The Credit Solution Copyright 2012 by Mike Roberts

Transcription

1 Settle Your Debts (For a Fraction of What You Owe) Bonus #2 The Legal and Tax Consequences of Settling Your Debts for Less! By Mike Roberts The Credit Solution Copyright 2012 by Mike Roberts

2 Copyright Information: Copyright 2011, 2012 by Mike Roberts All rights reserved. No part of this book may be reproduced, distributed, transmitted, stored in a retrieval system or used in any form or by any means, whether electronic, mechanical or digital, except as may be expressly permitted by applicable copyright laws or as expressly allowed by the publisher or the author in writing. Publisher Information: Published by Smart Consumer Solutions, LLC, 601 Van Ness Ave., STE E869, San Francisco, CA Disclaimer: All of the information contained in this publication is true and accurate according to the best information available to me at the time of publication. Please understand, however, that laws and credit industry practices and procedures are constantly evolving; so you should independently update laws, practices and facts before you take action. I do not accept any responsibility for errors or mistakes of any kind, or for any damages or losses that might result from the use of any information provided. Also, I am not a lender, a collection agent or a credit reporting agency. I am not an accountant or an attorney, and nothing in these materials is intended as professional advice. It is personal opinion only. I am providing it to you without any warranties or guarantees whatsoever. To obtain advice as to the tax or legal consequences of any action covered in these materials, or any action that you might consider based on these materials, you should consult an attorney, an accountant, or both. What I have tried to do here is simply offer solid, useful information that I have obtained through my own personal and business experience. Any action you choose to take based on any information that I provide, including forms and other attachments, is entirely your responsibility. 1

3 Contents Introduction... 3 Legal Issues... 3 The Disputed Value Settlement... 4 The Liquidated Debt Settlement... 5 Tax Issues... 7 Bob s Tax Calculation... 8 Sally s Tax Calculation... 8 Mike and Mary

4 Introduction If you settle a debt with a creditor for less than you owe, this is a good thing, right? Well, yes. Of course it is, but this doesn t mean there is no downside. In fact, debt settlement is just like many other good things in life there can be unforeseen consequences. In the following paragraphs, I m going to cover the legal and tax consequences of debt settlement. Why talk about them now? Because forewarned is forearmed. If you re going to settle your debts with your creditors, you need answers to these two questions BEFORE you make your deal: 1. If I settle my debt with a creditor for less than I owe, can that creditor sue me later for the balance? 2. Are there any tax consequences to settling a debt? One more thing before we get started: You can t count on your creditors to answer these questions for you during negotiations. They re only interested in how much money you re going to pay them. They see any downstream legal or tax issues are your problem, not theirs. Legal Issues If you settle a debt with a creditor for less than you owe, can that creditor bring a valid legal claim against you in court to force you to pay the rest of the debt? The answer is yes, unless you take certain steps in advance to protect yourself and lower the risk. First, it s important to understand that a debt settlement agreement does not work the same way that bankruptcy works. When a personal bankruptcy is approved, all debts are wiped out. After that, federal law prohibits creditors from doing anything to try to collect any unpaid amounts. A debt settlement isn t like that at all. It s just an agreement between two parties you and your creditor. It won t stop the creditor from suing you later unless (a) state law prohibits such suits or (b) the agreement cuts off the creditor s right to sue. How you should go about protecting yourself from a suit for the balance down the road depends on two things--what kind of debt you re settling and how you document your 3

5 deal. There are two different types of debt that you might be trying to reduce: Disputed Value: Let s say you re trying to knock the price down on a product or service you bought because the quality or performance wasn t up to par. Example: You bought a vacuum cleaner that was supposed to suck up nails; but yours won t pick up lint. You feel cheated. You didn t get the value you bargained for. If this describes what you re working on, then you re negotiating what we ll call a disputed value settlement. Liquidated Debt: The other type of debt you might be trying to reduce is a credit card account balance or some other bill or invoice on which the amount owed is clear and you were satisfied with what you bought. This is far more common. The main reason you re trying to negotiate is that you just don t have enough money to pay in full. If this is what you re doing, then you re working on what we re going to call a liquidated debt. The Disputed Value Settlement If you have a disputed value settlement on your hands, there s a way to put that deal together that should prevent the creditor from suing you later. Just about every state has adopted a law that allows you to negotiate a disputed value settlement and walk away clean if you follow the right steps. California is a good example. Here s what has to happen there to cut off the creditor s right to sue you down the road: You must be acting in good faith. Your motives must be pure. You can t be trying to cheat the creditor, or acting out of anger or resentment. You have to be able to prove that your creditor knew in advance that you intended to offer a reduced amount in full satisfaction of the claim. The amount of the claim must be subject to a bona fide dispute. As a practical matter this means that your problem has to be real, and not made up. You can t be trying to pay less than you agreed to pay for your new plasma TV just because the surround sound scares your cat. There has to be something wrong with the TV that actually reduces its value--something that most other people would agree is legitimate. You have to be reasonable. You must write these words on the check: This check constitutes payment in full. 4

6 You can use the sample letters in Appendix A. ( California Resident Full Payment Letter and California Resident Full Payment Letter with Check ) to meet the California requirements. Change them as necessary to identify your state. Keep these things in mind: If the creditor signs your first letter and returns it to you, that s all you should need as far as advance notice of your intent goes. If after two weeks you don t get a signed letter back, you probably won t. In that case, it s a good idea to wait another couple of weeks before sending the second letter with your check. Just understand that if the creditor doesn t sign and return the first letter, it becomes somewhat more likely that a lawsuit for the balance might follow. Whether the creditor signs the first letter or not, there are no guarantees; but if you follow these steps, and the creditor cashes your check, chances are you won t have to worry about a later lawsuit. At the time of this writing, all states but New York and South Carolina have adopted a law like California s. This doesn t mean the approach outlined here won t work in NY and SC; only that those two states don t have a law on the books that sets out the steps. You ll find the California statute (with my explanatory notes) in the Appendix. If you want to read the exact language that applies in your state, here is a website that at this writing has links to the individual state statutes-- Use the links under Article 3: Commercial Paper. In most cases, the number of the section you want is The Liquidated Debt Settlement More likely than not, you want to negotiate a lower payoff on a debt for the simple reason that you just don t have the money to pay in full. What then? The disputed value process isn t available to you because the amount owed is not disputed. Can you still make a deal and expect to avoid a court battle over the balance? The answer is yes, you can--if you do it right. Once upon a time, a small number of states had a simple rule that was very debtorfriendly. If you were a debtor, you could send a creditor a check for much less than the amount owed, write Payment in Full on the check, and the creditor had only two choices: 5

7 1. Cash the check and accept that amount in full payment (waiving any right to sue for the balance), or 2. Return the check to the debtor and keep trying to collect the entire amount owed (preserving the right to sue for the balance). These days, you can t count on any court applying this approach. Here s why: Your original agreement with your creditor is a contract, and it requires you to pay in full. If you don t, the creditor is entitled to sue you in court. You can expect the court to allow the suit unless your creditor has signed a later contract agreeing to waive a claim for the balance. When all you do is write something like full payment on your check, you re acting alone, without the prior agreement of the creditor. Increasingly, courts are saying that this isn t enough. The modern trend is to allow the creditor to strike out your full payment language, write under protest or without recourse (or something of the sort) on the endorsement, and then deposit the check and sue for the balance. States vary as to exactly which words the creditor must use to preserve his rights, but that hardly matters. What matters is that once you send off your check, you give your creditor full control over what happens next. If he wants to cash your check, keep your money and still sue for the balance, he can do it. So, what can you do to protect yourself from a later suit if the full payment -on- thecheck device isn t likely to work? You can create a paper trail showing that The creditor agreed in writing to accept your check in full payment, The creditor signed this agreement before you sent your check, and You sent the check only because of that agreement. You relied on it. I have created some sample letters (agreements) to help you create this paper trail. In the Appendix you ll find a form to use if you happen to get a verbal offer from a creditor that you want to accept Acceptance of Verbal Offer. Good verbal offers that are low enough to do you any good are rare. It s much more likely that you ll have to submit a written offer, deal with a counter offer, and make at least one more offer before you get into the range where you can afford to settle. You ll find forms for these letters in the Appendix to Settle Your Debts for a Fraction of What You Owe, which you have. If you use these sample letters as suggested, you ll dramatically reduce the likelihood of a 6

8 later suit for the balance; and if a suit does come your way, you ll have a good defense against it. Using this approach reduces the likelihood of a suit for the balance for the simple reason that your creditor will probably perform as promised. It will be obvious from the documents that your creditor promised to accept the negotiated amount as full payment in order to persuade you to send the money. More often than not, the company will honor the deal, take the settlement money, and leave you in peace. If your creditor turns out to be unscrupulous and sues you in spite of your agreement, then you ll have a good legal defense available. Normally courts simply enforce the most recent contract between the parties. If there is only one contract--the original agreement that allows the creditor to sue for any unpaid balance-- then that is the contract the court will enforce. If all you have is the fact that the creditor deposited your full payment check, you ll probably lose. If you use the sample forms as suggested, however, you ll be able to argue that the old contact is gone, and that you and your creditor have replaced it with a new agreement one that cuts off the creditor s right to sue for any amount other than the negotiated settlement. As always, there are no guarantees. Tax Issues Are there any tax consequences to settling a debt? Unfortunately, the answer to this question is yes. Here s the problem. If you owe $5,000 on a credit card and you settle the debt for $2,000, the IRS treats the unpaid balance as income to you. The $3,000 is a discharged debt, and under the IRS rules, discharged debt is taxable, pure and simple. Can you safely ignore the $3,000 and leave it off your income tax return? You can take this risk if you like; but it s a bad bet. In all probability, your creditor will send you a Form 1099-C in the mail. If you get one of these in your mailbox, you know for sure that the creditor has informed the IRS about your discharged debt. Even if you don t receive a 1099-C, you can t assume that the IRS remains in the dark. The creditor might have 7

9 made a mistake with your address; but you can rest assured that he has the correct address for the IRS. From the debtor s point of view, there is nothing good about the discharged debt rule; but here s a little silver lining: How the rule applies to you can vary a lot depending on which tax bracket you re in and the total value of your deductions. Here are some examples that show how the rule can affect the true cost of a debt settlement for people in different situations: Bob s Tax Calculation Bob is single, with one dependent, so he s filing his return as a head of household. He lost his job as a carpenter and was out of work for all of last year. His income (without any discharged debt) was only $4,000. Because his minor son Bobby lives with him he gets a standard deduction of $8,400, so his taxable income for the year (line 44 on his 1040 return) is zero. He pays no taxes. Now let s assume that Bob managed to negotiate a settlement on a $1,500 credit card bill last year and he got a $1,000 break. He recently got the dreaded Form 1099-C in the mail, so he knows the IRS will expect to see the $1,000 reported as income on his return. For Bob, this isn t a problem at all. He can add the $1,000 discharged debt to his income and the total will still be less than his standard deduction. For Bob, the discharged debt has no income tax consequence at all. True cost of Bob s debt settlement: $500. Sally s Tax Calculation Sally is single. She had a better year than Bob, but it was far from great. Though she was out of work for most of the year, her temp agency did manage to find her a good paralegal job that lasted four months. Her gross income for the year was $9,700. As a single filer she qualifies for a standard deduction of around $5,700, so her taxable income (without any discharged debt) will be some $4,000. For single filers, the low 10% tax rate applies to all taxable income below $8,500, so Sally will have to pay a tax of $400 on her $4,000 of adjusted income. Like Bob, Sally too cut a deal with her credit card company last year. She was able to lower a $4,000 balance to only $1,000. The 1099-C she just received shows a discharged debt of $3,000, so she ll have to add this amount to her $4,000 adjusted 8

10 income and bring the taxable total up to $7,000. Fortunately for Sally, this amount is still below the $8,500 break point for the next tax bracket (15%), so all of the $3,000 in discharged debt will be taxed at only 10%. Her total tax bill will go up $300 as a result of her negotiated settlement. True cost of Sally s debt settlement: $1,300 ($1,000 for the credit card company and $300 for the IRS). Mike and Mary s Tax Calculation Mike and Mary are married, filing jointly. Because of the down economy Mike was able to get only seasonal work as a waiter this past year, and Mary s job as a receptionist, though steady, doesn t pay much. Together they had a gross income of $41,400. Their standard deduction for their joint return is $11,400, so they will owe taxes on $30,000 (10% on the first $8,500 and 15% on the remaining $21,500). Or that s what they would have owed if they had not recently negotiated a big settlement on their credit card debt. A couple of years back, Mary had some health issues and couldn t work at all. To make ends meet, they used their credit cards heavily for several months and ran up some $20,000 in debt that they could not pay. In November they finally got it all resolved and the credit card companies agreed to accept $10,000 in full satisfaction of the entire $20,000 debt. Now Mike and Mary are looking at several 1099-Cs that show a combined discharged debt of $10,000. There is no good news here. Not only will they have to add this discharged debt to their $30,000 adjusted income and bring the taxable total up to $40,000, but the additional income will push them up into the next tax bracket. It will work this way: The break point for the 25% tax bracket is $34,500. Any taxable income between $8,500 and $34,500 is taxed at 15%; any income above $34,500 is taxed at 25%. Before they added in the $10,000 in discharged debt, Mike and Mary had $30,000 in taxable income. Now they have an additional $4,500 that will be taxed at 15%, plus an additional $5,500 that will be taxed at the next marginal rate of 25%. 9

11 Fifteen percent of $4,500 is $675, and 25% of $5,500 is $1,375. Last year s debt settlement will end up costing Mike and Mary a total of $2,050 in additional taxes. True cost of the settlement for Mike and Mary: $12,050 ($10,000 for the creditors and $2,050 for the IRS). Note: All calculations for Mary and Mike, Bob, and Sally are based on the 2011 tax tables and marginal rates. As you can see from these examples, it pays to understand how this works up front, before you negotiate your final deal. As part of the process of arriving at any settlement number, think through the likely tax consequences and factor in any additional costs that you might later owe to the IRS. If you don t, you could face an unpleasant surprise come tax time. One more point. A negotiated debt settlement isn t the only event that can trigger a Form 1099-C. Sometimes a creditor or a collection agency will issue a 1099-C if they just decide on their own to abandon collection efforts on a debt. There might have been no negotiations, and no debt settlement agreement; but if a creditor walks away from a legitimate claim, the abandoned amount is still a discharged debt as far as the IRS is concerned. If this happens to you, you ll have to report the income. If you think the creditor doesn t have the necessary paperwork to document the claim, or if you don t think the debt was ever your responsibility in the first place, you can explain this to the IRS in a letter accompanying your tax return. The IRS will investigate, but you ll have to pay taxes on the disputed amount in the meantime. If you don t, and you eventually lose the argument, you ll end up having to pay a penalty in addition to the tax. 10

12 Appendix California Statute California Statutes, Section 3311 (adopted 1992). (a) If a person against whom a claim is asserted proves that (1) that person in good faith tendered an instrument to the claimant as full satisfaction of the claim, (2) the amount of the claim was unliquidated or subject to a bona fide dispute, and (3) the claimant obtained payment of the instrument, the following subdivisions apply. Section (a) explanatory notes: A person against whom a claim is asserted is normally the debtor (the consumer). The claim is the amount the debtor owes. An instrument tendered as full satisfaction of the claim is normally the debtors check marked payment in full, or a check accompanied by a letter that shows the debtor s intent to make full payment. An unliquidated claim is a recognized debt for which the exact amount is not yet known. A claim that is subject to a bona fide dispute is a claim on which reasonable people could legitimately hold different opinions as to value. The claimant is the creditor. If the claimant obtained payment of the instrument this means that the creditor cashed or deposited the debtor s check. (b) Unless subdivision (c) applies, the claim is discharged if the person against whom the claim is asserted proves that the instrument or an accompanying written communication contained a conspicuous statement to the effect that the instrument was tendered as full satisfaction of the claim. Section (b) explanatory note: This section means that the creditor cannot sue the debtor for the balance if the check (or a letter accompanying the check) makes it clear that the debtor intended to make a payment in full settlement. (c) Subject to subdivision (d), a claim is not discharged under subdivision (b) if either of the following applies: (1) The claimant, if an organization, proves that (A) within a reasonable time before the tender, the claimant sent a conspicuous statement to the person against whom the claim is asserted that communications concerning disputed debts, including an instrument tendered as full satisfaction of a debt, are to be sent to a designated person, office, or place, and (B) the instrument or accompanying communication was not received by that designated person, office, or place. 11

13 (2) The claimant, whether or not an organization, proves that within 90 days after payment of the instrument, the claimant tendered repayment of the amount of the instrument to the person against whom the claim is asserted. This paragraph does not apply if the claimant is an organization that sent a statement complying with subparagraph (A) of paragraph (1). Section (c) explanatory notes: Subsection (1) recognizes that a large creditor like a credit card company or a bank might have a specific office or a designated person whose job it is to process settlements. It says that if the creditor notifies the debtor about such a department or designated person in advance, the debtor must mail the settlement check to that department or person. If the settlement check goes anywhere else, the settlement won t be effective. Subsection (2) recognizes that a creditor might accept and deposit a full payment check by mistake. It gives all creditors 90 days to discover the error and return the money to the debtor. If the creditor returns the money within 90 days, the creditor preserves the right to pursue the debtor for the full amount owed. (d) A claim is discharged if the person against whom the claim is asserted proves that within a reasonable time before collection of the instrument was initiated, the claimant, or an agent of the claimant having direct responsibility with respect to the disputed obligation, knew that the instrument was tendered in full satisfaction of the claim. Section (d) explanatory note: This section just says that the creditor can t return the money within 90 days and undo the settlement if the debtor can show that the creditor had actual knowledge of the debtor s intention to satisfy the claim in full and that there was no mistake when the creditor deposited the check. (Please note that the explanations that appear above in red bold italics are supplied by the author, and not by the California Legislature. They are not part of the statute.) 12

14 Acceptance of Verbal Offer Once you reach a verbal settlement with a credit card company or collection agency, you must confirm the entire agreement in writing before you pay. Don t send any money until you do so. Use the letter below, and remember that you don t have a settlement deal until the authorized representative of the credit card company or collection agency signs it and returns it to you. Date: (If to the Original Creditor) Name of Original Creditor Contact Person (if any): Original Creditor Department (if any): Original Creditor Name: Original Creditor Address: Re: Acc. # (If to a Collection Agency) Name of Collection Agent (if any): Collection Agency Name: Collection Agency Address: Re: Original Creditor Name: Acc. # CERTIFIED MAIL; RETURN RECEIPT REQUESTED Dear Sir or Madam (or Mr./Ms if you have a name), This letter confirms the debt settlement agreement that I reached with your authorized representative, (representative s name ), on (date ). I appreciate your willingness to compromise and allow me to resolve this debt with the limited funds I have available. Here are the terms. We have no settlement unless you agree to all of them. 1. Payment: I will pay you a single, lump sum of $. 2. Effect of Payment: This payment will reduce my account balance to zero and close the account. You will accept this payment as full settlement of all amounts charged to this account, including all principle, interest, late charges, penalties and assessments. You will make no further effort to enforce or collect on this account. 3. Credit Reporting: You will notify all credit reporting bureaus that this account has been paid as agreed, and you will remove from my credit report any and all negative references, including references to late payments, charge offs, or collections. 4. Successors and Assignees: This agreement is binding on the parties, their successors and their assignees. 13

15 If this letter accurately states our agreement, then please date and sign where indicated below and return the original to me in the enclosed self-addressed, stamped envelope. I have included a signed copy for your records. Once I receive the dated and signed original, I will send payment as agreed. Sincerely, Your name ================================================= CONFIRMATION OF SETTLEMENT AGREEMENT (Use this paragraph if you are dealing an Original Creditor.) By signing below, I attest that I am the authorized representative of, the original creditor and current owner of the account identified above. I have full legal authority to settle this account. This letter accurately states the terms of a settlement agreement that I approve and accept. (Use this paragraph if you are dealing with a Collection agency working on behalf of an Original Creditor.) By signing below, I attest that I am the authorized representative of, a collection agency hired by the original creditor,, to collect the account identified above. I have full legal authority to settle this account on behalf of the original creditor. This letter accurately states the terms of a settlement agreement that I approve and accept. Use this paragraph if you are dealing with a Collection Agency that has purchased the account and now owns it.) By signing below, I attest that I am the authorized representative of, a collection agency that has purchased and is now the owner of the account identified above. I have full legal authority to settle this account. This letter accurately states the terms of a settlement agreement that I approve and accept. Dated: Authorized Representative 14