Charles Phelan

UPDATE July 2020. For consumers struggling financially due to the COVID-19 crisis, this resource provides information on the relief programs offered by many of the major bank issuers of credit card products.

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In the days before debt settlement became so widely known by consumers as a bankruptcy alternative, it was often difficult for me to convince prospective clients that a bank would willingly forgive 50% or more of the principal balance on a credit card account. Consumer skepticism was very real in those days, since debt settlement was not very well known yet as a strategy.

Nowadays though, we are bombarded by radio and TV advertising for debt relief services, and the whole concept of negotiating with creditors became mainstream during the financial crisis of the past two years. Most people today are well aware that settlements are possible, and the main question has now become, “Should I hire a debt settlement company or do it myself?”

Here’s what the Federal Trade Commission had to say on the subject in a public release from March 2010:

Settling Your Credit Card Debts

If you’ve maxed out your credit cards and you’re getting deeper and deeper in debt, chances are you’re feeling overwhelmed. How are you ever going to pay it down? Now imagine hearing about a company that promises to erase your debt for pennies on the dollar. Sounds like the answer to your problems, right?

The Federal Trade Commission (FTC), the nation’s consumer protection agency, says slow down, and consider all the steps that can get you out of the red without spending a whole lot of green.
Many different kinds of services claim to help people with debt problems. Among them are “debt settlement” companies that negotiate with your creditors to reduce the amount you owe. Some debt settlement companies claim that they can arrange for your debt to be paid off for a much lower amount – anywhere from 30 to 70 percent of the balance you owe. For example, if you owe $10,000 on a credit card, a debt settlement company may claim it can arrange for you to pay off the debt for less, say $4,000.

But there is no guarantee that debt settlement companies can persuade a credit card company to accept partial payment of a legitimate debt. Even if they can, you must put aside money for your creditors each month and pay the hefty fees debt settlement companies charge before they settle any of your debts. On top of that, you may have to pay a final fee to a debt settlement company that’s a percentage of the money you’ve supposedly saved. Meanwhile, it may be months – or even years – before the debt settlement company negotiates with your credit card company to settle your debts. And, if you stop making your payments in the meantime, the credit card company usually will add late fees and interest to the debt each month. That can cause your original debt to double or triple. All these fees will put you further in the hole.

When You’re In a Hole…

Ever hear the expression, “When you’re in a hole, stop digging”? If you need help managing your debt, it’s crucial to keep the lines of communication with your creditors open.

• Contact your credit card company, even if you have been turned down before. If at first you don’t succeed, be persistent. Keep good records so that when you do reach them, you can explain your situation. Your goal is to try to work out a modified payment plan that reduces your payments to a level you can manage. If you don’t pay on your debt for 180 days, your creditor will write your debt off as a loss; your credit score will take a big hit, and you still owe the debt. Creditors often are willing to negotiate with you even after they write your debt off as a loss. Rather than pay a company to talk to your creditor on your behalf, remember that you can do it yourself for free. You can find the telephone number on your card or your statement.

If you decide to pay a company to negotiate your debt, do some research. Consider other people ’s experiences. One way to do that is to enter the company name with the word “complaints” into a search engine. Read what others have said. You are making a big decision that involves spending a lot of your money that could go toward paying down your debt.

• Another option is to contact a credit counselor. Reputable credit counseling organizations advise people on managing money, bills and debts, help them develop a budget, and usually offer free information and workshops. They should discuss your entire financial situation with you, and help you develop a personalized plan to get you out of the hole.

Finding reputable credit counselors has become more convenient. A new law requires credit card issuers to include a toll-free number on their statements that directs cardholders to information about finding nonprofit counseling agencies.

Most credit counselors offer services through local offices, the Internet, or on the telephone. If possible, look for an organization that offers in-person, face-to-face counseling. Many universities, military bases, credit unions, housing authorities, and branches of the U.S. Cooperative Extension Service operate nonprofit credit counseling programs. The federal government maintains a list of government-approved organizations, by state, at www.usdoj.gov/ust, the website of the U.S. Trustee Program. That’s the organization within the U.S. Department of Justice that supervises bankruptcy cases and trustees. Cross-check any credit counseling organization that says it’s government-approved against the U.S. Trustee’s list of approved organizations.

• Occasionally, a credit counselor may suggest that if these options don’t work, you consider filing for bankruptcy. Declaring bankruptcy has serious consequences, including lowering your credit score, but credit counselors and other experts say that in some cases, it may make the most sense. Filing under Chapter 13 allows people with a steady income to keep property, like a mortgaged house or a car, that they might otherwise lose through the Chapter 7 bankruptcy process. In Chapter 13, the court approves a repayment plan that allows you to pay off your debts over a three to five year period, without surrendering any property. After you have made all the payments under the plan, your debts are discharged. As part of the Chapter 13 process, you will have to pay a lawyer, and you must get credit counseling from a government-approved organization within six months before you file for any bankruptcy relief.

Red Flags

Avoid any company that promises to settle your debt if it:

• touts a “new government program” to bail out personal credit card debt
• guarantees it can make your unsecured debt go away
• tells you to stop communicating with your creditors
• tells you it can stop all debt collection calls and lawsuits
• guarantees that your unsecured debts can be paid off with pennies on the dollar
• requires that you pay the full fee within the first few months

Let’s take a closer look at the paragraph I find to be the most interesting part:

Contact your credit card company, even if you have been turned down before. If at first you don’t succeed, be persistent. Keep good records so that when you do reach them, you can explain your situation. Your goal is to try to work out a modified payment plan that reduces your payments to a level you can manage. If you don’t pay on your debt for 180 days, your creditor will write your debt off as a loss; your credit score will take a big hit, and you still owe the debt. Creditors often are willing to negotiate with you even after they write your debt off as a loss. Rather than pay a company to talk to your creditor on your behalf, remember that you can do it yourself for free. You can find the telephone number on your card or your statement.

This is a mish-mash of advice that includes the obligatory talk about modified payment plans alongside discussion of negotiating with creditors. It’s also pretty confusing relative to debt settlement, since some of the best settlements can also be negotiated *before* the charge-off event at 180 days late, not just *after* the loss has been taken by the creditor. Settlements are totally possible both before and after the deadline, but some of the best deals take place before charge-off, via negotiation directly with the original creditor.

Here is the money quote: “Rather than pay a company to talk to your creditor on your behalf, remember that you can do it yourself for free.”

In other words, the Federal Trade Commission is telling you to stay away from third-party debt settlement firms and talk to your creditors yourself. According to the FTC, you can negotiate payment options or settlements on your own.

There you have it, straight from the horse’s mouth. The FTC has spoken and said that DIY debt settlement is the way to go. Nobody has to take my word for it anymore! 🙂

Now, I want to add an important point here, one that I intend to expand on in future posts. I think that I probably made a significant mistake years ago, when I built my program around the core concept of “do it yourself debt settlement” (DIY). A true DIY approach would include a kit with training material, access to an online membership forum, and that’s about it. Aside from those minimal resources, the consumer would be totally on their own. (There are already a bunch of DIY debt settlement copycats and imitators out there gunning for high volume enrollments into this type of “service,” which is no service at all unless the client upgrades to more expensive “traditional” programs. Watch for TV ads that will start pitching DIY settlement any day now.)

Here’s the thing – no training course, no matter how well-done, can possibly be sufficient for getting the job done *with maximum efficiency and minimum stress*. People get stressed out by the collection calls, become uncertain whether to take a deal or hold out for something better, and unsure when a legal threat is real or bogus. I came to that realization within a few months of publishing the first version of my training course in 2004. I learned that what people want is a COACH to take them by the hand and GUIDE them through the process. That’s what we do here at ZipDebt. We coach people on how to settle with the *specific set of creditors* on their list. That’s all, really. Simple enough. But it works like magic. Take a few minutes to read some of the recent testimonials posted on the ZipDebt Client Comment Forum, and it will quickly become apparent that none of these clients were “on their own.” They had coaching and assistance every step of the way.

If you take what the FTC published at face value, you might conclude that there is no middle route. Either pick up the phone and start talking to your creditors (maybe after doing some research online and hoping you find something useful), or hire one of these rip-off settlement firms the FTC is warning against. Of course, the FTC cannot promote a specific business model, so I wouldn’t expect them to be forthcoming about a third option – hire a coach!

With ZipDebt, you are not on your own. You’ll do the work of talking to your creditors, while a very knowledgeable coach sits in your camp the whole way and guides you to the best possible settlements. Or, as a happy client once put it, “Do it yourself, but get some help from a professional!”

Regular readers of The ZipDebt Blog already know that I strongly advise consumers to steer clear of third-party debt settlement firms. These companies charge an outrageous 15% or more of the total enrolled debt, even before any meaningful work is performed. They deliberately mislead people on how the process really works, and they do not provide the services advertised.

Such companies also frequently get people sued by using obsolete and dangerous tactics like “cease communication” notices to creditors. Given the poor reputation of the industry, many consumers have already figured out that traditional debt settlement companies should be avoided like the plague. However, more and more people have recently been asking about the legitimacy of an alternative called “attorney debt settlement.” For the benefit of consumers doing their homework on debt solutions, let’s take a closer look at this so-called “attorney model.”

Over the past several years, many of the big players in the debt industry shifted to the attorney model for debt settlement in the hope they could avoid state laws pertaining to the debt industry, and also with an eye toward surviving pending major regulatory changes at the Federal level. The shift was based on legal loopholes that — generally speaking – make attorneys exempt from laws on debt adjusting, negotiating settlements, handling credit disputes, and so on. The idea is to have an attorney head your debt settlement company, thus providing a “fig leaf” of protection against regulations that restrict fees or business practices. The idea was to completely sidestep any concern over regulatory problems. (Of course, the problem with this approach is that the FTC is already wise to this tactic. The proposed Federal rule change will include attorney firms in its definition of “debt relief services.” If third-party debt settlement is what you do, then attorney or not, you’re a debt relief service under the pending rule change, and that means all the new restrictions will still apply to you.)

Although the attorney model for debt settlement has been around for quite some time, lately it seems to be coming up more and more frequently during consultations with consumers looking into this strategy. In addition to the tactical reasons discussed above, what’s happening is that numerous new companies have popped up across the country over the past 1-2 years trying to exploit the current financial environment (which is very good for selling settlement services). They are using boiler room call centers to “close” people on enrolling in settlement programs, and the pitch is now being framed around the attorney-led debt settlement firm to a much greater degree than a few years back. Many of these “debt consultants” are the same high-pressure salespeople who were peddling subprime mortgages before the real estate meltdown.

From the viewpoint of someone trying to *sell* debt settlement services, the attorney model is a great boon because it instantly calms the consumer’s worst fears. When a person first hears about the debt settlement strategy, the next thing they learn is that the accounts must be behind and headed toward charge-off before the creditor will discuss reasonable settlement figures. So the logical next question would be, “If I just stop making payments, won’t the banks just take me to court to recover what I owe? What about lawsuits?”

“You’ll have an attorney on your side,” the sales rep will respond. “It’s far less likely that a creditor will sue you when they know you have an attorney helping you. That’s why you should sign up with us instead of that other debt company that doesn’t have attorneys on staff.”

Sounds logical, right? The problem is that it’s a fairy tale from start to finish.

Let’s separate fact from fiction on this subject. First of all, just because someone happens to have a law degree, it doesn’t mean that person is ethical, or even competent at what they do. Some of the *worst* offenders among companies shut down by various state Attorneys General are companies headed by lawyers. Case in point: Allegro Law Center. Here is a link to an article about the Alabama Attorney General’s recent shut-down of this toxic bunch of scam artists.

The victims who were duped into retaining the help of this so-called attorney were left holding the bag. The Alabama AG has seized $12 million in the company’s assets for distribution back to victims, but that will probably be a drop in the bucket compared to the actual fees collected by these crooks. All of these victims thought they would be protected by having a “lawyer” on their side. Wrong. The shut-down happened precisely because the attorney heading this company did not perform the services advertised. Clients got sued. Allegro Law Center didn’t help. People complained. The AG responded to the mountain of complaints and closed the operation. Thousands of distressed consumers were left in worse shape than when they hired the supposed “law firm.”

This is by no means the only such case. Hess Kennedy (yet another bogus law firm) in FL was shut down last year and the lead attorney was disbarred from practicing law. And this same game has been going on for a very long time, with similar firms getting shut down as far back as the 1990s for scamming consumers in the exact same fashion. (There really is “nothing new under the sun” when it comes to the debt industry!)

Next, let’s apply a little logic here. If you live in North Carolina, for example, how is a Florida or Alabama attorney going to help if you get sued? They don’t even have a license to practice law in your state! To counter this natural objection, some sales reps will claim their company has “lawyers in all 50 states.” Not true. Just try asking to speak with that attorney! Heck, just try asking for the *name* of the attorney who will be assigned to your file – you won’t get a straight answer. That’s because they do not actually have an attorney in your state.

Now, what if you’re talking to an attorney-based debt settlement firm that *does* happen to be located in your home state, or they really *do* have an attorney on staff in your neck of the woods. What then? Well, it doesn’t matter one tiny little bit! The creditor will do whatever they are going to do, even if you have an attorney involved. It won’t stop the collection process from rolling forward, and it will *still* cause the creditors to escalate in retaliation. (That remains the fatal flaw of ALL third-party debt settlement programs. The mere fact that you have hired a negotiator causes the other side to escalate in retaliation. The result is a fast-track to multiple lawsuits, which come much sooner than they would otherwise. By taking a do-it-yourself-with-coaching approach, you can avoid that fatal flaw and get *better* settlements than the poor client who hired the settlement firm!)

Think about this for a minute. If you owe the money fair and square, what good would it be to have an attorney represent you anyway? If you get sued, the creditor can easily prove you owe the money (a freshly printed stack of copies of all your monthly statements should do the trick), and the attorney will then just advise you to set up payment arrangements on the full balance in order to avoid having a judgment recorded against you. Or maybe he can get you an 80% settlement. Big deal! You can negotiate 80% settlements or 100% payment arrangements by yourself, before or after a lawsuit gets filed. You don’t need an attorney’s help and an extra $5,000 or $10,000 in fees just to wind up paying back 80-100% anyway!

If you think I am biased because I offer DIY debt settlement coaching services, or that I have an axe to grind here, there is no reason to simply take my word for any of this. If you are doing research on a debt settlement company representing itself as a law firm, ASK FOR A COPY OF THEIR CONTRACT. If they refuse to show you a copy in advance without hooking a payment from you, doesn’t that tell you right there you don’t want to do business with them? If they do forward a blank copy of their contract, read it very carefully. Aside from the fact that 100% of the contract language is designed to protect the settlement company from YOU (should you decide to go after them for various misrepresentations), and not the other way around, please pay close attention to the paragraph on *what happens if you get sued*. You’ll see language in most of these contracts that clearly states that the firm *does not and will not represent you in court*.

Huh? What’s the point of hiring a supposed “law firm” then? Well – there is no point! There is *no* extra advantage to be gained by using a settlement firm operating on the attorney model, only extra problems! It’s just another *marketing gimmick* designed to separate you from your hard-earned cash, right when you can least afford to part with that cash! That fee money would be far better spent on funding your settlement account.

The bottom line is that “attorney debt settlement” is no better than traditional settlement programs offered by non-attorney firms, and in some cases, it’s actually worse. So it’s nothing more than “lipstick on a pig.” Don’t fall for this version of the tired old debt settlement sales pitch. You CAN settle your debts on your own. You just need some training and coaching from ZipDebt to tackle the project properly. We’ll teach you how to successfully implement the debt settlement strategy without the huge fees!

Do you remember what it was like back in October 2008? That’s when the financial crisis rocked the world and we all collectively held our breaths and waited to see if the entire banking sector would collapse. From my own perspective, it had pretty much been “business as usual” in the world of debt settlement up to that point. And then the whole world froze for about two weeks. I had just started to wonder about what the future would hold for my own business. And then the dam burst wide open.

Starting around mid-October 2008, the phone started ringing off the hook, and I could barely keep up with the flow of inquiries. The tidal wave continued all throughout 2009. The way I explain it now, with the benefit of more than a year of hindsight, is that I was already “surfing in the ocean of debt,” and had been doing so for many years. After the financial crisis unfolded, a giant tsunami rolled up right underneath me, so I just kept surfing! The banks were seeing default rates double, triple, and even quadruple in some cases compared to “normal” times, and that spike in the number of financially distressed consumers was reflected in the volume of settlement activity.

Long story short: 2009 was a *very* good year to settle unsecured debts. Virtually every major creditor was accepting settlements at figures at or below the thresholds I had been seeing previously, and many consumers therefore did better than expected with their settlements. I don’t mean to imply that it was “easy” to settle with creditors last year. It still required determination, patience, persistence – and, of course, a really good coach! 🙂

That said, it was certainly less difficult for many consumers to achieve settlements than it would have been prior to the financial meltdown. Bear in mind that none of this had anything to do with the bank “bailouts,” TARP, or any of the other emergency measures taken by the Federal Reserve or the Treasury Department. The banks are agreeing to settlements simply because it’s in their own best interests to do so. They don’t settle for less than the full balance out of altruism, or any sort of desire to actually help people. They do it to *survive*. Settlements are what creditors do in order to reduce their losses (before charge-off), or to recover against losses already booked (after charge-off).

So due to the economic recession, 2009 was certainly a banner year for settling debts. How about 2010? As I write this post at the end of February, I can say with confidence that 2010 will also be a very good year for settlements. ZipDebt clients have reported settlement activity that represents more than $1.8 million of forgiven debt, and that figure is only the total for January and February to date. In other words, it’s still “business as usual” with all of the major creditors, just a whole lot more of it than in “normal” economic times when default rates are below 5% (rather than above 10% the way they are today).

If you are facing a credit card debt burden that you simply cannot sustain anymore, and you’re starting to worry that your situation will lead to bankruptcy, take the time to check into debt settlement as a potential solution. It’s not the right strategy for everybody with a debt problem, but if you’re a good candidate for this approach, it works like magic.

If you do decide on debt settlement as your strategy of choice, steer clear of the third-party debt companies that just want your fee money up front. Nowadays, settlement negotiations are an extremely common thing, and there is absolutely no reason to pay thousands of dollars in “fees” to some rip-off company who will not perform as advertised. You CAN learn to negotiate and settle your own debts. All that’s needed is a little training and coaching, and here at ZipDebt, that’s what we do best.

Pretend for a moment that you are the CEO of a debt settlement company, or a company that is in the business of generating “leads” for the settlement industry. You know that a regulatory freight train (called the Federal Trade Commission) is headed your way, and that within a matter of months the entire industry may be effectively run out of Dodge. (See my blog post on recent FTC scrutiny of the industry.) You also know that regulators are watching very carefully during this period between the FTC conference (held in November 2009) and the actual vote by the Commission on their proposed rule change to ban “advance fees” for debt settlement.

What do you do while you are waiting to find out if you still have a viable business model? Well, for starters, you would think that the smartest thing would be to begin making changes now, in advance of regulations you know will be coming down the road in a matter of months. You would also think that a smart CEO would take extra care with any advertising during this crucial period, right? I mean, that *is* one of the key reasons the FTC is looking at the industry – massive consumers complaints about deceptive advertising.

With that in mind, take a look at this little gem, reported to me by a client who received this solicitation in his mailbox in December, well after the FTC conference was held:

Stimulus Plan Center
(address omitted)
Case # (omitted)

Dear (client name),

This announcement is to inform you that you may be eligible to receive as much as $28,942 in debt relief through the Economic Stimulus Act of 2009.

The Consumer Debt Initiative instituted a plan on April 27, 2009. To qualify you must meet the following conditions:

(1) You must have at least $10,000 in unsecured debt,
(2) You are employed or you must have a viable source of income,
(3) You are in a financial hardship, or have great stress in your current situation.

If you meet these conditions, please contact us immediately at 1-888-XXX-XXXX.

This program applies to all unsecured debt types including, but not limited to; credit cards, medical bills, personal lines of credit, business lines of credit, and auto repossession loans.

Your debt relief amount may be as much as 50% of your total outstanding debt amount.

Please call the Stimulus Plan Center at 1-888-XXX-XXXX to speak to your assigned professional debt arbitrator to determine your total debt relief amount.

Sincerely,

Debt Relief Division

Due to the high volume of calls, have your Case Number (omitted) available when you call.

Folks, this solicitation is about as deceptive and misleading as it gets. It’s 100% bogus from top to bottom. First of all, there is no such program, no “Consumer Debt Initiative.” It does not exist. Further, no part of the Economic Stimulus Act of 2009 had anything whatsoever to do with credit card debt relief for consumers. That is an egregious lie. There is no other word for it. The people who mail out this piece are bald-faced liars, period. They are nothing more than scam artists, and they are using this ad to get their phones ringing. Desperate consumers call them hoping for relief, only to run straight into a sales pitch for debt settlement — a pitch that omits virtually every negative aspect of it. And once you become a “lead” in the debt settlement industry, then sales people will start calling from multiple companies trying to sign you up, and it quickly becomes worse than the call bombardment from your creditors!

Now, take a look at this next masterpiece of creative baloney, which comes on an official looking form:

FAIR DEBT ASSESSMENT NOTICE

In response to the global recession concerns, banks being more strict on who and how they lend money, rising unemployment, rising credit card rates, declining property values and a national foreclosure problem the DDS program has been established to help consumers reduce the overall unsecured debt they have. It is now more important than ever for people with unsecured debt to participate in a program that will reduce the monthly expenses they have.

Our records indicate that you may be eligible to participate in the above DDS program, and possibly qualify to receive assistance to legally reduce the amount of your unsecured debt by up to 60%.

The DDS program was created to negotiate or settle debt for individuals with an unsecured debt amount of $8,000 or more and allow individuals who have little or no equity in their home to reduce their debt without refinancing or obtaining a new loan or line of credit.

There’s more, but you get the idea. It’s the exact same approach – let’s trick consumers into thinking this is some sort of “official” government sponsored program. If we don’t actually say it’s from the government, that’s not deceptive, right? Wrong! This ad is also 100% bogus from top to bottom.

What the heck are these people thinking? With ads like this are going out all across the country, is it any wonder that the FTC views the settlement industry as being totally out of control? Frankly, the industry has done a poor job of policing itself, and the chickens are coming home to roost any day now.

I do not yet know whether the FTC will act to ban the industry (or ban charging fees in advance, which amounts to the same thing). It make be many months before action is taken at a Federal level. In the meantime, I do not want consumers to be scammed by these rip-off companies. My sincere hope is that by publishing some of the solicitation text verbatim it will get picked up by the search engines, thereby making it easier for people to find this post and get the straight story.

In January and February of every new year, I get numerous emails from people who have settled unsecured debts during the prior calendar year. They are surprised to find 1099-C forms in their mailboxes, which report to the IRS the forgiven debt balances as ordinary income. Many consumers are totally shocked to find they might owe taxes on cancelled debt balances. “How can I owe tax on a debt?” they want to know. “Can this be true? Is there anything I can do about it?” I figured I would write about this subject now, so I can point to this post when the email queries start hitting in January.

[UPDATE December 2013 — NEW Insolvency Calculator now available! Only $29 to save countless hours of frustration! Instant download. Read more …]

At first glance, it really doesn’t make much sense. How can a debt be treated as income? The logic is that the consumer enjoyed the goods and services purchased on credit. So when the lender has to record a loss on part of the balance, the IRS takes the position that this is equivalent to income to the consumer. You got a bunch of stuff, essentially for free, goes the argument, so therefore you need to pay taxes on that “gift.”

Under the current IRS code, that’s just the way it is, and there’s little point in wishing it were otherwise. Fortunately, there is a loophole provided by the IRS in the form of the insolvency exclusion. “Insolvent” means the same thing as negative net worth, where you owe more in debts than you own in the value of your assets. If you are insolvent at the time you reach a settlement with a creditor, then you can offset the 1099-C income up to the total amount by which you were insolvent.

Here’s an example to make it more clear. Let’s say you settled $50,000 of debt during 2009, and you paid an average of 50 cents on the dollar, resulting in a savings of $25,000. Will you have to pay taxes on the savings of $25,000? That depends on your net worth situation. Let’s assume that your home equity was flat or upside down (very common nowadays), so you don’t have any positive asset in the form of home equity. To keep it simple, we’ll ignore personal effects and automobiles. Your assets at time of settlement were limited to $20,000 in a 401k account (yes, retirement funds count in the asset column), plus $1,000 in checking, for a total of $21,000. You had $50,000 in unsecured debt. Therefore your net worth was negative $29,000 ($21,000 of assets, less $50,000 of debt).

Come January, you receive 1099-C forms from the creditors you settled with, and the total of those forms adds to $25,000 – the amount of debt that was forgiven. Since you are “insolvent” by $29,000, you can exclude the full $25,000 saved during the negotiation. In this situation, no extra tax liability would result from the 1099-Cs issued for the settlements, and the insolvency exemption has come to the rescue.

[UPDATE December 2013 — NEW Insolvency Calculator now available! Only $29 to save countless hours of frustration! Instant download. Read more …]

What would happen if you did have home equity? Let’s say that you had $30,000 of home equity based on the fair market value of your property, and all the other figures quoted above also held true. In that situation, your net worth would be positive. The $30,000 of equity added to the $21,000 of 401k and cash yields total assets of $51,000, against $50,000 of debt, for a positive net worth of $1,000. Under these circumstances, you would be liable for taxes on the full $25,000 of 1099-C income associated with the canceled debts. 🙁

It’s also possible that you might overlap these two scenarios, where you get to exclude some of the 1099-C income but not all of it. For example, let’s adjust the equity value in the above scenario from $30,000 down to $10,000, giving you $10k equity + $21k other assets, for a total asset value of $31k. Against $50k of debts, this results in a negative net worth of $19,000. Yet with $25,000 of debt forgiven, only $19k of this figure could be excluded, and the remaining $6,000 would have to be treated as ordinary income.

The above seems pretty simple when laid out like this, but for some reason, this entire discussion on insolvency still seems to throw many people a curveball. I see a lot of confusion on how to calculate net worth, and one of the biggest misunderstandings pertains to income. Sometimes people ask, “I’m working and my job is stable, so how can I declare insolvency?” Income has nothing to do with your net worth, so let’s at least try to clear up this key point. Income & expenses are one accounting category, while assets & liabilities (debts) are another category. It’s possible to be insolvent while you still make a six-figure income! Income is not an asset, until it becomes excess cash in your bank account, after expenses. So just because you have a job with a steady paycheck, that does not block you from claiming the insolvency exemption via Form 982. You can still owe more in debt than you own in assets even if you are working steadily.

Another stumbling block is when to perform the net-worth calculation. Technically, the IRS says you must calculate net worth at the time of settlement. OK, but what is the time of settlement? Is it the date the creditor verbally agrees to settle? Or is it the date their accounting department actually makes the ledger entry to write off the forgiven part of balance – and how could we ever know that date anyway? Pending any possible adjustments or improvements to the clarity of the IRS language on this subject, my standing advice to clients is that they should perform one net worth calculation for each settlement. For “time of settlement,” we use the date the settlement payment is due rather than the date of the agreement letter itself. If the settlement is a multi-payment arrangement, then we take the date of the final payment as the date of settlement. In the absence of any clear directive on this point from the IRS, the above would seem to be the most logical interpretation.

I strongly urge consumers to get professional help to assist with the tax issues associated with settlement, but I wanted to at least get across the fundamentals. Mainly, consumers really need to understand that the insolvency exemption is available, especially since debt collectors often try to talk people out of settlements by scaring them on the tax issue. In my experience, the majority of people pursuing debt settlement are insolvent and do qualify for the exemption. However, I also feel that it would be very foolish to reject the debt settlement strategy just because it might result in a tax bill. After all, the total of the settlement payout + taxes would still be well under the full balance on the account, resulting in an overall net savings. And even when taxes are “part of the lunch,” settlement still yields a vastly better outcome than the “forever plan” (i.e., endless minimum payments) offered by your friendly credit card bank!

Don’t let the 1099-C tax issue scare you away from debt settlement. Just be sure to follow the rules and document everything correctly. Settle your debts, claim insolvency if you are entitled to, and pay your taxes if you aren’t! Whether or not you owe taxes on your settlements, you’ll still be vastly better off without the debts on your back.

UPDATE February 29, 2012:

Consumers are now receiving 1099-Cs from creditors for debts that are several years old, in some cases decades old. In response to new rules by the IRS, companies are sending out these forms, and consumers are seeing little guidance from the IRS on dealing with this confusing situation. If you have received a 1099-C on an old debt obligation, here is a link to an excellent article by Gerri Detweiler, who has thoroughly researched this issue.

[UPDATE December 2013 — NEW Insolvency Calculator now available! Only $29 to save countless hours of frustration! Instant download. Read more …]

There may be major changes coming soon to the debt settlement industry. I’ve written recently about how the industry is being targeted by various regulatory bodies, such as the Federal Trade Commission, state Attorneys General, and various consumer advocacy groups. Recently, the FTC announced a proposed change to the “Telemarketing Sales Rule” (TSR) that will include the regulation of “debt relief services” within its purview. If the rule change is implemented as written, it has the potential to immediately change the entire dynamic of the settlement industry. The main reason is because the proposal includes a clause that will deny settlement firms the ability to collect any fee in advance of having performed the service contracted for.

Back in 1998, a similar action was taken that resulted in the “Credit Repair Organizations Act,” and that legislation effectively outlawed credit repair, where fees were charged in advance for such services. The net effect was to push credit repair “underground,” with very few firms able to clear the necessary hurdles to operate on a legitimate basis. Leaving aside any discussion on the merits (or lack thereof) of credit repair services, the proposed change to the TSR could have the exact same effect on third-party debt settlement companies across the nation.

Readers of the ZipDebt blog are already aware that I really don’t like the front-loaded fee structure adopted by most settlement firms. However, that doesn’t mean I think what the FTC is doing is a good idea. It’s a transparent attempt to literally hand over the debt settlement sector to the existing network of credit counseling organizations, and that would be a fiasco for consumers. I outline my reasons for this position in an open letter to the FTC, written in response to their request for public response to the proposed rule change.

Here is the full text of my open letter to the FTC:

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Manchester Publishing Company, Inc.
132 N El Camino Real
Encinitas CA 92024

Federal Trade Commission
Office of the Secretary
Room H-135 (Annex T)
600 Pennsylvania Avenue, NW
Washington, DC 20580

October 6, 2009

Subject: Proposed Rule Change to TSR, Request for Public Comment

Dear Commissioners:

The purpose of this open letter is to provide a response to the Federal Trade Commission’s proposed change of the Telemarketing Sales Rule (TSR) to include regulation of “debt relief services.”

As someone intimately involved with debt settlement since 1997, I am very familiar with the evolution of the industry from its earliest inception. Further, since 2004 I have adopted a completely different approach to debt settlement. Rather than negotiating as a third-party representative, I provide consumers with training and coaching as they negotiate their own settlements. The training comes in the form of an audio-CD seminar, and the coaching is delivered via email and telephone. I have personally provided one-on-one coaching for thousands of consumers to settle their own debts without direct intervention by a professional negotiator. As a result, I literally have no “stake” in the continued existence of the industry in its current form. So my perspective on debt settlement is unique and different from that of most industry insiders who will reply to the request for public commentary.

With respect to reining in the abuses that are rife within the industry, I welcome the proposed rule-change to the TSR as it pertains to the requirement for full disclosure to prospective consumers. My chief criticism of the proposed change lies with the suggestion to eliminate any form of advance fee, a concern that I will address below. With regard to disclosure requirements, however, there is no question that tighter rules are called for. For too many years, debt settlement has been promoted by unethical firms looking to exploit the vulnerable consumer. One major problem with lack of proper disclosure pertains to the manner in which the debt settlement process is proposed and structured. I am referring to the common practice within the industry where 36-48 month program durations are routinely quoted to the consumer, without disclosure that the probability of creditor litigation approaches 100% during that long a timeframe. Further, debt settlement is being promoted to virtually any consumer who carries a revolving balance of $10,000 or more (total) on their credit cards. People who were otherwise fully capable of maintaining normal payments against their debts have been convinced to purposely sacrifice their credit and risk legal action in order to reduce their debt burden. Suitability analysis, independent underwriting standards, and lack of internal oversight within the industry has led to a situation where virtually anyone with a credit card debt is targeted for enrollment in debt settlement programs.

The reality is that the majority of consumers being enrolled into traditional debt settlement programs are not suitable candidates for this strategy. Once all the marketing hype is peeled away, debt settlement can properly be viewed for what it is – nothing more than an alternative to Chapter 13 bankruptcy. Consumers who can qualify for Chapter 7 bankruptcy, still approximately 60% of annual bankruptcy petitioners, should not even consider enrollment in a debt settlement program. Why should they? Instead of years of exposure to legal risk, in exchange for high service fees charged by the settlement company, they can simply discharge their obligations in court, usually within a matter of months (not years) and at a fraction of the cost of a settlement program.

Once the “target market” for debt settlement is properly understood to consist only of those individuals otherwise facing Chapter 13 bankruptcy (i.e., 5-year restructuring of the debt), it immediately becomes apparent that settlement is erroneously being promoted as a suitable alternative for all bankruptcy petitions, with no distinction made between Chapter 7 and Chapter 13.

Further, just because a person would otherwise be required to file bankruptcy under Chapter 13 rather than Chapter 7, this does not automatically mean they are a good fit for a settlement program. They must also have sufficient resources for the settlements to be negotiated quickly enough for legal action to be avoided. In my own experience, this generally translates to only a “fast track” settlement strategy being effective – 12 months or less. So much of what drives settlements in the first place is the charge-off event – normally at 6 months’ delinquency – with creditors seeking to reduce the booked loss via settlement prior to charge-off, or a quick recovery after charge-off via external collection agencies. Settlement firms enrolling consumers into 36-48 month programs are misrepresenting the realities of debt collection in the current financial environment. Mounting risk of legal action is totally ignored by these sales-driven organizations.

When adjustment has been made to reduce targeted enrollments to consumers who are truly qualified for debt settlement (i.e., Chapter 13 candidates with sufficient available resources for a successful “fast track” settlement strategy), what is left is a greatly reduced pool of prospective clients. Simply put, if debt settlement was presented properly, meaning only to people who qualify for it, then there would not be more than one thousand such firms in existence today.

The reality is that debt settlement services are being “sold” rather than bought. Over-promotion of this approach has led to a backlash by the major creditors, in turn making it more difficult for consumers who attempt to negotiate their own settlements. So I welcome disclosure requirements that would assist people in properly understanding this approach as it fits among the range of options available to debt-stressed consumers.

The above concerns about disclosure and suitability notwithstanding, this writer remains deeply concerned about the FTC’s proposal to fully eliminate the ability of debt settlement firms to charge any fee whatsoever in advance of having achieved settlements on behalf of clients. While I have personally coached many consumers to handle their own settlement negotiations, I recognize there will always be some continued need for third-party representation in the debt settlement arena. Some consumers are overly fearful of the process, some are truly incapacitated or disabled and require outside assistance, while still others simply do not wish to tackle the process of negotiating on their own. So while I do believe that one thousand or more debt settlement firms is far too many for the true size of the market for this type of program, that does not mean the FTC should take action that will effectively eliminate the entire industry.

By forcing debt settlement (as conducted by third-party representatives) into the non-profit sector, and eliminating any potential for for-profit service companies to work in this industry, the FTC is effectively handing this entire segment of the debt industry over to the existing network of non-profit companies currently delivering credit counseling services to consumers. This, in my opinion, is a disaster in the making. Why? Simply because it will automatically mean that the essential core basis for third-party leverage is effectively removed. I refer to the well-known fact that consumer credit counseling organizations already receive a significant portion of their income directly from the creditors who sponsor their services in the form of the “fair share” agreement. Such organizations who choose to also operate in the debt settlement arena will automatically be operating with a major conflict of interest, making them subject to pressure from lenders – pressure to accept higher settlement percentages than would otherwise be the case. Some may challenge this prediction – but a little common sense will indicate otherwise. Why should a bank accept a 40% settlement offer from one of the counseling organizations it routinely accepts debt management proposals from, when a little pressure from the top to “hold the line” at 60% will result in higher collection recoveries (in theory)? The original intention of the debt settlement approach was to provide consumers with access to a service organization that had no direct ties with the clients’ creditors – freeing the organization to truly place consumers’ best interests as top priority. Take away this core feature by only allowing non-profit companies to work in this sector (i.e., companies that are already beholden to the major creditors), and the results will automatically be inferior to what clients can currently achieve – either through third-party settlement programs (properly implemented) or on their own with training and coaching. If the FTC rule on “no fees in advance” is implemented as proposed, it will be the consumer who suffers the most – and the FTC will therefore be achieving the exact opposite of its intended effect.

This writer recommends that the FTC consider adopting the fee structure proposed by the National Conference of Commissioners on Uniform State Laws (NCCUSL) model legislation for regulation of debt settlement firms – a project which has already been under way for several years, with several states having already adopted rules based on this model. This would provide a reasonable fee structure that eliminates the worst abuses within the industry, while avoiding the unintentional forcing of the industry toward non-profit companies who simply will not deliver the best results for those consumers who most need it.

Finally, with respect to the question on whether the definition of “debt relief services” in the proposed rule-change should be expanded to include “debt relief products,” the expanded definition is completely unnecessary and should not be implemented. Clearly, products in the form of books, tapes, CDs, or printed matter (whether hard-copy or online) contain speech protected under the First Amendment. The marketing of such products is already regulated under existing laws pertaining to deceptive trade practices, and the FTC already has adequate authority to deal with deceptive marketing of such products. Further, where the true intention of the product offering is to “up-sell” consumers to a full-service debt program, then the proposed rule-change would already govern, making an expanded definition of “debt relief service” redundant and unnecessary.

Sincerely,

Charles J. Phelan
President/Founder
Manchester Publishing Company, Inc.
www.zipdebt.com
[email protected]
Toll-Free Direct Line: 1-866-515-2360