The Tax Man Cometh: Strategies For Retiring Debt

As litigators, we often represent clients being pursued by creditors (banks, private lenders, bankruptcy trustees, etc.) seeking payment on loans or indebtedness. A strategy employed by many lawyers is to simply negotiate a discount on the indebtedness in exchange for immediate payment, with the remainder of the debt being “written off” by the creditor. If successful, this strategy will typically eliminate the client’s debt on better terms than if the debt were collected at face value. However, there is a potentially significant downside. The IRS considers forgiven or cancelled debt to be “income,” which lenders are required to report on form 1099-C. As such, your client will have to pay income tax on the amount of the forgiven debt. Depending on the amount forgiven, the income tax could be substantial. Knowing this, there is another alternative to consider.

Rather than seeking a discount and write off, consider an offer to purchase the indebtedness from the creditor for a discounted amount. Many creditors are amenable to this, as it makes no difference to their bottom line. They get their money (discounted of course) and walk away from the rest of the debt, leaving the purchaser holding the bag. The purchaser then simply holds the loan and does not discharge it (or take further action to collect it). As a result, there is no forgiveness of the debt, no “income” to your client and, consequently, no income tax to be paid.

Of course, every loan is different, and there is no one-size-fits-all method to accomplish this strategy. Lenders may be constrained by their own requirements (e.g., SBA loans cannot be sold to an affiliate of the borrower) and a third party purchaser may be needed to effectuate the purchase (oftentimes a company set up specifically for this purpose). As they say, the devil is in the details. That being said, knowledge of the tax consequences of debt forgiveness and the use of this strategy to retire debt, can result in significant tax savings to your debtor clients.

Please contact Ken Neuman with any questions about tax and accounting issues at kneuman@nagmlaw.com

Managing Partner Kenneth Neuman is a Certified Public Accountant (CPA) that has previously worked for a Big 4 accounting firm. Neuman specializes in complex commercial litigation including tax and accounting issues.