Monday, June 2, 2014

Bankruptcy vs. Debt Settlement

I am often asked about debt settlement and whether it is a better option than filing bankruptcy.  Before we go any further, it may be useful to talk about what bankruptcy is and what a debt settlement is.

Bankruptcy is a legal proceeding where a petition is filed with a bankruptcy court.  After certain proceedings through either a chapter 7 or chapter 13 filing (typical for most consumer debtors), debts are often discharged meaning that you are no legally obligated to pay those debts.  Your case is monitored by a bankruptcy judge and the court’s orders can be enforced through various means.  Your creditors are prohibited from contacting you and the process is generaly well organized.

A debt settlement is a voluntary arrangement between you and a creditor where the creditor will accept less than full payment usually in a lump sum payment or in a limited number of payments.  If an agreement is reached, the creditor will cancel or forgive some portion of your debt while you pay other portion.  One thing to remember about debt settlement is that it is a voluntary agreement.  The creditor does not have to accept your settlement offer.  The process may take many months, is often stressful for the borrower as collection call and letters will continued to be received, and there is little organization in the process. 

One other point about debt settlement is that if a debt is settled, the creditor will most likely issue a Form 1099 for the balance of the debt forgiven or cancelled.  This will be reported to the IRS as income to you and it could affect your tax liability.  But see Form 982 and instructions. 

There is also a significant difference in the professional fees associated with the two approaches. With bankruptcy, legal fees and court costs are generally agreed upon and know up front.  For a Chapter 7, one may expect to spend int eh neighborhood of $2,000 plus filing fees.  A Chapter 13 will be a bit more, but generally less than $4,000.  By contrast, the fees for debt settlement are generally set on a percentage basis, which 15% being the industrial norm.  Because of this, bankruptcy cases are generally far less expensive than debt settlement. 

Let’s use an example case for comparison of the two approaches. Let’s assume a consumer has accumulated $90,000 in unsecured debt, including credit card debt, medical bills, etc.  Assume further that the consumer’s assets are all “exempt” (state and federal law allow consumers to “exempt” certain types and amounts of assets in a bankruptcy so that the debtor may retain those assets.  For most people in bankruptcy, all of their assets will be “exempt”)

In a bankruptcy, the consumer would pay attorney fees of between $2,000 and $4,000 plus about $300 in court costs.  At the end of the case, the debts are gone and there are no tax consequences.  The consumer most likely never had to go to court and the collection calls stopped immediately.  A Chapter 7 case is often over in as little as 4 months.  When the case is complete, the consumer’s credit will usually begin to improve.

If the consumer elected to settle her debt, the consumer will likely pay about 40% of what is owed.  In this example, that would equate to $36,000.00.  In addition, the consumer will be taxed on the $54,000 charged off, thereby resulting in significant tax liability.  Next, the professional fees will run from $8,000 to more than $10,000, depending on how the relationship was structured.  During the process, which may take many months to over a year to complete, the consumer’s credit is being dragged through the mud.  When the debts are all settled and “off the book”, the consumer will be sad to learn that the damage to the credit from the process will be long lasting and often worse than a bankruptcy, which has a clear ending point. 

So, in the end, the bankruptcy costs around $2,300 (Chapter 7) while the debt settlement cost over $44,000, plus the added tax liability.  So, which option makes the most sense?  Of course, each person’s situation is different and, believe it or not, there are time in which debt settlement makes sense.  This is your financial future.  Do risk it on a catchy radio add or late night television spot advising against filing bankruptcy.  The right advise will lead to the right solutions.  Please feel free to call us to go over your options so that you may selected a course which would be most beneficial and cost-effective.