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How Cancelled Debts Affect Business Taxes: An Accountant’s Advice

By Spodek Law Group | February 20, 2024

How Cancelled Debts Affect Business Taxes: An Accountant’s Advice

Dealing with debt cancellation can be confusing for business owners when it comes to taxes. As your accountant, I want to provide some advice on how cancelled debts impact your business taxes, as well as your options.

Overview of Debt Cancellation

When a debt is cancelled or forgiven, this essentially means you no longer legally have to pay back the debt. This commonly happens when you settle a debt for less than the full amount owed. However, even though you don’t have to repay the cancelled debt, there can still be tax consequences.1

Cancelled Debt is Usually Taxable

If you are a business that has debt cancelled, the cancelled amount is generally considered taxable income by the IRS.2 So if you have $10,000 in business debt forgiven, you would have to claim that $10,000 as income on your business tax return.

There are some exceptions where cancelled debt is not taxed:

  • If the debt is cancelled in a bankruptcy case
  • If the debt is cancelled when you are insolvent (liabilities exceed assets)
  • If the debt is qualified farm debt
  • If the debt is qualified real property business debt (with exceptions)

But in most common situations, cancelled business debt will be taxable.

You May Get a 1099-C for the Cancelled Debt

When a lender cancels or forgives a debt of $600 or more, they are usually required to send you a 1099-C form.3 This details the amount of debt cancelled so both you and the IRS are aware of the taxable income.

So if you settled a business credit card debt for less than you owed, you would likely receive a 1099-C showing the amount of debt forgiven.

The Cancelled Debt is Taxed at Your Marginal Tax Rate

As a business, the cancelled debt amount is subject to your ordinary business income tax rate. Whether you are a sole proprietor, partnership, corporation, etc., the income is taxed at your marginal rate.4This means if you are in the 22% tax bracket, $10,000 of cancelled business debt would create $2,200 of federal income taxes owed (10,000 x 22%). Plus you may owe additional state taxes on the cancelled debt as well.

You Can Negotiate to Avoid a 1099-C in Some Cases

When negotiating a debt settlement on a business obligation, you may be able to convince the lender not to issue a 1099-C. This requires getting written confirmation from them stating they will not report the cancelled debt or file any forms with the IRS.5If you can successfully negotiate no 1099-C, then you do not have to claim the cancelled debt. However, if audited, the IRS may still determine the debt cancellation was taxable income. So this approach does involve some risk of additional taxes/penalties down the road if not reported. Consult with your accountant on the risks and benefits of this strategy before implementing.

Bankruptcy and Insolvency Exceptions

As mentioned before, there are exceptions where cancelled debt does not create taxable income. Two common business examples include:

Bankruptcy: Debt discharged through a Chapter 7 or Chapter 11 bankruptcy case does not create taxable income for a business.6 However, there are still many downsides with using bankruptcy, so discuss with both a lawyer and accountant before pursuing this option.

Insolvency: If your business liabilities exceed your total assets, then cancelled debt may be excluded based on insolvency rules.7 This involves filing detailed forms demonstrating insolvency with your tax returns.

These exceptions can eliminate taxes on cancelled debt, but still have negative consequences overall. Meet with your accountant to review if they truly make sense for your situation.

Options to Pay Tax on Cancelled Debt

If you do end up with taxable income from cancelled business debts, you have a few options on how to pay:

  • Pay from available funds: Ideally you have enough reserves or working capital to pay the additional tax created.
  • Payment plan: The IRS allows payment plans to pay off tax debts over 6 years. You still owe interest and penalties until paid off.8
  • Offer in Compromise: In some hardship cases, you may qualify for an offer in compromise to settle tax debts for less than the full amount.9

I can help you review the cancelled debt tax implications for your business and discuss setting up an IRS payment plan if needed. Reach out to review your options.

I hope this overview gives you a better understanding of how cancelled debts affect your business taxes. 

Resources

Videos

What is Canceled Debt? Will I Have to Pay Taxes?

Articles

What You Need to Know About Cancellation of Debt Income

Forgiven Debt and Its Tax Implications

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