The Tax Man Cometh: What to Expect When Debt Gets Cancelled
So your business is struggling, drowning in debt that feels like it’ll never go away. You’ve tried everything – cutting costs, taking out more loans – but nothing seems to help. Finally your creditors agree to settle for less or even forgive some of what you owe. Phew, right? Not so fast. While debt relief may solve some of your financial woes, it could also create new ones in the form of taxes. Let’s break down what happens when debt gets cancelled and how you can avoid any nasty surprises from the IRS.
What is Canceled Debt?
Also called debt forgiveness, canceled debt is when a creditor agrees to accept less than the full amount you owe. Some common ways businesses get debt cancelled include:
-- Debt settlements – Agreeing to pay a lump sum that’s less than what you owe
- Bankruptcy – Getting some or all debt discharged through court proceedings
- Foreclosure/repossession – Losing property used to secure a loan
- Statute of limitations expiring – Creditors giving up on ever collecting
So if your business has had any debts reduced, settled for less, or just plain written off, that counts as canceled debt. And while it may feel like you just got away with something, the tax man sees it differently…
Why Canceled Debt is Taxed
To the IRS, any money you owed but no longer have to pay back looks just like income. So if a creditor forgives $100K you owed, the government sees it as you making an extra 100K that year. And as we all know, Uncle Sam wants his cut of anything that resembles “income.”
It doesn’t matter if your business is still struggling or even closing down. As far as the IRS is concerned, that forgiven debt enabled you to keep funds you otherwise would have paid your creditors. So now they want their piece of the “pie” so to speak.
What Forms To Expect
If you have over $600 of canceled debt, your creditors will report it to the IRS using Form 1099-C. You’ll get a copy showing the amount discharged and any interest. Lenders will also include the fair market value of any property they took back. The IRS gets all this info too, so don’t think you can just ignore it and hope no one notices!
-You may also get a Form 1099-A reporting foreclosed property and Form 1099-B for repossessed property. And if part of your canceled debt relates to your principal residence, look for Form 1099-C with box 6 checked. We’ll talk more about the special home mortgage rules later.
How To Report Canceled Debt
Now comes everyone’s favorite part…reporting! For business debt relief, you’ll need to use Form 982 to claim any exceptions and exclusions we’ll cover next. This gets filed along with your regular business tax return.
You’ll also have to report the full amount shown on Form 1099-C as income on your return, then subtract any nontaxable amounts. The total ends up on Line 8 of Schedule 1, Additional Income and Adjustments. Any interest included with canceled debt should go on Line 1 of the same schedule.
Sound confusing? That’s why most businesses turn to a tax pro when they have debt discharged. The rules can get complicated fast!
Exceptions and Exclusions
While the IRS generally treats forgiven debt as taxable income, there are quite a few exceptions business owners can qualify for. Common ones include:
-- Bankruptcy – Debt discharged in Ch. 7 or Ch. 11 bankruptcy is not taxable. To exclude it, file Form 982 and check the bankruptcy box.
- Insolvency – If total debts exceed total assets right before cancellation, you can exclude some or all of the amount. But calculating insolvency involves forms and complex math, so get help!
- Certain farm debt – There’s an exclusion for discharged qualified farm indebtedness secured by farm land or equipment.
- Real property business debt – Non-recourse debt from business real property, like an office building or store, can also be excluded in some cases.
There are also exceptions for student loans, alimony, deductible business expenses, and others. As you can see, the rules are complicated with lots of ifs, ands & buts. Getting advice from a tax pro is crucial here.
What About Mortgage Debt Relief?
Special rules apply for canceled mortgage debt on a principal residence. Up to $2 million of discharged home mortgage debt is tax-exempt for married couples ($1 million if single). To qualify, the home loan must have been used to buy, build or substantially improve your principal home. And the debt must have been secured by that residence.
If you meet these criteria, there’s nothing to report and no forms to file. The canceled mortgage debt is simply tax-free.
-But again, there are exceptions here too. If you used any home equity loan proceeds for non-house-related purposes – like vacations, cars, or business expenses – that portion would still be taxable. Work with a tax preparer to determine which parts of discharged home debt qualify for the exemption.
What If You Can’t Pay The Tax?
So you survived a financial crisis, only to end up with a big tax bill you also can’t afford. What are your options?
Well first, carefully review the exceptions we covered to make sure you claim everything allowed. You may find you owe less than you thought. If you still can’t pay in full, the IRS does offer payment plans and other relief options like:
- Installment agreements – Pay over 6 years or less
- Offer in compromise – Settle for less than the full amount
- Currently not collectible status – Puts a hold on collections
You can also request penalties be waived if you show reasonable cause. And in certain disaster areas, canceled debt tax may qualify for postponement.
The Bottom Line
Having debt forgiven may feel like you’ve been thrown a lifeline. But don’t let the tax implications drag you back under. As long as you review the rules, claim exclusions, and set up affordable payment options if needed, you can come out the other side with your business and finances intact.
The tax man may cometh for his cut, but with some planning he doesn’t have to breaketh your bank. Consult the pros and don’t fear the debt relief reaper!