A very effective asset protection plan could lead your judgment creditor to abandon efforts to collect a judgment based upon a money debt and decide to write off the loan or settle for a very small percentage of the judgment. In some cases, this could be a very bad result for the debtor because of the income tax consequences.
A judgment creditor that abandons all or part of a judgment may want to take a tax write off if the judgment is based upon a collection of money or other property provided to the debtor. The creditor would report the result to the IRS as a “bad debt” in order to document the loss related to the funds previously provided to the debtor. The creditor’s IRS reporting usually includes issuance of a 1099 to the debtor for the amount of debt forgiven. The debtor has to recognize the forgiven debt as income. The debtor can avoid recognition of income if the debtor is insolvent as insolvency is defined by the IRS. Bankruptcy establishes insolvency for tax purposes, but a taxpayer may be insolvent without bankruptcy.
The point is that when a debtor has to consider the potential income tax effect of negotiating a reduced debt or for causing a creditor to write off the debt because collection has become uneconomical. In some cases, the debtor is better off paying the creditor more money if the settlement can be structured to avoid the debtor’s imputed income. Find out if you’ll qualify for IRS insolvency exception before you settle a debt to make sure the tax effect does not exceed the benefits of your asset protection.