company. So they will have you pay a few hundred dollars a month into a special bank account that you authorize them to control and manage.

After a while, that account will grow to $4,000 or $5,000. At that point, the debt settlement company knows that you are close to having enough to make an offer so they begin to negotiate with that particular creditor who holds the $10,000 debt.

They’ll go to that credit card company and they’ll say, “Hey, let’s settle this. They owe $10,000, but will you take $4,000?”

Say the credit card company says, “No, but we’ll take $5,000.” What will happen is the consumer thinks, “Oh, I just got a great deal. I just saved $5,000.” Wrong. Wrong answer.

They saved $5,000, but the IRS says, “Oh, well, forgiveness of debt is actually income. Why?

Because you would have had to have earned the money to pay back the debt, and the money you earned would have been taxed.

Because you don’t have to earn the money to pay that extra $5,000, then that $5,000 that you didn’t have to pay is now income to you.

It’s called imputed income.

So the $5,000.00 that you had thought you had saved actually costs you another say 28% (it depends on what your marginal tax rate or bracket you fall in) or just under $1,500.00.

So when debt settlement companies advertise that they save consumers “x” of money that is simply not always the case.

Keep in mind one caveat though. There are exemptions to imputed income. You should ask and accountant or CPA about whether the insolvency exemption applies in your case.

The Credit Card Companies Have to Notify the IRS if They Forgive Some Debt

The Internal Revenue Service will know about this because the creditor will send 1099 to them.

They have to. The credit card companies are afraid, just like everyone else. They’re all afraid of the IRS.

The credit card companies have to follow rules and regulations so if they forgive some debt, they have to send a notice to the IRS.

So the IRS will get notice of that and if the consumer doesn’t report it on their taxes, usually the IRS doesn’t make a big deal about that but they will inform the consumer, “No, you have $5,000 of imputed income.”

There are some serious tax issues that people don’t even think about.

That’s also a big problem for a lot of consumers.

So the first problem is the tax implications. The second problem is the large fees charged by debt settlement companies.

Illegal Fees Charged by Many Debt Settlement Companies

Under Michigan, law debt management companies are limited on the fees that they can charge.

Debt management companies are allowed to charge a $50.00 after establishing a debt management plan.

Also, once a debt is settled then a licensed debt management company can charge 15% of the amount of debt to be liquidated.

The problem is that there are only three licensed debt management companies in Michigan.

A lot of the companies you see advertising on television are not licensed to do business in Michigan.

These companies charge a lot more than 15% of the amount “saved”.

Keep in mind that because of the IRS rule on imputed income

Debt Settlement Companies Must Perform All Services within Ninety Days

The third problem is the time it takes. Let me give you an example.

Let’s say you have 10 credit cards, okay? And you have a total of $30,000 in credit card debt. The debt settlement company is going to want to get you on a payment plan.

What you’re going to do is make payments of maybe $300, $400, $500 a month to the debt settlement company for a few years.

What the debt settlement company will do is, as soon as you have enough money in that account, to make an offer to one of those credit card companies that you owe.  Let’s say after a few months they’re able to make an offer to credit card company number one and that’s accepted.

Then a few months later, they make an offer to credit company number two, but credit card companies numbers eight, nine, and ten aren’t patient. They continue collection activity. They continue to call and send letters, and eventually, they’ll sue.

People end up facing lawsuits where they’re going to get garnished if they don’t defend the lawsuit and then the money that they have to pay the debt settlement company is reduced by the garnishment amount.

This really frustrates people because the last thing they want is to have to file for bankruptcy.

They are trying to do the right thing by paying their debts back and they end up getting taken by these companies that 1) aren’t licensed in Michigan, 2) don’t fully perform all services within ninety days and 3) charge more than they really should.

The reality is their credit becomes tarnished because the debt settlement company said, “Look, stop paying all your credit card debt. Stop now.” As soon as you do that, you’re going to start getting hit with delinquency notices on your credit report and that will drop your score.

In the end, the damage to your credit could be far greater than if you had simply filed for bankruptcy.

Obviously, this may not always be the case but if you are looking into debt settlement you should at least first consult with a bankruptcy attorney to determine your options.

In bankruptcy, you don’t have tax implications. The Bankruptcy Code does not allow the IRS to impute income to any debt forgiven in bankruptcy. It is not allowed. You don’t have that worry.

It is not allowed so you don’t have that worry.

Yeah, you’re going to have your credit tarnished, of course, but what people don’t understand is it’s not that bad. Have you heard of Credit Karma?

Interviewer: No, I haven’t.

Credit Karma

Andrew Campbell: Credit Karma is a free site where you can get your credit score for free. It’s a really useful site.

Now the data is not always the best but if you use the site the right way you can learn some very useful things.

I urge you to go on and do it even if you don’t have any debt at all.

I remember going on there once and I had a good score. It was something like 760 or something; it was a pretty good score. There was a little box, I think in the top right, and it said, “Click here to see what happens if you file bankruptcy.”

I clicked there and my score would have dropped 100 points, which isn’t really that bad, frankly. I thought it would drop a lot more than that.

What people have to understand is your score will initially drop when you file for bankruptcy and the bankruptcy will stay on your credit for 10 years.

You have to answer “yes” if anyone ever asks you on an application for credit if you’ve ever filed for bankruptcy.

You have to admit it, otherwise, it’s potentially a criminal offense.

What people don’t realize is that for a Chapter 7, which takes about four months, upon receipt of your discharge, your credit score usually pops back up.

It won’t pop up all the way necessarily but it will pop up a little bit because generally speaking 35% of your credit score is determined by your debt-to-income ratio.

When you filed, you had a certain amount of debt and a certain amount of income. When you get a discharge, suddenly that debt is gone so the ratio isn’t what it used to be. Now creditors looking at you as a potential risk think you are safer.

That’s why the score can pop up.

Those are important things that people have to consider when they’re thinking about debt settlement.

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