One advantage bankruptcy has over debt settlement is that the discharged portion of the debt is not reported to the Internal Revenue Service as income. Creditors that forgive debt in a debt settlement agreement are required to report the forgiven portion to the Internal Revenue Service in an IRS form 1099-C. At the end of the year the 1099-C is sent to the debtor who must include the forgiven portion of the debt as taxable income for the prior year. Creditors rarely tell debtors that this will happen at the time the settlement agreement is signed, and as a result many debtors don’t realize their tax liability for the transaction until the end of the year when the 1099-C arrives in the mail. This attribute of debt settlement makes it a much less attractive option to bankruptcy for many debtors.
In bankruptcy, debt is discharged rather than forgiven. Discharged debt is not reported as income to the Internal Revenue Service, or at least it shouldn’t be reported as income. On occasion a creditor will mistakenly file a 1099-C for discharged debt. When this happens the debtor should file Internal Revenue Service Form 982 with their return. Form 982 is used to exclude the discharged portion of indebtedness from the debtor’s income. Most debtors will only have to fill out Part 1 of the form, but if you are not familiar with the Tax Code or do not have training in preparing a tax return it may be helpful to hire a local accountant or tax attorney to assist you with your return and Form 982.