The Risks of Small Business Debt Settlement You Should Know

The Risks of Small Business Debt Settlement You Should Know

Debt settlement can seem like an appealing option for small business owners struggling with high amounts of debt. The promise of settling debts for less than you owe sounds great. But debt settlement comes with major risks that small businesses should understand before going down this route.

This article will break down the key risks of debt settlement for small businesses so you can make an informed decision. We’ll also look at some alternatives that may be better for your business.

What is Debt Settlement?

First, let’s quickly recap what debt settlement entails. Debt settlement involves hiring a company to negotiate with your creditors to settle your debts for less than the full amount owed. The debt settlement company contacts each of your creditors and tries to get them to agree to accept a lump sum payment that is less than the total debt, in exchange for considering the account settled.

To do this, you’ll stop making payments on your debts and instead put money in a separate account to save up for the settlement offers. This means your accounts will become delinquent or go into default as you stop paying on them [4].

Risk 1: Damage to Your Credit Score

One of the biggest risks of debt settlement for small businesses is the hit your credit score will take. When you stop making payments to creditors, your business accounts will become delinquent. This will cause a significant drop in your business credit score [2].

Defaulting on accounts also means creditors will likely close those accounts. Having closed accounts with past due balances on your credit report makes it very hard to get approved for new credit or get the best rates. Your personal credit score can also take a hit if you personally guaranteed any business loans or credit cards.

A damaged credit score can have major consequences for a small business:

• Higher interest rates on loans and credit cards
• Rejection for new financing needed to operate and grow
• Difficulty getting approved for business services

This damaged credit score can plague your business for years. Negative information stays on your business credit report for up to 7 years [3].

Risk 2: Creditors May Reject Settlement Offers

There is no guarantee creditors will accept a low settlement offer from the debt settlement company. Creditors may reject an offer that is say, 50% of the amount owed, if they believe they can recover more through other means [3].

If creditors reject a settlement offer, the debt settlement company will need to come back with a higher counteroffer. But there is still no assurance it will be accepted. You may have to reach out to creditors yourself if the debt settlement company hits an impasse.

In a worst case scenario, you could end up owing the creditor more than you originally did between interest, penalties and fees. If settlement attempts completely fail, bankruptcy may be your only remaining option.

Risk 3: Debt Settlement Fees Can Add Up

Debt settlement companies typically charge 15% to 25% of the amount settled [2]. On top of that, you’ll pay fees for the dedicated savings account you need to set aside money in. So even if the settlement amount is less than your total owed, fees could tack on an additional chunk of change.

For example, if you settle a $20,000 business credit card balance for $10,000, you may pay $2,500 (25%) to the debt settlement company. Plus account fees that could total a few hundred dollars. That means your total cost would be $12,500, not $10,000.

If the debt settlement company is not able to settle all your debts, the additional interest, penalties and fees charged by creditors could end up costing you more than if you had stuck to your original payment plans.

Risk 4: Tax Implications

Settled debt could be considered taxable income by the IRS. If a creditor forgives or cancels $600 or more of debt through a settlement, they will send you a 1099-C form reporting the amount [2].

You would then have to claim the forgiven debt as income on your taxes. This could bump you into a higher tax bracket and result in owing the IRS. Make sure to discuss potential tax implications with your accountant before pursuing debt settlement.

Risk 5: Debt Collection Lawsuits

When you stop making payments on accounts, creditors may pursue legal action to recover what you owe. It is common for creditors to sue debtors in order to get a court judgment against them [6].

If you are sued by a creditor and they are awarded a judgment, the creditor can then pursue aggressive collection methods like garnishing your bank accounts or placing liens on your business property and assets. This can cripple a small business’s finances.

Some debt settlement companies claim they can prevent creditors from suing. But there is no foolproof way to stop legal action. Debt settlement essentially pokes the bear by ceasing payments, so lawsuits are a very real risk.

Risk 6: Scams and Unethical Companies

The debt settlement industry unfortunately attracts some unscrupulous operators looking to take advantage of desperate small business owners. Some warning signs of shady debt settlement firms include:

• Asking for large upfront fees before settling any debts
• Making unrealistic claims about how much debt they can settle or how fast they can do it
• Advising you to stop communicating with creditors
• Telling you to stop making payments without a plan in place

Scam debt settlement companies pocket the fees you pay, but make little effort to actually settle your debts. This leaves you worse off than before. Make sure to thoroughly research any debt settlement company with the Better Business Bureau before using their services.

Alternatives to Debt Settlement for Small Businesses

Given the risks involved, business owners should consider all other debt relief options before turning to debt settlement. Some alternatives to explore first include:

Debt Consolidation Loan

With a debt consolidation loan, you take out a new loan to pay off multiple existing debts. This combines everything into one monthly payment. Debt consolidation can help you get lower interest rates, reduce monthly payments, and simplify bill pay.

Just beware of very long loan terms that end up costing more in interest over time. Also, taking on additional debt adds risk should the business’s finances take a hit in the future.

Balance Transfer Credit Card

A 0% balance transfer credit card offers 0% interest for 12-18 months. You can transfer existing balances over and avoid interest charges during the intro period. This temporary reprieve gives you time to pay down principal without growing balances from interest.

Make sure you have a payoff plan though, because high standard rates kick in after the intro period ends. The balance transfer fee also cuts into potential savings.

Credit Counseling

Meeting with a non-profit credit counseling agency can help you evaluate your financial situation and develop a personalized debt repayment plan. They can often negotiate better terms, lower payments, and reduced interest rates with creditors.

The key is committing to the debt management program and following through. If you fail to make the agreed upon payments, you’re back to square one.

Bankruptcy

As a last resort, small businesses can explore filing for bankruptcy protection. This stops collections and wipes out many debts entirely through liquidation or reorganization. Bankruptcy allows you to start fresh but comes with long-term damage to business credit.

Proceed with Caution

If you do decide debt settlement is your only viable option, proceed with extreme caution. Thoroughly research any debt settlement company before signing anything or paying fees. Get agreements in writing upfront and understand the process. Consider consulting an attorney to review any contracts and protect your business’s interests.

Debt settlement often seems like the easy way out of debt problems. But the risks involved can end up harming your business more in the long run. Exhaust all other options before turning to debt settlement as a last resort.