Debt settlement can be an excellent solution for business owners who are struggling with their debt burden. But it doesn’t come without a catch — you often have to pay taxes on settled debt. Luckily, there are some exceptions in place that could help you avoid paying additional taxes, but not everyone will be eligible.
Understanding Taxes on Settled Business Debt
Before settling your business debt, make sure you fully understand the tax consequences. The last thing you want is a surprise tax bill when you’re already struggling with your finances.
Why Debt Cancellation May Be Taxable
According to the IRS, any debt that’s forgiven or discharged for less than the full amount is considered income and is subject to income taxes. The amount you’ll pay income taxes on is equal to the amount of debt that was forgiven and is known as cancellation of debt income (CODI).
For example, if you owe $10,000 and settle your debt for $7,500, you’ll have $2,500 of taxable income. With an effective tax rate of 20%, you’d pay $500 in income taxes.
Once your debt is forgiven, you’ll receive IRS Form 1099-C from your lender. Your lender will also file the form with the IRS to alert them of the discharged debt.
Depending on where you live, you may also owe state income taxes on your settled debt. The vast majority of states impose income taxes, while only eight don’t. If you live in a state with income taxes, you’ll likely pay state income tax on your settled debt.
Key Legal Strategies to Reduce or Eliminate Tax Liability
As a general rule, the IRS requires you to pay income taxes on any debt that you legally owe that is forgiven or discharged. But there are two key exceptions that apply.
Insolvency Exception
What It Is and When It Applies to Business Owners
You don’t have to include your canceled debt in your taxable income if you were insolvent immediately before settling. You’re considered insolvent if your liabilities are more than the fair market value of your assets.
To determine whether you were insolvent when the debt was forgiven, add up all of your assets (i.e., everything you own) and all of your liabilities (i.e., all of your debt). If your liabilities exceed your assets, you are insolvent.
How to Document Insolvency for the IRS
To show the IRS you’re insolvent and, therefore, exempt from income taxes on your canceled debt, follow these steps:
- Use the IRS Insolvency Worksheet (found in IRS Publication 4681) to determine your insolvency amount
- Complete IRS Form 982
- Check the box on line 1b
- On line 2, enter the smaller of your canceled debt or the amount by which you were insolvent
- Complete Part II of Form 982, reducing your tax attributes
- Attach Form 982 to your federal income tax return
Keep in mind that you can only avoid paying taxes on the amount you were insolvent. For example, if you were insolvent by $10,000 when your debt was canceled, but your total canceled debt amount was $20,000, then you’ll still have to pay income taxes on the $10,000 difference.
Bankruptcy Exclusion
How Bankruptcy Affects CODI for Businesses
If you’ve filed for bankruptcy, any debt that’s canceled as a part of that process isn’t considered cancellation of debt income for tax purposes. This exclusion applies to Chapter 7, Chapter 11, and Chapter 13 bankruptcy.
Proving Bankruptcy Status for Tax Purposes
Here’s how to show the IRS you qualify for the bankruptcy exclusion:
- Complete IRS Form 982
- Check the box on line 1a
- On line 2, enter the total amount of debt canceled
- Complete Part II of Form 982, reducing your tax attributes
- Attach Form 982 to your federal income tax return
Reporting Settled Debt to the IRS
The IRS requires that you report all of your taxable income each year, including income as a result of canceled debt.
Understanding Form 1099-C
Form 1099-C is an IRS form that lenders complete for borrowers when they have canceled debt. It looks just like any other 1099 form you might receive for interest income, dividends, non-employee compensation, etc. The form includes:
- Your creditor’s name and contact information
- Your creditor’s TIN and your TIN
- Your name and contact information
- The date of debt cancellation
- The amount of debt discharged (including interest)
- A description of your debt
What It Means When You Receive One
If you receive Form 1099-C, it means one of your creditors has forgiven at least $600 of debt that you legally owed. If you qualify for an exclusion, you’ll complete Form 982 to report it to the IRS. Otherwise, you’ll have to report the income on Form 1099-C as part of your taxable income when you complete your income tax return.
It’s important to note that, when your lender sends you Form 1099-C, they also send a copy to the IRS. This means that if you fail to report that income on your tax return, the IRS will know, and you could be on the hook for financial penalties.
Using IRS Form 982 to Claim Exclusions
As we mentioned, Form 982 is the form you’ll use to report any exclusions that allow you to avoid paying income taxes on your canceled debt.
When to Use It
In addition to insolvency and bankruptcy, the IRS offers exclusions for a few other types of debt:
- Qualified farm debt
- Qualified real property business debt
- Qualified principal residence debt
If you qualify for any exclusions, make sure to read Form 982 and its instructions carefully, fully complete the form, and report it with your federal income tax return.
Potential Deductions and Credits After Debt Settlement
If you owe income taxes due to your canceled business debt, you may be able to reduce your tax burden using deductions and credits.
Business Expenses Related to Debt Settlement
Individuals can’t deduct any fees they pay related to debt settlement because they are personal expenses. But as a business owner, you may be able to deduct your debt settlement fees and other related costs as business expenses. Be sure to consult a tax professional to ensure you’re complying with tax laws.
Credits That May Apply to Offset Tax Liability
There are no tax credits directly related to business debt cancellation. However, if you qualify for any other tax credits, they’ll help reduce your total debt burden on a dollar-for-dollar basis. For example, if you owe $1,000 in income taxes and qualify for a $1,000 tax credit, that credit will completely eliminate your tax bill.
Common Misconceptions and Mistakes
Unfortunately, some business owners settle their debt without fully understanding the tax consequences. Here are some common misconceptions and mistakes that could result in surprise tax bills or fees later on.
“If the Debt Is Settled, I Owe Nothing Else”
Perhaps the biggest misconception borrowers have is that when they settle their debt, they’re off the hook for the rest of the debt. While it’s true that you won’t have to pay your lender the settled debt amount, it’s not true that you don’t owe anything else. Unless you qualify for one of the exclusions we mentioned, you’ll still have to pay income taxes on the discharged debt amount.
Assuming the IRS Won’t Know About the Settlement
If your lender discharged some or all of your debt, you should assume the IRS knows about it and report it on your tax return accordingly. When your lender sends you Form 1099-C, they also send a copy to the IRS. If you don’t include the canceled debt in your total income, the IRS will follow up with you, and you could be on the hook for financial penalties and interest.
Failing to Keep Documentation
The IRS offers exclusions that can help you avoid paying income taxes on your discharged debt, but you should be prepared to back up your claims. If you were unsolved when your debt was settled or the debt was discharged in bankruptcy, maintain any documents that show that.
When to Seek Professional Help
Navigating the waters of debt settlement and its tax implications can be challenging. If you run into questions or problems, or you simply want to make sure you’re doing everything correctly, consider working with an experienced debt resolution professional like a debt relief attorney or accountant.
Choosing a Tax Professional Experienced in CODI
When you’re looking for a tax professional, specifically seek out certified public accountants (CPAs), Enrolled Agents, and tax attorneys. These professionals will have plenty of experience navigating the complex waters of cancellation of debt income.
How a Financial Advisor Can Help with Post-Settlement Planning
Once you’ve ironed out the taxes on your settled debt, consider working with a financial advisor who can help you with your post-settlement financial planning. An experienced financial advisor can help you address the root cause of your financial issues and why you sought out debt settlement in the first place. They can also help you make a financial plan to get your finances and your credit back on track.
Risks of Ignoring Taxes on Settled Debt
While ignoring your financial problems often feels easier than addressing them head-on, it’s never a good solution for the long term.
IRS Penalties and Interest
The IRS imposes financial penalties when you fail to file your tax returns, fail to pay your taxes, or fail to report all of your income on your tax return.
- Failure to file: If you don’t file your tax return by the due date, you’ll pay 5% of the taxes due per month, for a maximum of 25%, until you file your return.
- Failure to pay: If you don’t pay your tax bill, regardless of whether you’ve filed your taxes, you’ll pay 0.5% of your unpaid taxes, up to 25%, until you pay.
- Accuracy-related penalties: If you fail to follow tax laws or substantially understate your income on your tax return, you’ll owe 20% of the underpaid tax amount.
The IRS charges interest on late or unpaid taxes, as well as on penalties. While IRS interest rates fluctuate, the rate in 2025 is 7% of your unpaid tax amount.
Legal Consequences for Non-Reporting
In extreme cases, you could face legal consequences on top of your financial penalties. Tax evasion can result in criminal charges, significant fines, and even imprisonment. These consequences are typically reserved for the most serious cases.
Conclusion
Debt settlement can relieve a significant financial burden for your business, but it doesn’t necessarily mean you’re out of the woods. The IRS requires that you pay income taxes on your discharged debt, unless you qualify for exclusions like insolvency or bankruptcy.
If you’re considering debt settlement, it’s important to plan ahead for the possible tax implications and document anything that could help you avoid taxation.
If you need help navigating your business debt settlement, consider speaking with a legal debt professional, such as a debt settlement attorney. Tayne Law Group has experience helping business owners navigate their debt and the settlement process, including everything that comes after the settlement. To learn more, contact our offices by calling (866) 890-7337 or filling out our short contact form. We never share or sell your information, and all conversations are confidential.
