While there may be many reasons to file bankruptcy, as opposed to seek partial loan forgiveness from a creditor, an often overlooked benefit to bankruptcy is that the discharge of a debt in a bankruptcy proceeding is a non-taxable event whereas non-bankruptcy loan forgiveness is a taxable event. While there may not be a logical reason for this disparity, it is the law. For example, assume that you have a $20,000 balance due on a credit card. While you cannot pay the full balance, you could pay $5000 in a lump sum. Were you to reach an agreement with the creditor to accept $5000 in full and final satisfaction of the debt with forgiveness of the remaining $15,000, by law, the creditor would be required to send you an IRS Form 1099-C which states that $15,000 of the $20,000 was forgiven. You, in turn, must report the $15,000 as income on your federal income and state income tax returns. Assuming that you pay a combined state and federal income tax rate of 25%, then you would owe $3,750 in state and federal income taxes. Logically, the tax treatment of debt forgiveness makes sense. In this scenario, you received $20,000, but paid back only $5,000. So, your income did increase by $15,000, and accordingly, is taxed. Conversely, were you to file a bankruptcy petition and receive a discharge of the $20,000 credit card debt, the discharge would not be taxed. For this reason alone, filing bankruptcy in lieu of obtaining loan forgiveness directly from a creditor may be beneficial to you. If you find yourself in this position, you should call Winegar, Wilhelm, Glynn & Roemersma where experienced bankruptcy attorneys can assist you.
This blog is a general discussion on the law and is should not be a substitute for legal advice. If you have a specific legal question, please contact our office and speak with an Attorney.