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Why the IRS Cares About Your Debt Troubles

By Garrett Sutton, Esq.

People in debt should, and often do, explore every option before filing for bankruptcy. One option is to settle your debts for less than owed. The company owed takes a partial payment and forgives the rest of the debt. And that forgiveness of debt may just bring the IRS knocking on your door.

I know that it sounds crazy and wrong, but the ‘forgiveness of debt is income’ issue does kind of make sense in a strange way. Suppose you borrowed $10,000 from a company and now you need to pay it back. You are struggling and the company in an unusual burst of magnificence lets you off the hook. They tell you, “You don’t have to pay the $10,000 you owe us.” As a result, you are suddenly $10,000 richer. It is as if you ‘earned’ the $10,000. Can you see where the IRS comes in here? If you earn $10,000, the IRS wants a piece of that. And so when you “earn” $10,000 by having a loan forgiven they want to get a piece of that, too. Accordingly, forgiveness of debt is income, and you can expect the IRS to tax you on it.

To further understand the IRS position it helps to think like a thief. What if a worker arranged with his boss to not receive a salary, but a ‘loan’? A year later the boss forgives the loan because the worker just happened to help him out. The worker maintains he didn’t really earn anything, he just had a loan forgiven. He further maintains he doesn’t owe taxes. Well, if this worked, we’d all do it. And for that reason alone, the IRS taxes it.

If you settle a debt for less than you owe, or if the creditor writes it off, the lender may send the IRS a 1099-C which is used to report “discharge of indebtedness income.” In fact, creditors are required to do this if the forgiven debt exceeds $600. You normally will be sent a copy of this too, but if you’ve moved it may not reach you. The IRS expects you to pay taxes on this “income.” If, however, you qualify for an exclusion or exception, you may be able to get out of paying taxes on some or all of that income.

You’ll be using Form 982 plus instructions from the IRS to walk you through this process. But it can be confusing. Just take a look at the title of that form, “Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).” So I recommend you work with a tax professional who can guide you through it.

Credit Reporting is Big Business!

Whether you’re a real estate investor, business owner, or just a consumer who has paid bills, you’ve got a credit report. And that report is probably more important to your financial life than any report card you ever received in school. In fact, it plays a key role in what kind of credit you get and how much you pay. Even if you don’t ever borrow or use a credit card, it likely affects how much you pay for your auto and homeowner insurance. So you have to know what’s in your credit report, as well as how credit reports work.

Credit reporting agencies (more commonly called “credit bureaus”) are in the business of compiling information about people’s bill-paying habits and selling that information to other companies that may want to extend credit, insurance, or even a job offer, to them.

There are three major, national credit reporting agencies reporting on personal credit in the United States: Equifax, Experian (formerly TRW), and TransUnion. Plus there are hundreds of smaller credit bureaus that are affiliated with one or more of these “Big Three.” These specialized agencies get information from one or more of the three major bureaus and may supply additional credit information as well. There are also business credit bureaus; Cortera, D&B, Equifax and Experian are the main ones that compile reports solely on businesses around the world.

Credit reporting is big business, and the major credit reporting agencies are businesses in competition with each other. They are all trying to make their reports “better” than the others and they will not share information unless they are required to do so by law. That’s one reason why, when you see your credit report, you’ll see that it looks somewhat different depending on which agency supplied it. While most of the accounts will likely show similar information, they won’t all be exactly the same.

Is a Venture Capital Firm Right for You?

Venture capital firms are a useful component in the business engine of growth. They are also hard-nosed investors who have earned the not so flattering nick name ‘vulture capitalists’. When it comes to ‘VCs’, you need to be knowledgeable and cautious.

A venture capital firm is a company that raises large amounts of money from individuals and institutions and then invests in startup businesses. Because these firms don’t do anything else, they are very interested in the finances of the businesses in which they invest – so much so that they will usually want significant ownership in the company (and possibly a seat on the board or a place in management) with input on day-to-day decisions.

Members of venture capital firms are big on profits and big on growth. Some want to triple their money in 18 months. Others want even greater returns. To do that they’ll need a large chunk of your shares and they’ll drive your (their) company with the accelerator past the floorboard. In achieving their goals, they’ve left many a founder behind at the rest stop. Of course, being left behind with 10% ownership of a company whose stock is soaring may not be such a bad result for some. But for others it can be bruising.

Be sure to talk to your advisors and other clients of the venture firm you are considering before formalizing a relationship. In many cases a venture firm can be a big help, in others a major hindrance. Be careful.