Now that you’ve settled your merchant cash advance, you might be tempted to pour yourself a drink. For many owners, though, it can be surprising to learn that settling your debt can have negative tax implications. After the settlement, the IRS may come knocking, and the result could be less thrilling than you’d expect. Here are six tax surprises we think every business owner should know about.
Debt Cancellation Counts as a Form of Income
The first surprise is the big one. Any time your business (or you) pays back less than it owes, that “forgiveness” of debt is considered income. By canceling part of the debt, the lender is forgiving your debt. So you must include the canceled amount in your gross income, and pay taxes on that “income.” The reasoning is that you have likely benefited from the money. Odds are good that the merchant cash advance taken out at some point was used to cover business expenses. You keep that benefit even though part of the balance was never repaid, so the IRS thinks you should pay taxes on it anyway. Sitting down to face the tax bill that year can create sticker shock for a business owner.
The second surprise arrives in the mail. If you settle a debt during the year, you should receive IRS Form 1099-C showing the amount of debt forgiven. Then you’ll need to bring the 1099-C when you file your taxes. It’s not the form itself that’s the trouble; it’s what you owe the IRS as a result of receiving it. In tax terms, debt cancellation counts as a form of income to a taxpayer, and typically that increase is reported and reflected in the overall tax bill. Your accountant or tax preparer will use the form to include that sum as income on your return.
The third surprise is that it may not happen just once. Debts can be settled at a varying pace, so if several advances or loans are enrolled, you’ll settle debts differently and at different times. Different amounts may be canceled each year. One funder might agree this year, and you might end up settling another debt in another year. Surprise! Here’s another Form 1099-C! It’s easy to forget and be caught off guard by these surprise tax implications year over year.
The fourth surprise is how broad the rule is. Forgiveness of a debt counts as income, and that includes just about any kind of debt. Equipment raises its own question. If a lender repossesses property, it is usually treated as though it were a sale of the asset between you and the lender. It matters whether you were personally liable to the creditor for the debt. In practice, that turns on whether you signed a note claiming personal liability for the property. The calculation can be tricky, so it’s best to get advice from an accountant. They can help interpret what the canceled debt means to you.
Cancellation of Debt Income Is Not Taxable
The fifth surprise is a happier one: in some circumstances, cancellation of debt income is not taxable. There is also an exception if the debt forgiveness occurred in the context of bankruptcy. Specifically, that means a Title 11 bankruptcy case. Likewise, some debts aren’t taxable if they’re forgiven as a gift, an inheritance or a bequest. Another exception to paying tax on forgiven debt is if the debt was a qualified farm debt. And if a funder cancels a debt when you’re insolvent, the canceled debt may not count as income. You would need to be able to prove it. Insolvency refers to a situation where the filer’s total debts are greater than the total of their income and wealth. Insolvency is a very specific state of affairs, and you should not treat it as an excuse for failing to pay taxes if it is not 100% accurate. The rules that apply in each situation are complex, so it’s best to talk with an accountant.
Be Prepared
The sixth surprise is that you still have to come up with the cash. If you expect a settlement to be taxed, or a 1099-C is already on your desk, there are four things worth doing. First, consult a tax professional who can give you specific advice tailored to your situation. We get it: tax law is complex and confusing. A tax professional can verify which forgiven amounts are actually taxable and which you may not need to worry about. The tax rules governing debt forgiveness are complicated, and we are not tax professionals. We strongly recommend you work with your tax accountant as you go through settlement.
Second, keep good records. Whether you want to show you were insolvent when you settled, or that some business or farm debt should not result in taxes, it pays to be able to show documentation proving your case. So keeping tax records and other documentation about your financial situation is essential.
Third, start saving now. Hopefully the settlement has freed up some cash flow. Don’t spend it all, though. Put some money aside to make sure you’re not caught off guard by the tax bill come April. It’s a good time to start setting aside money each month in anticipation of that 1099-C.
Fourth, if you can’t afford to pay the tax bill that arrives as a result of settling debt, look at a payment plan. For those who qualify, the IRS offers an installment plan, allowing you to pay taxes in monthly installments. But you must actually ask for help; it won’t fall in your lap. The IRS does charge additional fees for these plans, but if you’re able to enroll, it can take the sting out of your tax bill. It beats not paying and carrying tax debt on top of everything else.
Tax surprises are no fun. The best way to avoid them is to plan. By setting money aside, staying organized, talking to tax experts and keeping cash on hand, you can be prepared when the next tax season arrives. Whether you are weighing a settlement or already have one behind you, taking care of tax issues is key. While no one looks forward to writing a check to the IRS, taking care of the tax situation while there is time should be everyone’s priority. That’s how you avoid getting an unwelcome surprise when Tax Day comes around. A settlement is a hard-won step forward. Don’t let the tax bill ruin it.
