Are Business Debt Settlements and Forgiveness Taxable Income?
This is a common question that many business owners face when struggling with debt. The short answer is – yes, most business debt settlements and forgiveness are considered taxable income by the IRS[1]. However, the full answer is more complicated, as there are some exceptions and defenses business owners can use.
-When Cancelled Debt is Taxable
In general, if your business debt is canceled, forgiven, or discharged for less than the full amount owed, the IRS considers the amount of canceled debt to be taxable income[1]. This is known as “cancellation of debt income” or COD income.
Some examples of when cancelled business debt would be taxable include:
- Negotiating a lump-sum settlement with a creditor for less than you owe
- Having part of your business loans or credit lines forgiven
- Reaching a settlement in bankruptcy where creditors agree to accept pennies on the dollar
- Having creditors “charge off” unpaid debts they no longer expect to collect
So if your business owed $100,000 across various debts, but through settlements and forgiveness you only had to pay back $60,000, the $40,000 in cancelled debt would likely be considered taxable COD income.
The creditor is required to file a 1099-C form with the IRS detailing the amount of cancelled debt[2]. You will also receive a copy of this 1099-C form from the creditor. This documents the taxable forgiven debt amount that must be claimed as income.
-When Cancelled Debt is Not Taxable
However, there are some important exceptions where cancelled business debt would NOT be taxable[1]:
- Debts discharged through bankruptcy under Chapters 7 or 11
- Debts cancelled when you are insolvent (liabilities exceed assets)
- Certain farm debts cancelled by qualified persons
- Debts cancelled in 2010 which were related to real property business debts
These exceptions can provide useful defenses against having cancelled debt taxed for struggling business owners. For example, if your business is deeply insolvent, with much more debt than assets, then any debt forgiveness likely would not incur income taxes.
Tax Rates on Cancelled Debt
The cancelled debt amount is taxed at your ordinary federal income tax rate, which can range from 10% to 37% depending on your total taxable income amount[3]. You would also owe applicable state income taxes.
So in the earlier example with $40,000 of cancelled business debt, if you were in the 22% tax bracket, you would owe around $8,800 in federal income taxes on the forgiven amount. State taxes could add another few thousand dollars.
As you can see, the tax bills can be quite steep. Some settlements that seemed like a lifeline can be dampened by high tax rates on the cancelled debt.
-Reporting Cancelled Debt on Tax Returns
You must properly report any taxable cancelled business debt on your federal tax return[4]. The forgiven debt amount gets reported on Form 1040 as “other income”. The 1099-C form you receive from the creditor serves to notify the IRS of the taxable debt discharge.
If you fail to report cancelled debt that the IRS has been informed of, you are very likely to face an audit, penalties, and back taxes. It is crucial to fully disclose any taxable forgiveness received.
Strategies to Minimize COD Income Taxes
Here are some proactive strategies business owners could employ to reduce taxes resulting from debt cancellation[5]:
-- Time forgiveness to occur in lower-income years when tax rates are reduced. This lowers the percentage owed.
- Offset COD income with current operating losses. Net operating loss carryforwards can also help minimize taxable income.
- Accelerate deductible business expenses into the tax year with debt discharge to reduce net taxable income.
- Transfer assets to family members if insolvency exception could apply due to reduced assets.
- Explore state tax laws, as some states do not tax cancelled debt income from insolvency.
While cancelled debt often does create a tax liability, working closely with both a tax professional and debt specialist can uncover ways to minimize the ultimate tax impacts.
The Pros and Cons of Settling Business Debt
Settling business debts for less than the full amount can provide critical relief to struggling companies. But the tax consequences can reduce the net benefits. Business owners should carefully weigh the pros and cons.
Potential Pros
- Immediate increase in cash flow when debt payments stop
- Removes burden of overwhelming debt payments each month
- Allows business to continue operating rather than liquidating
- Creditors agree to settle for pennies on the dollar
Potential Cons
- Settled debt forgiveness is treated as taxable income
- Income tax bills on cancelled debt could be substantial
- Damages business credit rating and ability to access affordable financing
- Lose business assets put up as collateral on the cancelled debts
As this overview displays, the positives of settling debts have to be balanced against the costs – like income taxes and collateral forfeited. Every business situation is unique, so owners need to analyze their own circumstances with advisors to determine if debt relief is prudent.
Key Takeaways
- Most business debt cancellation from settlements is treated as taxable COD income
- Exceptions exist when insolvent or bankrupt, but tax bills can still be thousands
- Carefully report cancelled debt and utilize strategies to lower tax rate impact
- Weigh pros and cons of settling debt given tax consequences
Settling overwhelming business debts can be a lifeline, but also creates complex tax implications. Understand the rules around COD income and work with financial and legal experts to pursue tax-efficient approaches to debt reduction. Relief from unpayable debts may come at the price of higher taxes owed – so make informed decisions.
[1]: https://www.irs.gov/taxtopics/tc431
[2]: https://www.cnbc.com/select/taxes-on-forgiven-debt/
[3]: https://www.incharge.org/debt-relief/debt-settlement/tax-consequences/
[4]: https://www.wtaxattorney.com/tax-problems/forgiven-liabilities/
[5]: https://www.lendingtree.com/credit-repair/tax-implications-of-settling-your-debt/