Debt Settlement Vs. Bankruptcy

When you are overwhelmed by debt, it can feel like you don’t have many choices. Continuing to pay interest only on your bills that never seem to go down can make you financially and emotionally weary. It is possible that bankruptcy has crossed your mind, but perhaps you aren’t sure how you feel about it. One possible alternative that might make sense to you is entering into a debt settlement plan. In either case, consulting with a bankruptcy attorney can help you make the decision on what you want to do.

How Bankruptcy Looks

For most individuals or small businesses, bankruptcy falls into one of two categories, Chapter 7 or Chapter 13. In a Chapter 7 bankruptcy assets are liquidated to the point where the filer keeps a modest amount of possessions and the remainder of their unsecured debt is forgiven. Filers must meet income and other requirements to file Chapter 7.

Chapter 13 is a reorganization of debt and in many ways, it looks a lot like debt settlement. The idea is to work with a bankruptcy trustee to figure out how much of your debt you should be able to afford and come up with a payment plan to pay off as much of your debt as you can over a 3-5 year period. The remainder of the debt is forgiven. Debt settlement does this too, but the participation of creditors is optional, while it is court-ordered in a bankruptcy filing.

Chapter 13 is a common choice for those who have higher incomes, have assets that they would have to forfeit if they filed a Chapter 7 bankruptcy, or are trying to prevent their home from being foreclosed on. Both Chapter 7 and Chapter 13 create an automatic stay, which prevents creditors from trying to collect on debts.

How Debt Settlement Looks

Many times people will opt for debt settlement simply because they feel better about it. While they are asking for some debt to be forgiven, they will rationalize that at least it falls short of bankruptcy. There will still be a negative effect on your creditworthiness, but perhaps not to the extent you would face by filing bankruptcy.

The Fine Print

If your main creditors seem to be open to the idea of debt settlement, it might seem like it is the right choice, but there are elements of debt settlement that many people forget to consider. Two of these involve existing taxes and future taxes.

Existing taxes

Those who owe money to the IRS might want to think twice before opting for debt settlement over filing a Chapter 13 bankruptcy. Many companies that specialize in debt settlement will advertise that they can get the IRS to settle tax debts. In reality, this hardly ever happens. Generally, if the IRS sees any glimmer of hope of getting the money, they won’t approve a settlement. The rarely approved cases normally involve people who are disabled or elderly to the point where they are unable to work,

Future taxes

When a person gets an offer from a creditor that they are allowed to pay just a fraction of their debt, the prospect can be inviting. However, there is a catch – taxes. When you pay off half of a debt, the IRS considers the other half of the debt “income.” and you will be asked to pay taxes on it. If you need to make these arrangements with several creditors those dollars can add up fast.

When debts are settled as part of a bankruptcy agreement, the amount discharged is not taxed. Your income stays in the exact place you expect it to be, and there are no unpleasant surprises just when you thought your financial outlook was going to be brighter.

Your Unique Situation

Obviously whether to file for Bankruptcy or seek debt settlement is a personal decision that you will need to feel comfortable with. In some cases having a few hundred or a thousand or so dollars won’t hurt you enough to cause a problem. But whatever you decide, do the math, and don’t count on long shots to work in your favor. Consult with professionals and make an informed choice that’s right for you.

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