For any financial institution seeking to negotiate with one of its debtors over a lump-sum settlement of the debtor's delinquent, unsecured debt,1 one potential roadblock is IRS Form 1099-C. This form reports the amount of a debtor's debt that is forgiven or canceled, and although a debtor is unlikely to want any such debt to be taxed as income, financial institutions are required by law to issue this form. In light of these facts, the issue becomes how to keep debtors from walking away from a mutually beneficial settlement.
One possible solution is IRS Form 982, which allows a debtor to exclude the amount canceled from his income up to the extent of his insolvency at the time the debt is settled. Insolvency exists when the debtor's liabilities exceed the Full Market Value (FMV) of his assets, and proving insolvency will require the debtor to assemble a worksheet (provided in the current Publication 4681) which lists both his liabilities and the FMV of his assets at the time of the settlement, along with any helpful supporting documents (such as a copy of his credit report reflecting debt balances). IRS Form 982 should be filed along with that tax year's return, with the "Discharge of Indebtedness to the Extent Insolvent" exception checked (Box 1b on the current Form 982).
To better illustrate the above, here are two examples:
Of course, debtors should always consult their tax advisor to make sure that Form 982 can be used in their particular circumstance. For financial institutions, however, making their debtors aware of this form and the option it may present to them, has the potential to salvage mutually beneficial settlements that may otherwise not come to fruition.
1 If a debt is secured, other rules and considerations will apply that are outside the scope of this article.