Debt Settlement

Debt settlement is the negotiated resolution of a debt for less than the amount owed. A creditor or the collector holding the account agrees to accept a reduced sum, usually in a lump payment or a short series of payments, and treats the balance as satisfied. It is the one route among the common alternatives that actually reduces the debt: consolidation replaces several obligations with one on new terms, a debt management plan reorganizes the payments and the concessions, and settlement lowers the number itself.

The regulatory vocabulary is broader than the market term, and the difference is worth keeping straight. The Federal Trade Commission's Telemarketing Sales Rule defines a debt relief service at 16 CFR 310.2 as any program or service represented "to renegotiate, settle, or in any way alter the terms of payment or other terms of the debt between a person and one or more unsecured creditors or debt collectors, including ... a reduction in the balance, interest rate, or fees owed." That category covers debt management plans as well as settlement, and it reaches unsecured debts only. Debt settlement is one form of debt relief service, not a synonym for the whole class.

Settlement can be done by the debtor directly with the creditor, at no fee, or through a company that enrolls the debts and negotiates. The rules described below are almost entirely about the second case, because that is where the money and the documented harm are.

How the enrolled model works, and why the mechanics create the risk rather than the negotiation. A settlement company typically instructs the customer to stop paying the enrolled accounts and instead pay into a dedicated account each month, building a pool from which offers can be funded. Creditors settle at a discount because a delinquent, likely-to-be-charged-off balance is worth less to them than a performing one. So the model depends on the accounts deteriorating first, and everything that happens to a delinquent account happens meanwhile: late charges, the loss of favorable rate terms, monthly reporting of the delinquency, referral or sale to a collector, and the possibility of being sued. The reduction in the balance is the product, and the deterioration is the mechanism that produces it.

The advance-fee rule is the central federal protection, and its conditions are cumulative. Under 16 CFR 310.4(a)(5)(i) it is an abusive practice to request or receive any fee for a debt relief service until three things are true: the provider "has renegotiated, settled, reduced, or otherwise altered the terms of at least one debt pursuant to a settlement agreement, debt management plan, or other such valid contractual agreement executed by the customer"; the customer "has made at least one payment pursuant to" that agreement; and, where debts are settled individually, the fee is either proportional to the debt's share of the enrolled total or a fixed percentage of the amount saved, with the percentage the same from one debt to the next.

The dedicated account has its own rules, and they favor the customer more than most customers realize. Section 310.4(a)(5)(ii) permits requiring funds to be set aside only if the funds are held at an insured financial institution; the customer owns them and receives any accrued interest; the entity administering the account is not owned, controlled by or affiliated with the provider and takes no compensation for referrals; and "the customer may withdraw from the debt relief service at any time without penalty," receiving all funds in the account other than fees lawfully earned, within seven business days of the request. So the accumulated money is the customer's, and leaving the program is a right rather than a negotiation.

The pre-enrollment disclosures are a short list, and reading them is the cheapest due diligence available. Under 16 CFR 310.3(a)(1)(viii) a seller must disclose the time necessary to achieve the represented results and, where settlement offers are contemplated, when a bona fide offer will be made to each creditor; how much money or what percentage of each debt must accumulate before an offer is made; and, at (C), where the service relies on or results in the customer not paying creditors on time, that using it "will likely adversely affect the customer's creditworthiness, may result in the customer being subject to collections or sued by creditors or debt collectors, and may increase the amount of money the customer owes due to the accrual of fees and interest." Subparagraph (D) requires disclosure of the ownership and withdrawal rights over the dedicated account.

The scope limit matters, and getting it wrong in either direction is a mistake. The Telemarketing Sales Rule is a telemarketing rule. It does not by its terms regulate every debt relief arrangement everywhere. But its exemptions are drafted tightly here: 16 CFR 310.6(b)(5)(i) and (6)(i) expressly carve debt relief services back out of the exemptions for inbound calls responding to an advertisement or to a direct mail solicitation, so the ordinary call-the-advertised-number sale is covered. Section 310.6(b)(3) does exempt transactions not completed until after a face-to-face presentation. The practical translation: a demand for money before anything has been settled is a strong warning sign about the company, and it is not automatically a federal violation. The Consumer Financial Protection Bureau's own bottom line on the industry is worth quoting rather than paraphrasing: "Debt settlement may well leave you deeper in debt than you were when you started."

The tax consequence is not among the disclosures the rule requires, and it changes the arithmetic materially. Forgiven debt is generally gross income under IRC 61(a)(11), and a settled balance is squarely a reportable event: 26 CFR 1.6050P-1(b)(2)(i)(F) lists as an identifiable event a discharge "pursuant to an agreement between an applicable entity and a debtor to discharge indebtedness at less than full consideration." Where the creditor is an applicable entity and the amount discharged is at least $600, it must file a Form 1099-C under IRC 6050P(b) and 26 CFR 1.6050P-1(a)(1) and furnish a copy to the debtor. Note that the regulation requires reporting "regardless of whether the debtor is subject to tax on the discharged debt," so receiving the form is not itself a determination that the amount is taxable.

Two exclusions do most of the work for consumers. Under IRC 108(a)(1)(A) a discharge in a title 11 bankruptcy case is excluded entirely. Under 108(a)(1)(B) a discharge occurring while the taxpayer is insolvent is excluded, capped by 108(a)(3) at the amount by which the taxpayer is insolvent, where 108(d)(3) defines insolvent as "the excess of liabilities over the fair market value of assets," measured "immediately before the discharge." People deep enough into debt to be settling are frequently insolvent by that test, which makes the exclusion both commonly available and commonly missed. It is claimed on a return rather than by omitting the income, and excluding an amount under 108 also reduces tax attributes under 108(b). State income tax may apply separately. This is the point in a settlement decision where the arithmetic is worth doing before the offer is accepted rather than after.

Either the debtor negotiates directly with each creditor, or a company enrolls the accounts, has the customer accumulate funds in a dedicated account, and negotiates as the pool grows. When a creditor accepts, the settlement is paid and the account is reported as settled for less than the full balance. Where a company is involved and the sale was covered by the Telemarketing Sales Rule, its fee cannot be requested until at least one debt has actually been altered under an executed agreement and the customer has made a payment under it. In January, a Form 1099-C may arrive for the forgiven amount.

A hypothetical example of the full cost, because the headline saving and the real saving are different numbers. Kai owes $24,000 across three cards and enrolls all of it. Over time the company settles the accounts for a total of $12,000, and its fee is 22 percent of the enrolled balance, which is $5,280 ($24,000 × 0.22).

Cash out of pocket is $17,280 ($12,000 + $5,280). The forgiven amount is $12,000 ($24,000 − $12,000), and each creditor's share of it above $600 is reportable on a Form 1099-C.

Suppose Kai is solvent when the settlements happen and his next dollar of income is taxed at 22 percent federally. The tax on the forgiven $12,000 is $2,640, and any state income tax comes on top. His true cost is $19,920 ($17,280 + $2,640) against the $24,000 he owed, a saving of about $4,080.

Two things that arithmetic does not capture, and both cut the same way. It excludes the interest, late charges and any collection costs that accumulated on the accounts while they went unpaid, which raise the balances being settled. And it assumes every creditor settled, which none of them was obliged to do. Had Kai instead been insolvent immediately before the discharges, the exclusion at IRC 108(a)(1)(B) could have removed the $2,640 entirely, which is why establishing insolvency before filing the return is worth the effort.

Pros

• It is the only one of the common routes that reduces the amount owed rather than rescheduling it.
• A resolved balance ends the exposure to being sued on that account, which consolidation does not do because the debt continues in full.
• Where the sale is covered by the Telemarketing Sales Rule, no fee may be charged until a debt has actually been altered and the customer has paid under that arrangement.
• The money accumulated for settlements is the customer's own, held at an insured institution and administered by an unaffiliated entity, and the customer may leave the program at any time and take it back within seven business days.
• The insolvency exclusion at IRC 108(a)(1)(B) is frequently available to the people who most need it, and it can remove the tax on the forgiven amount entirely.
• Settling directly with a creditor costs nothing in fees.

Cons

• The model generally depends on the accounts becoming and staying delinquent, so the damage to the credit record is a designed feature rather than a risk.
• No creditor is obliged to settle, and nothing in the arrangement prevents one from suing while funds accumulate.
• Interest, late charges and collection costs continue on the unpaid accounts, so the balance being settled can be larger than the balance enrolled.
• The forgiven amount is generally taxable, and a settlement that looks like a saving can be much smaller after tax.
• The fee is commonly calculated on the enrolled balance rather than the amount saved, so it does not fall when the settlements are less successful.
• Because the Telemarketing Sales Rule is a telemarketing rule, an upfront fee is a warning sign about a company rather than automatically a federal violation with a remedy attached.