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By Michael S. Anderson of Anderson Tax Law logo for Arizona tax attorney Michael S. Anderson P.C.
  • Debt Settlement Plans – Watch out! It’s a Trap

    A few weeks ago, the National Association of Consumer Bankruptcy Attorneys (NACBA) issued a “Consumer Road_runner_cartoon-5216-thumb-375x405-52308Alert” regarding Debt Settlement Companies. I have attached the document and you can read it here: NACBA debt settlement trap consumer alert.pdf

    The paper makes some points that I think every person in Arizona with serious credit card or other consumer debt needs to be aware of.

    The main point is that most “Debt Settlement” companies promote a scheme that usually doesn’t work.

    Problems with most “Debt Settlement Plans”

    Default

    The first problem the article points out is that most debt settlement companies encourage consumers to default on the debt. Most creditors and collectors won’t discuss the reduction of principal balances unless the consumer is late on the payment.

    The problem is that If the debt isn’t settled, the default causes a higher interest rate, penalty, collection calls and letters, credit score reductions and an eventual lawsuit.
    Of course, the debt isn’t usually settled, and the situation is much worse as a result.

    Taxable Income

    If the debt settlement is successful, the creditor will issue a 1099 to the IRS. The IRS considers the forgiven portion of the debt to be income and unless the consumer meets the “insolvency” test, he or she will have to pay income tax on the forgiven debt.

    If the consumer is embarking on a debt settlement plan, he or she should first seek some guidance about whether the best settlement will result in a large tax bill and if so, whether that will negate the effectiveness of the settlement.

    Fees

    Most companies that sell debt settlement services charge a percentage of the debt or a percentage of the savings. I have seen fees as high as 33% of the overall debt. Often the fee is comprised of some sort of set up fee as well, and maintenance fees each month and in addition to a percentage of savings.

    If the debt is $50,000.00 and the settlement is 50% of the total, a fee structure based on a set up fee of $1500.00, a monthly maintenance fee of $250.00, and a percentage of savings Fee of 1/3 could be as high as $12,750.00.

    If the consumer is forced to pay tax on the forgiven $25,000.00 at 10% that is an additional $2500.00 cost.

    Using that example, the cost of the settlement could be as high as $15250.00, an overall total savings in that scenario of about $10,000.00

    There are two problems with this:

    1. In exchange for what the company is doing, the fees can be really high

    If the debt settlement company charged a $250.00 hour rate for all the work related to settling a $50,000.00 debt for 50%, over a period of several months, the fee would be a fraction of what the typical debt settlement fee is.

    Most debt settlement work is clerical and phone call oriented. There is no “secret”. The debt settlement company is not typically a Law Firm. It can’t represent the consumer in court, threaten bankruptcy, represent the consumer in a lawsuit, or file a Fair Debt Collection Practices Act claim. It can’t even stop phone calls, collection letters, or a lawsuit from being filed.

    Debt Settlement companies aren’t regulated. Fees are based on sales skills, which are often better than negotiation skills.

    2. The consumer can usually obtain a result that is superior overall, to what the Debt Settlement Company can provide

    If a creditor sees that the consumer is delinquent and has a debt settlement policy in place, it may offer to settle the debt for a reduced amount just because it has been asked to do so. It is often the case that a debt collector will immediately offer 40% to 50% reductions in principal for cash payment.

    Debt Negotiation Firms are hoping that the debt collector will fold quickly. The percentage of savings or debt fee structure relies on it.

    I have seen many consumers obtain terrific settlements on delinquent debt and without paying any fee.

    If the consumer needs representation, he or she will be far better served paying an hourly rate for services. A licensed and regulated debt attorney who knows the law and can actually use it to the consumer’s advantage should at least be consulted.

    Many Debt Settlement Plans Fail Even Though a Settlement is Reached

    Even if the creditor or collector agrees to the reduction in debt, the agreement usually requires that the settlement be paid in full. Most debt settlement schemes attempt to solve this problem by making the consumer set aside money each month.

    The problem? In many cases, the company is keeping their fee or getting it pre-paid from the savings the consumer is sending to them. Many will make sure the fee is paid before any money is set aside for settlement purposes.

    As a result, it often takes many months or even years before there is enough money in the “account” to “settle” the debt. By the time the day comes that the money is saved, the debt has grown out of reach, and the consumer’s wages are being garnished.

    Conclusion

    If you live in Arizona and have credit card debt or other consumer debt you should think long and hard about the following before you hire a debt settlement company to help you:

    1. Will you have the money to settle the debt and when?

    2. Can you do it yourself or would it be wiser to hire someone to help at an hourly rate?

    3. Are you prepared to hire an attorney to help you defend or deal with a lawsuit while the debt negotiation process is in place?

    4. Have you discussed bankruptcy with an experienced attorney so that you understand all of your options and compared those options to the debt settlement program you are considering?

    5. Have you made sure that you won’t owe tax on any forgiven debt or at least that the additional tax will be justified by the amount of the settlement?

    I suggest that you review all options before embarking. Contact an experienced attorney who has settled debt and who deals with bankruptcy so that you can get both sides of the story, and read the NACBA Consumer Alert about Debt Settlement before you proceed.