Business Debt Settlement Pros and Cons: A Balanced Look

When your business is behind on its loans and merchant cash advances, you basically have four choices: refinance, restructure, settle, or file for bankruptcy. And when it comes to this third option - debt settlement - you’re making the decision to pay off your debt for less than the original amount that you owed. You are essentially negotiating with your lenders to accept less than what they are owed in exchange for paying off what you can. Debt settlement makes the most sense when the other options, like refinancing or restructuring, are not in play. When debt settlement is successful, you save money and put those debt problems behind you. On the other hand, it can hurt your business credit score, and not every creditor is willing to deal. The difference (the “discount”) between the settlement amount and the actual amount owed is debt forgiveness that is generally taxable.

Debt settlement may be a win-win, but why would a creditor take such a cut? Well, creditors and lenders have no interest in owning a collection of debt. It costs money to keep track of debt, to chase debtors, and to keep their legal machinery working. The longer debt stays unpaid, the more likely a debtor or debtor business is to declare bankruptcy, which may result in the creditor receiving nothing at all.

Debt settlement is most often associated with business loans, merchant cash advances, and vendor balances. Credit card debt and other types of revolving credit are good candidates for debt settlement. The key factor, again, is whether or not the creditor is willing to work with you.

When you opt for debt settlement, you’re opening the door to more than just a reduction in total amounts owed. Debt settlement can also help you preserve the business itself, which is often the point of the whole exercise.

When you are in the process of debt settlement, there is a real chance that your creditors or lenders will file a lawsuit in order to collect what’s owed. They are also able to charge interest, apply late fees and penalties, and ultimately harm your credit score. If the creditor prevails in court, it may even be able to garnish wages or put a lien on property.

Federal law requires many lenders to file an IRS Form 1099-C, Cancellation of Debt, to show the difference between the settlement amount and the amount actually owed, when that amount is $600 or more. You may be able to exclude the forgiven amount from your taxable income under the so-called insolvency exclusion, but the exception applies only to the amount by which your liabilities exceeded your assets just before the cancellation. This is a Form 982 situation, so see a tax professional before settling.

Debt settlement companies generally charge a fee that is a percentage of the total debt or a percentage of the amount that gets saved. Federal law protects consumers against debt settlement companies that charge fees before a debt is actually settled, but these rules do not apply to business debt. It’s critical that you understand and document when fees are due and the total cost of the engagement.

When you personally guarantee business debt, you are basically telling the creditor that your personal credit is on the line too, so the creditor can pursue you personally. Make sure the debt settlement agreement actually releases you from the guarantee, and keep in mind that settled accounts and judgments can affect both your personal credit and your business credit.

Debt settlement programs can run from six to 24 months, and that time frame depends on many factors, including whether your creditors are even willing to play. If you want to settle up-front with lump-sum offers, a program can go faster and usually for less money. And in some cases, a creditor will not start to negotiate until they have filed a lawsuit.

When the Business Itself Is Viable

Debt settlement can really help when the business itself is viable, but the size and frequency of debt payments is more than the business can support. It makes sense when you are unable to refinance your debts or find other ways to lower the payments, and you want to avoid bankruptcy. MCA debts can have a nasty impact on cash flow, and it may be that the best solution is simply to reduce the amount owed and move on. Debt settlement usually makes less sense when you are a reasonable candidate for a refinance, the business is going through a short-term cash crunch that could be fixed by a payment deferral, or you have determined that the business is simply not viable and its debt is mostly secured.

Get the Deal in Writing

Everything really hinges on your ability to get the deal in writing. Make sure the writing is clear on what you agree to and that the creditor is accepting less than the full balance in exchange for full and complete discharge of the entire obligation. Keep copies of your debts, of your offers, of your correspondence with your creditors, of the final deals, and of the amounts you pay (and when). The agreement should also cover dismissal of any pending lawsuit and a deadline for the creditor to file a UCC-3 lien termination. When you have paid as promised, get a paid-in-full letter and confirm the termination was filed.

You know you’re probably talking to the wrong debt settlement company if it offers a fixed percentage without first looking at your contracts, pushes you to sign up the same day, keeps fee terms vague or verbal, or has no written plan. They cannot know what they can save until they review your contracts.

Debt settlement isn’t a good fit for everyone, but if you want to put bad debt behind you without putting the business itself in peril, it may be the right call. Make sure you do your research and pick the right company, but most importantly, be realistic about your own situation, about what your creditors will agree to, and about the impact the process can have on your credit. You should be clear on what your legal rights are, the tax implications, and the terms of your contracts before you start the debt settlement process.

This is not advocacy. It is accounting.