An Accountant Discusses Tax Implications of Business Debt Settlements

Settling business debt can seem like a great solution when you’re struggling under a heavy debt load. But before you take that route, it’s important to understand how debt settlements can affect your taxes. As an accountant, I often consult with business owners looking to settle their debts and want to walk them through the potential tax consequences. There’s no one-size-fits-all answer here — a lot depends on your specific situation. But I can share some general guidelines and scenarios to help you make an informed decision.

Canceled Debt is Usually Taxable

First, the basic tax rule is that canceled or forgiven debt is generally considered taxable income. This means if your creditor agrees to accept less than the full amount you owe, that canceled portion may be treated as income on your tax return[1].

For example, let’s say you owe $100,000 to a creditor and negotiate a settlement where they agree to accept $60,000 as payment in full. That remaining $40,000 in canceled debt would likely be viewed as taxable income by the IRS.

There are some exceptions to this rule, which I’ll get into shortly. But in most cases, any amount of debt forgiveness over $600 will trigger a 1099-C form from the creditor, reporting that income to the IRS. So you can’t simply make a deal to settle debt and assume it won’t affect your taxes.

How Canceled Debt Increases Your Tax Bill

Once canceled debt gets reported as taxable income, it can increase your tax bill in a couple different ways:

• It raises your gross income, which could bump you into a higher tax bracket.
• It increases your adjusted gross income (AGI), which reduces the value of deductions and credits.
• It could trigger alternative minimum tax (AMT), which eliminates certain deductions.
• It could make you ineligible for certain tax credits and deductions that phase out at higher incomes.

The end result is you could owe a lot more in taxes by settling your business debts. For some companies, the extra tax hit negates much of the financial relief they hoped to gain. It’s critical to estimate your potential tax liability ahead of any debt settlement.

Exceptions That Allow Tax-Free Debt Cancellation

Now for the good news—there are quite a few exceptions that allow tax-free debt cancellation[2]:

• Bankruptcy: Debt discharged through bankruptcy is not taxable. However, debt canceled outside of bankruptcy is taxable.
• Insolvency: If your business liabilities exceeded your assets immediately before the debt was canceled, that canceled debt is generally not taxable.
• Non-recourse debt: This is debt where the creditor’s only recourse, if you stop paying, is to take back the collateral securing the loan. A common example is mortgage debt. Up to the fair market value of the property securing the debt is not taxable.
• Purchase price adjustments: If debt is canceled as part of negotiating the purchase price of a business, the canceled amount is treated as a reduction in purchase price rather than income.
• Deductible debt: If the original borrowed funds would have been fully tax deductible, then cancellation of that debt is not taxable. This mainly applies to business debt, not personal.
• Student loans: Certain student loan debt forgiven through government programs is not taxable.
• Excluded farm debt: Canceled debt from the disposition of farm property is excluded subject to certain limits.
• Excluded real property business debt: Up to $2 million of canceled debt from qualified real property used in your business is excludable.

As you can see, there are quite a few potential exceptions, but they each have specific requirements. It’s important to consult a tax pro to confirm whether any of them apply to your particular situation.

Strategies to Minimize the Tax Hit

If your canceled debt doesn’t meet one of the exceptions, here are some strategies to consider to reduce the tax impact:

• Time the debt cancellation strategically in a year when you have losses to offset the income or tax credits to utilize.
• Look for tax deductions you can accelerate into the current year to offset the income.
• Check if any business tax credits may now be available due to the higher income.
• Consider an installment agreement with the IRS to spread the tax liability over multiple years.
• Be aware that state tax laws on debt cancellation may differ from federal.
• A tax professional can help model different scenarios to find the optimal timing and structure.

Bottom Line on Settling Business Debt

Settling debt often makes good business sense – it improves cash flow and gives you a fresh start. But before pursuing that option, be sure to plan for the tax impact. Consult a trusted CPA or tax attorney to run the numbers and look at your specific situation. With proper tax planning, you can settle your debts while optimizing the outcome on your tax return. Don’t let the fear of taxes stop you from a sound business decision. But do make sure you go in with eyes wide open!

I hope this overview gives you a good sense of how debt settlements can affect your taxes as a business owner. Reach out if you need help assessing your particular situation – I’m always happy to consult with business owners on strategic tax planning. Here’s to lightening your debt load and your tax burden!