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Debt Settlement Risks

March 12, 2014

One of the riskiest propositions for getting out of debt is hiring a debt settlement company. While state, federal, and private consumer protection agencies continue to fight to regulate these companies, dangers still exist, even when the company is entirely legitimate and operating within the law.

A large tax bill is a consequence that often surprises individuals after a debt settlement. The IRS considers a settled debt essentially a gift from the creditor and taxes the forgiven amount as income to the taxpayer. The creditor is directed by law to send a Cancellation of Debt Form 1099-C to the taxpayer and to the IRS. The taxpayer must then account for the cancelled or forgiven amount to the IRS and pay taxes (unless otherwise exempt). Many debt-settlement companies do not adequately explain this risk when offering to settle a debt for “pennies on the dollar.”

Another risk is the extensive damage to the individual’s credit during the debt settlement process. Most creditors will not discuss debt settlement while the debt is being paid as agreed. Consequently, in order to settle the debt for less than 100%, the person must first stop making monthly payments. The effects of missed payments are devastating on a credit score and will continue for up to seven years. Additionally, the account may be sold or transferred to a collection agency, which further damages a credit report. Finally, even after the debt is settled, any final payment for less than 100% is a negative entry on a report.

Harassing phone calls and legal action may continue while the debt settlement company works to resolve your debt. There is no additional legal protection while a debt settlement company is attempting to settle a debt. The Fair Debt Collection Practices Act offers protection when an attorney is engaged to settle a debt, something most debt settlement companies cannot provide.

Many individuals find that the debt collection process can continue even after a debt is finally paid and settled. A settled debt can be erroneously reported as open and outstanding on a credit report, and the debt may be sold by the original creditor and pursued by a collection agency. In extreme cases, the individual may have to defend a wrongful lawsuit. Debt collectors rarely take the time to ensure the accuracy and legitimacy of a debt, and collection efforts may resume unexpectedly some months or years after the debt is settled and paid. In most cases, it takes some time and effort to ensure that a settled debt finally settled and is correctly reported to the credit reporting agencies.

Perhaps the most serious risk when engaging a debt settlement company is the company going out of business. Some companies ask their clients to deposit funds or make regular payments into a settlement account. If the company folds or files bankruptcy, it may be years before your money is returned – if ever.

Debts settlement companies are fraught with dangers. On the other hand, bankruptcy is a legal process, filed in the federal courts, and overseen by a judge. Your bankruptcy attorney is licensed and will represent your interest as you reorganize your finances. Discharged debts are not taxed as income, creditors may not contact you directly at all, and all negative credit reporting must stop after you file bankruptcy. If you are considering debt settlement to resolve your financial trouble, discuss your situation with an experienced bankruptcy attorney to get a different perspective. Call the experienced attorneys at Fears | Nachawati for a free consultation. Contact us at 1.866.705.7584 or send an email to


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