People keep trying to reinvent the wheel when it comes to debt negotiation and settlement. It’s not rocket science, and there are really only a few simple principles that need to be followed to avoid problems. It’s the fancy footwork and dodgy tactics that cause all the trouble.

Here’s a good example. Recently, I’ve been asked by several people about a recommendation they came across on the Internet regarding debt settlement letters. I have not yet been able to locate the source of this spectacularly bad “advice,” so I don’t know the exact language of the recommendation. But the basic idea is that a special clause be added to the settlement letter with the aim of avoiding income taxes on the cancelled debt.

A little background first. When a creditor forgives or cancels a debt, and the portion forgiven is $600 or greater, the creditor is required to report that to the IRS on Form 1099-C, Cancellation of Debt. This amount must be claimed as ordinary income by the debtor on their income tax return for that year.

Someone apparently thinks they have invented a way of dodging the tax issue by getting the creditor to add a clause to the settlement letter that the unpaid balance is “in dispute,” or words to that effect — the theory being that no tax liability can result from a debt that is in dispute rather than formally cancelled or forgiven. In other words, if the written-off portion is classified as being “in dispute” rather than cancelled, then the creditor does not need to issue a 1099-C, and if you get audited you produce the letter to prove to the IRS that no agreement was reached.

This is a DANGEROUS technique that should NOT be used.

The purpose of a settlement letter is to document PERMANENT RESOLUTION of the debt. It’s a document that proves once and for all that you are done with that debt forever. And proper documentation is ESSENTIAL to the settlement process. The main reason is because of the massive $100 billion debt purchasing industry that scoops up millions of old debts for pennies on the dollar, with the aim of making a hefty profit on what they collect. Mistakes happen all the time.

People who settle only based on a verbal agreement may find that their supposedly settled debt was sold to a debt purchaser, who simply refuses to believe the account has been settled. “Prove it!” they will say. Without a settlement letter, you don’t have a leg to stand on. It’s your word against theirs, and don’t expect any cooperation from the original creditor. They already lost money on you and won’t want to spend any more labor-hours trying to help you fix your own problem two years later.

If you have a rock-solid settlement letter, then none of this is a problem, and you can instantly put to bed any issues that might crop up along these lines. However, if you have DISPUTE language in the settlement letter, then you do NOT have a settlement letter at all! You are left wide-open to collection activity and possible litigation in the future. You will not be able to prove this settlement was a formal settlement acknowledged by both you and the creditor.

This is a good example of someone trying to be too clever for their own good. No one wants to pay more taxes than necessary. But by trying to make a settlement letter do double duty like this, you run the risk of collection activity on the unpaid balance. Further, there is usually no reason to have such language added in the first place. The IRS allows debtors to exclude 1099-C amounts from income to the extent by which they are insolvent at the time of settlement.

A majority of people who pursue debt settlement are insolvent (i.e., they have a negative net worth), and therefore do not need to pay taxes on the forgiven balances anyway! What a shame to blow a nice settlement over something that was never even an issue in the first place.