Answer: Good question. A settlement is the acceptance of a partial payment of the amount of debt owed. The remaining amount of the debt is known as the deficiency balance. The deficiency balance, not collected, is essentially forgiven. Debt cancellation is the forgiveness of the entire amount owed.
The creditor can file a 1099-C, which is a cancellation of debt form, with the IRS if the creditor has either 1) reached a settlement with a debtor for less than was originally owed, or has 2) forgiven the entire debt, concluding it will never be able to collect the debt. If the creditor files a 1099-C for the amount forgiven to the IRS, that amount will have to be claimed as income on the person's personal tax return.
If and when a creditor issues a 1099-C in your name to the IRS, the amount included on the form is considered income that you must claim and pay taxes on.
Creditors must file a 1099-C with both the IRS and with the debtor for all debts of $600 or more under the following circumstances:
- Cancellation or extinguishment making the debt unenforceable in a receivership, foreclosure, or similar federal or state court proceeding.
- Cancellation or extinguishment when the statute of limitations for collecting the debt expires, or when the statutory period for filing a claim or beginning a deficiency judgment proceeding expires. Expiration of the statute of limitations is an identifiable event only when a debtor's affirmative statute of limitations defense is upheld in a final judgment or decision of a court and the appeal period has expired.
- Cancellation or extinguishment when the creditor elects foreclosure remedies that by law end or bar the creditor's right to collect the debt.
- Discharge of indebtedness by agreement between the creditor and the debtor to cancel the debt at less than full consideration.
- Discharge of indebtedness because of a decision or a defined policy of the creditor to discontinue collection activity and cancel the debt. A creditor's defined policy can be in writing or an established business practice of the creditor. A creditor's practice to stop collection activity and abandon a debt when a particular nonpayment period expires is a defined policy.
- The expiration of nonpayment testing period. This event occurs when the creditor has not received a payment on the debt for a 36 month period beginning on December 31st. (this 36 month period is rebuttable by creditor based on facts and circumstances)
If you settle with a creditor or if they agree to forgive the debt, be sure to ask the credit if they file a 1099-C with the IRS. A settlement or cancellation of debt may help you with your budget and credit on the front end but it may cost you during tax time if you have to claim that amount on your taxes as income.
Some creditors may settle a debt with the debtor without filing a 1099-C and just report the debt as a debt "settled for lessor amount" on the credit report. The affect on the credit report will relatively both be the same. These accounts will eventually have less of a negative affect on the credit report the older they get. Time heals all credit report wounds.
If you received a 1099-C, make sure to give this to our tax accountant for further guidance and assistance.