Many people who are unable to pay their credit card bill naturally seek a balance reduction from the credit card company or the collection agency. Sometimes the balance is reduced, and the account holder is happy. However, they may have unknowingly made a serious mistake.
The IRS generally considers forgiven debt, or debt settled for less than the full amount owed, to be “cancelled.” Cancelled debt is generally treated as income that must be included on the filer’s tax return. Accordingly, the card holder may have reduced the amount he or she owes to the credit card company, but they increased the amount owed to the government. Of course, the amount of cancelled debt will be greater than income tax on the cancelled debt which results in a net positive. However, a problem arises when: 1) the individual is a candidate for bankruptcy; and/or, 2) the individual fails to realize that they qualify for an exemption or exclusion from taxation on their cancelled debt.
It is not uncommon for debtors to settle a few unsecured debts prior to realizing that, given their circumstances, filing bankruptcy is an optimal approach. In doing so, they likely incur income tax on cancelled debt. Unsecured debt is generally dischargeable in bankruptcy meaning the debt is no longer owed. Tax debt is generally non-dischargeable in bankruptcy unless a number of factors are present (primarily involving the age of the tax debt).
In other words, in many instances the debtor unknowingly converted dischargeable unsecured debt (which would not be taxed as a result of the discharge) into non-dischargeable priority tax debt.
Exceptions and Exclusions to Income on Cancelled Debt
Additionally, there are a number of exceptions and exclusions to the general rule that cancelled debt will be treated as income. The IRS describes the exceptions and exclusions in detail here: http://www.irs.gov/pub/irs-pdf/p4681.pdf.
One exception commonly applicable to people who cannot pay their credit card debt is the insolvency exception. As explained by the IRS in the above link:
[d]o not include a canceled debt in income to the extent that you were insolvent immediately
before the cancellation. You were insolvent immediately before the cancellation to the
extent that the total of all of your liabilities was more than the [Fair Market Value] of all
of your assets immediately before the cancellation.
Many people overlook this exception when filing their taxes and thereby pay too much in taxes or incur unnecessary tax debt which, again, is difficult to discharge in bankruptcy.
Those who have committed this error should contact a qualified attorney who can advise them on how to rectify the situation.