Question 1

What Exactly Is Debt Settlement, And How Is It Marketed To Orange County Residents?

Accepted Answer

A company that does this sort of thing will tell you, “We’ll work things out with your creditors. We'll negotiate with them so that you can come into a program that's manageable. You'll be able to pay your debts, perhaps at a reduced amount over time, and this will take care of all of your problems.”

There are problems with that particular line of reasoning. But at least that's the idea; that “If you have overwhelming debt, don't do bankruptcy! We'll work things out for you.” I have a few comments about this.

First, suppose you call a creditor and ask, “Could we work something out to reduce the balance, or the interest rate, or the payments?” If the balance is relatively small, they might work things out with you. However, with larger balances they will want to have evidence to establish that you are unable to pay them everything that you owe them.

They won't take your word for it. They will want to see hard evidence. They typically want to see paystubs, a list of your other debts, and a list of your assets. As I just indicated, this request for evidence is if the debt's significant. If you call a creditor to whom you owe $500, they're probably not going to demand supporting evidence. But somebody to whom you $40,000 will very likely require evidence of your inability to pay.

If the Debt Negotiation Company or the Debt Settlement Company, doesn't ask you for copious evidence that it can present to the creditors, then you should be very, very suspicious. Because if the creditor isn't going to take your word for your payment inability, why would the creditor take the Debt Settlement Company's word for it, since their source of information about you is you?

Approximately 10% to 15% of my clients have been in these programs for a few years, and then contact me because they're being sued by the very creditors that were supposed to have been taken care of in the program. In fact, yesterday I had a conversation with someone who told me that he had been in debt settlement program for a while. He called me because Wells Fargo had just filed suit against him, and Wells Fargo was one of the creditors that was listed in the debt settlement program. Therefore, from my perspective, something isn't be right about the Debt Settlement Company’s promises.

They claim that they can work things out so that your creditors will go along with what they propose, but frequently their promises are nothing more than vaporware.

Question 2

How Does Debt Settlement Impact My Credit Score Compared To Chapter 13 Bankruptcy?

Accepted Answer

In a debt settlement program, presumably there's going to be some reduction in the debt. Your credit reports typically will say that the portion of the debt that the creditor waived was “charged off.” When you see “charged off,” you might think the debt's gone. It isn’t.

Outside of bankruptcy there are two possibilities.

The first is the one I just mentioned: The creditor discharges some, or all of the debt ― whether in a debt settlement or otherwise. When the creditor discharges the debt it will file a Form 1099-C with the taxing authorities – the IRS, and, in California, the FTB – so it can use the loss to lower its taxable income to concomitantly lower its tax. The taxing authorities will comply with the request. They will then credit the discharged amount to you as income. It’s called cancellation of debt income, or imputed income from discharge of indebtedness. You will then owe income tax on that debt. Thus, you have changed the identity of the creditor from ABC Bank to the IRS and the FTB.

The second possibility is the creditor will sell the debt to someone else at a reduced price. You might see “charged off” on your credit reports after this transaction. Does this mean the debt is gone? Or that you only owe the reduced amount?

No, the debt isn't gone. Somebody else has bought it, and for tax purposes, the original creditor is putting “charged off” because they're claiming that this is a bad debt, and, as in the first possibility discussed above, they want to lower their taxable income to concomitantly lower their tax liability. Once again, the identity of the creditor has changed from the original creditor to the entity that purchased the debt – and you still owe the full amount, not the sale price.

Things are different in bankruptcy.

When you complete a Chapter 13 plan and receive a discharge, or you receive a Chapter 7 discharge, your credit reports will say “discharged in bankruptcy.” Will you owe income tax on the discharged debt? No. The tax code has a provision that excludes debts discharged in a bankruptcy from taxable income.

The bankruptcy entry will stay on your credit reports for 7 years, if you do a Chapter 13, and 10 years, if you do a Chapter 7.

This may lead you to conclude that you won’t be able to get any credit or buy a car, while the bankruptcy entry remains on your credit reports. That conclusion is incorrect for two reasons.

First, when you discharge the debt you free up future income to pay on future debt. Second, when you receive a discharge, you become ineligible to receive another discharge for several years – the number of years depends on the chapter of the previous bankruptcy and the chapter of the next bankruptcy.

As a result, you will become more attractive, not less attractive, to creditors.

As a matter of fact, I've had plenty of clients who, while they were in their Chapter 13 plan, have bought cars.

If you buy a car while you are in Chapter 13, you have to get the judge's permission because the new car payment will reduce the amount you have available to make plan payments. Thus, when you go into Chapter 13, you cede some of your financial independence to the Court. One reason for this apparent paternalism is that the judges genuinely want people to succeed in Chapter 13. When they exercise this gatekeeping role, they are trying to improve your chances of having a successful case.

In sum, you'll be able to get credit. You'll be able to get loans.

If you want to make a big purchase such as a house, either you must wait a few years, or you must have a very large down payment. A large down payment will cover a multitude of financial sins.

I have had a couple of cases where my clients were in Chapter 13, and while they were in the Chapter 13, they bought a house. In both cases, the parents stepped up to the plate and helped them out with the down payment. With a large downpayment the creditor will pay attention because the borrower has some skin in the game.

On the loans that my clients took out, the monthly payments were right about the same as what the rent payments had been, so nobody was prejudiced. The judges in those two cases were happy to grant the motions for authority to incur new debt to purchase real property.

Similarly, with a car, the larger the down payment, the better the terms. Anytime you have a low down payment, the interest rate will go up because there is a perception of increased risk on the part of the creditor. Larger down payment, less risk. This is because you've bought some equity, and if you don't make the payments and the creditor repossesses, then the chances are very great that it will be paid in full through the sale.

Just because a bankruptcy is on your credit reports does not mean that you will not be able to get credit or that you won't be able to buy cars or whatever. But it does mean that you might have to have a larger down payment in order to get more favorable terms.

Question 3

Are Creditors Legally Required To Participate In Debt Settlement?

Accepted Answer

Well, this is where it gets to be a little bit vague. Technically, no. Some of the creditors will engage in debt settlement, I think insincerely, so that the Federal Government doesn't come on in and sort of shake them down. But in a very real sense, not really.

There is no cudgel that a debt negotiation or debt settlement company can use to force the creditor to go along with what you're proposing.

In contrast, one of the great benefits of Chapter 13 Bankruptcy is the power of the U.S. Government.

When you propound a plan of reorganization under Chapter 13, as soon as the judge for your case confirms the plan, the creditors just have to accept it. There isn't any “That doesn't really work for me.” You have the power of the United States Federal Government to force your creditors to accept the terms of the plan. With a debt settlement program, there is no cudgel. There is no government agency that can come in and force the creditors to go along with what you're proposing.

As a result, Chapter 13 tends to be much more effective in addressing debt problems. Yes, you're going to enter into a debt repayment plan, but the terms are always structured to be manageable and as I said, you've got the power of the Federal Government to force your creditors to go along with what you're proposing.

Question 4

What Happens If Just One Creditor Refuses To Negotiate?

Accepted Answer

There's a common term (I didn't come up with it) for this problem: “The free rider problem.”

Let's say you have 10 creditors. You'd like to work things out with all 10 of them. Suppose one of them is recalcitrant and says, “I'm not going to go along with it. You owe me this money; pay up!” You're not going to get a nice global resolution. The uncooperative creditor may say, “You've got these other creditors. Let them take the bath, and you pay me in full”.

This is a problem for a debt negotiation company because it can't force the creditor to go along with what you're proposing. Again, that's the great benefit of Chapter 13. You have the power of the United States Federal Government to force your creditors to go along with the plan.

It's binding on everybody, and if a creditor says, “I don't care about your rinky-dink little court,” it is making a very expensive mistake. I think Chapter 13 is a much more effective way to deal with debts than using a debt settlement company.

Question 5

Can Debt Settlement Stop Lawsuits Or Garnishments?

Accepted Answer

Only if the creditor agrees to it and again, if you've got that free rider problem where the creditor is suing you and the debt settlement company contacts them and says, “Hey, could you drop the lawsuit?” the creditor will undoubtedly respond by asking, “What's in it for me?”

If the creditor has already filed suit, it has already paid an attorney so it wants to recover not only the underlying debt, but if possible, the costs and attorney fees. Thus, if you were going to have any hope of doing some sort of negotiation, you needed to do it a long time before the lawsuit was filed.

Ultimately, with negotiations, here's the key, the magic bullet: You have to convince the person on the other side of the table that it's in that person's best interest to do what you're proposing. If you're going to appeal to compassion or “Oh, can't you help me out?” you've already lost. That's the beauty of Chapter 13. There really isn't negotiation.

If your proposed plan satisfies the statutory requirements, the Judge will confirm it. While a creditor can object to confirmation based on a claim that the plan is unfair, once the judge confirms the plan, it's binding on everybody. A creditor that violates the terms of the plan can be sanctioned and sometimes sanctioned a lot of money.

So, there is potency in Chapter 13 that is unavailable with debt negotiation.

Debt negotiations won't stop lawsuits or garnishments unless the creditor agrees to stop those things. However, filing a bankruptcy petition will stop lawsuits and garnishments.

Question 6

What Happens If The Company Collecting My Monthly Negotiated Payments Shuts Down?

Accepted Answer

You're in an awkward position, aren't you? Because now you've paid this money to that company, and frequently they'll have you pay their fees up front before they start remitting any payments to any of your creditors.

So, you've just shoveled money out into a company that has evanesced into the ether. You're in trouble because now you're out a whole bunch of money without having got any relief at all.

Not a good situation in which to find yourself. I have had clients who found themselves in that exact situation where they paid that debt settlement company a whole bunch of money and that debt settlement company ceased operations.

Once again, I recommend Chapter 13 over debt settlement.

Question 7

Are Forgiven Debts Taxed As Income Under The IRS Rules?

Accepted Answer

Very interesting question I discussed above. Here’s a folksier analysis:

Suppose you owed me $100,000. And I'm such a nice guy that I say, “I forgive you the debt. You don't have to pay me.” Pretty nice guy, if you ask me. I've just taken a financial bath, what am I going to do? Report the loss on my income tax return because I want to use the loss to lower my taxable income to concomitantly lower my tax liability.

The taxing authority, whether it's the IRS or the Franchise Tax Board will allow me to write off the loss. It will then ask who got the benefit? You got the benefit. Therefore, they're going to say to you, “You owe us income tax on $100,000;” and you're thinking, “Where is this $100,000?” Here's the way they reason it: When I forgave you that $100,000 debt, that was financially equivalent to you going out and earning $100,000 and paying me off.

Put another way, you've got a $100,000 benefit because you don't have to pay me. The $100,000 is then imputed to you as income, and it's genuine taxable income, even if you don't have one penny to show for it. However, Section 108 (a) of the Internal Revenue Code, which is title 26 of the US Code, has some carve outs. One carve out is for debts that are discharged in a Title 11 case.

The Internal Revenue Code is Title 26, the Bankruptcy Code is Title 11. Thus, if you have debts discharged in a bankruptcy, there is no taxable event, no matter how big the discharge was. That's another really good reason to discharge of the debts through bankruptcy.

Unfortunately, if you have the debts discharged before you file the bankruptcy, that is, the creditor says, “I forgive you the debt,” now you've got a real problem because you've just changed the identity of the creditor. It's no longer ABC Bank. It is now the IRS or the Franchise Tax Board, and that tax debt is probably not going to be dischargeable in bankruptcy.

If you're in this situation, you need to file your bankruptcy petition before there's any cancellation of debt. Because if you get a 1099(c) (which stands for cancellation of debt) from the creditor, you now have a tax liability, and that tax liability is not going to be dischargeable in bankruptcy.

So, file the bankruptcy petition before you get any debts canceled, because if debts are discharged in bankruptcy, it does not create a taxable event.

Question 8

Why Does Chapter 13 Bankruptcy Offer More Protection And Peace Of Mind Than Debt Settlement?

Accepted Answer

At the risk of being a bit pleonastic, what we've already talked about really captures what's going on here.

First you have a cudgel, the United States Federal Government, to force your creditors to accept what you're proposing. They cannot opt out and say, “That doesn't work for me”.

Second, as long as the debts have not been forgiven before you file the bankruptcy petition, when you complete your Chapter 13, you’ll get a discharge of the unpaid portion, and whatever accrued interest there might have been.

Third, there is no taxable event; whereas if you go through one of these debt negotiation programs (and somehow you're successful and get these debts reduced), you will have taxable events with each of those creditors. I think of those three things--all by themselves--as giving peace of mind for choosing to file bankruptcy rather than choosing debt settlement.

Fourth, you have just one monthly payment you're making to the Chapter 13 Trustee appointed to your case. The Trustee will take the payment and distribute it to the creditors according to the terms of the judge-confirmed plan, but you no longer have to deal with a whole bunch of creditors.

For the most part, there is no interest accumulation after you file the petition, so the whole thing is not a moving target; you know where you're headed.

Chapter 13 is a very attractive option for dealing with debt, and much more attractive than debt settlement. Someone might argue that to a fellow with a hammer everything looks like a nail, and to a bankruptcy attorney with a client with debts, Chapter 13 must be the way to go. I suppose there’s some truth to that assertion. However, Chapter 13 isn’t the only chapter we use.

Generally speaking, if you are a good candidate for bankruptcy, we start with Chapter 7 ― if you're eligible ― then we try Chapter 13 ― if you're eligible. If neither of those works, we try Chapter 11.

Of course, if you have the resources to pay your debts in full, then don't worry about bankruptcy. Just pay the debts. Bankruptcy is for debts that you're having real trouble paying.

Bankruptcy is a financial nuclear weapon. It's very potent. It's very useful, but it's not necessarily for everybody, and I'll have people call up and say, “I'd like to hire you to do a bankruptcy;” but once I get some information about their situation, it becomes clear that maybe bankruptcy isn't the right thing for them.

If you're thinking about bankruptcy, and you are in the Central District of California, not in Michigan or Mississippi, give me a call, and we'll talk. If bankruptcy isn't right for you, I'll let you know, and if it is, we'll talk about which chapter makes sense.

Question 9

Still Have Questions? Ready To Get Started?

Accepted Answer

For more information on debt settlement dangers in Orange County, an initial consultation is your best next step. Get the information and legal answers you are seeking by calling (562) 777-9159 today.

The Hidden Dangers of Debt Settlement In Orange County, CA: What Most Companies Won’t Tell You