Know The Difference: Debt Workout vs. Settlement vs. Bankruptcy?

What Are the Differences Between a Debt Workout, Settlement, and Bankruptcy?

A debt workout negotiates new repayment terms with your creditor. A debt settlement resolves the debt for less than owed. Bankruptcy is a federal court process that discharges most debts entirely. Each carries different tax, credit, and privacy consequences that determine which option is right for your situation.

When you are a business owner who borrowed money to grow your company and circumstances prevent repayment, you have more options than filing for bankruptcy. Consider a restaurant owner with an $800,000 SBA loan who lost revenue during an economic downturn. That owner might assume bankruptcy is the only path forward, but a debt workout or settlement could resolve the situation with less disruption.

Understanding how these three approaches differ is essential before choosing one. The right path depends on how much you owe, what assets and resources you can access, and whether you need to protect your credit and public record.

Consider a common scenario: a business owner has several outstanding debts, perhaps an SBA loan with a bank, a business credit card balance, and maybe a loan from a private lender. When cash flow deteriorates to the point where repayment is no longer realistic, the business owner’s first instinct is often to file for bankruptcy. But bankruptcy is not the only option, and in many cases, it is not the best one. A debt workout or settlement may resolve the situation while preserving your credit, keeping the resolution private, and potentially costing less in the long run.

What Is a Debt Workout and How Does It Work?

A debt workout is a private agreement between you and your creditor to restructure repayment terms or settle the debt for a reduced lump sum. It avoids bankruptcy, keeps the resolution private, and preserves your credit when negotiated properly.

A debt workout typically takes one of two forms. The first is restructuring: you and the creditor agree to a different payment schedule than the original loan terms, sometimes with adjusted interest rates. The second, more common form, involves paying a lump sum that is substantially less than the full balance in exchange for a complete release from the debt.

The process works like this: you or your attorney contact the creditor and present the financial reality. If you have access to some funds, whether from savings, home equity, or family, you offer that amount as an alternative to bankruptcy. The creditor evaluates whether receiving something now is better than receiving nothing through a bankruptcy proceeding. Once both sides agree, a settlement agreement is drafted, signed, and payment is made.

An important part of that negotiation is discussing whether the creditor will issue a 1099-C form to the IRS, which would report the forgiven amount as cancellation of debt income. If a 1099-C is issued, you will owe income tax on the forgiven amount. Your attorney should also explore whether there are any possible claims or counterclaims that could form the basis for a broader settlement, which may avoid triggering cancellation of debt income. These tax and structural details are why working with an experienced attorney matters in a workout negotiation.

By contrast, a debt settlement, as the term is commonly used, involves a creditor agreeing to accept less than the full amount owed. The terms “debt workout” and “debt settlement” are often used interchangeably, but settlement is a broader term that can apply to resolving any sort of claim, including a debt or breach of contract. In this context, both refer to the same process: a private agreement between debtor and creditor that resolves the obligation outside of bankruptcy court.

The critical distinction is between a workout or settlement (which are private contractual arrangements) and bankruptcy (which is a federal court proceeding under the bankruptcy code). A workout or settlement is simply a contract where the parties agree to different terms regarding repayment of the debt. Bankruptcy is a court-supervised process with specific eligibility requirements, mandatory disclosures, and standardized procedures. Understanding this distinction helps clarify why the consequences of each option are so different: one is a private agreement, the other is a public legal proceeding.

Why Would a Creditor Accept Less Than the Full Amount?

Creditors accept reduced payments because the alternative is often worse. If you qualify for Chapter 7 bankruptcy, the creditor receives nothing. A discounted lump sum is better than zero recovery.

Here is a concrete example. A business owner borrowed $600,000 and offers to settle for $50,000. At first glance, no creditor would accept that. But if the business owner has no other assets and qualifies for Chapter 7 bankruptcy at a cost of roughly $2,500 in attorney fees, the creditor faces a choice: accept $50,000 now or receive nothing through bankruptcy. In practice, settlements often go even lower, to $10,000 or $15,000, when the debtor’s financial position makes bankruptcy a credible alternative.

The key leverage in any workout negotiation is a genuine ability to file for bankruptcy. Without that credible alternative, creditors have less incentive to negotiate. This is why having an attorney who can evaluate your bankruptcy eligibility is so important in the workout process. The attorney can speak with authority to the creditor about whether Chapter 7 is a viable option, and that credible assessment of your bankruptcy position drives the entire negotiation.

Consider a real-world scenario: if a business owner can file for Chapter 7 bankruptcy by paying an attorney approximately $2,500, and the bankruptcy would discharge the entire $600,000 debt, the creditor has a clear economic incentive to accept any offer above $2,500. The business owner’s attorney can present this calculation directly: “My client would rather pay you $10,000 than pay $2,500 to a bankruptcy attorney and have the entire debt discharged. If you decline, my client will file for bankruptcy and you will receive nothing.” This is the fundamental dynamic that makes debt workouts possible.

What Are the Pros and Cons of a Debt Workout?

Debt workouts avoid bankruptcy’s public record, preserve credit, and resolve debts at a substantial discount. The main risk is a potentially large tax bill if the agreement is not structured properly.

Advantages of a debt workout:

• You avoid the public record of bankruptcy
• Your credit score can remain unaffected if the settlement agreement addresses credit bureau reporting
• You resolve debts at a significant discount, often below 20 cents on the dollar
• The resolution is private, which matters for security clearances, mortgage applications, and professional licensing

Disadvantages of a debt workout:

• If the forgiven debt is treated as cancellation of debt, the IRS considers it taxable income. On $590,000 of forgiven debt, you could owe over $150,000 in income tax
• You negotiate with each creditor individually, which takes more time than a single bankruptcy filing
• You will likely pay more total dollars than you would spend on bankruptcy attorney fees alone
• You need access to some funds to offer creditors, unlike bankruptcy which requires no payment to creditors

There is a way to structure a workout that avoids cancellation of debt income: when the settlement agreement resolves disputed claims rather than simply canceling debt, a 1099-C form may not be issued. An attorney experienced in debt workouts and restructuring can explain whether this structure applies to your situation.

Here is how that works in practice. If there are claims that are in dispute between you and the creditor, and the settlement agreement frames the resolution as a comprehensive settlement of those claims rather than a simple cancellation of the debt, the creditor may agree not to file a 1099-C with the IRS. The debt is not being canceled; it is being resolved through a complex settlement agreement that addresses the disputed claims. An attorney experienced in this area can structure the agreement accordingly, and a CPA can advise on the tax reporting side. This is an option available in many circumstances that can help you avoid a significant income tax bill to the IRS.

The other benefit to choosing bankruptcy over a workout is simplicity. Bankruptcy is a standardized process. You file once and wipe out all debts that are outstanding. A workout, by contrast, requires you to negotiate with each creditor on a loan-by-loan, debt-by-debt basis. That process can take longer than simply filing for bankruptcy, though the privacy and credit advantages of a workout often make the extra time worthwhile.

How Does Bankruptcy Compare to a Debt Workout?

Chapter 7 bankruptcy discharges most debts with no tax liability on forgiven amounts, but it creates a public record that affects credit for years. A workout is private and preserves credit, but costs more and may trigger tax consequences.

In a Chapter 7 bankruptcy, you are relieved of tax obligations on forgiven debts. Nearly all debts are discharged, with limited exceptions like student loans, spousal maintenance, and child support. The process is standardized: you file once and resolve all debts simultaneously. The filing is a public record that affects your credit score, may complicate future mortgage applications, and can impact security clearances or professional licensing.

Chapter 13 bankruptcy takes a different approach, creating a three-to-five-year repayment plan. You keep your assets but commit to paying creditors a portion of your income over the plan period. Once the repayment plan is complete, any remaining debts are discharged. Chapter 13 is more structured than a workout and involves ongoing court oversight throughout the repayment period.

A debt workout, by contrast, involves no public filing. The bankruptcy code is not triggered. You negotiate privately with individual creditors and the resolution does not appear in court records. There is no court oversight, no trustee involved, and no public record of the arrangement. It is simply a contract between two parties agreeing to a different arrangement regarding the repayment of debt.

For business owners with special bankruptcy considerations, understanding both paths is critical before making a decision. The choice between bankruptcy and a workout depends on the total amount of debt, the number of creditors involved, whether you have assets to protect, and how important it is to keep the resolution private.

Who Should Consider a Debt Workout?

A debt workout is best suited for business owners who cannot repay their debts, have access to some funds for a lump-sum offer, and want to avoid the public record and broader consequences of bankruptcy.

Generally, the right candidate is a business owner who has a legitimate reason for being unable to pay, is out of money or nearly so, and for whom bankruptcy is a viable alternative. The timing matters: you do not pursue a workout too far in advance. The right time is when you realize there is no realistic path to repaying the loan under its current terms.

If you have no money at all, no home equity, and no family or friends willing to help, there may not be enough to negotiate with. In that situation, bankruptcy may be the only realistic option. But if you can access even a modest sum, that gives your attorney leverage to present the creditor with a choice: accept a reduced payment now or receive nothing through bankruptcy.

The timing of a workout is also a strategic question to discuss with an attorney. Generally, business owners do not pursue a workout too far in advance. The right time is when you start to realize there is no realistic way to repay the loan under its current terms. Acting too early may signal desperation to creditors, while waiting too long may result in collection activity, lawsuits, or judgments that complicate the negotiation.

Is a Debt Workout Usually a Lump Sum or a Payment Plan?

Most workouts involve a discounted lump-sum payment, not a payment plan. Creditors prefer immediate partial recovery over extended monthly payments that may never be completed.

Consider the math on a payment plan for an $800,000 debt. At $1,000 per month with interest, you will never pay it off. Without interest, it takes 800 months. That is not realistic, and creditors know it. What creditors will accept is a one-time payment funded by sources the creditor cannot reach in bankruptcy, such as loans from family or home equity.

The two main types of workout programs break down accordingly. The first is a substantial reduction in the total amount owed, paid as a fixed lump sum within a short period, such as ten days. So instead of a $100,000 debt, the creditor agrees to a $15,000 payment. The second type keeps the total debt amount the same but modifies the monthly payment to something the business owner can actually afford, perhaps reducing a $2,000 monthly payment to $1,000 and adjusting the interest rate. Creditors will typically agree to one structure or the other, but rarely both. They will either give you a discount for paying immediately or accept a payment plan for the full amount. It is highly unusual for a creditor to agree to both a reduced total and payments over time.

Which Types of Debt Can Be Resolved Through a Workout?

Business loans and credit card debts are the most common candidates. Student loans generally cannot be reduced through a workout because they are not dischargeable in bankruptcy, which eliminates your negotiating leverage.

The key to any workout negotiation is a credible bankruptcy alternative. If the creditor knows you could file for Chapter 7 and walk away from the debt entirely, they have strong incentive to accept a reduced payment. That dynamic applies to most business debts and credit card obligations.

Student loans are the exception. Because student loans survive bankruptcy in most cases, the creditor has no reason to accept less than the full amount. You can consolidate student debt or negotiate a modified payment plan, but a discounted payoff is rarely available. The creditor knows you cannot walk away from the obligation through bankruptcy, so the creditor will simply wait until the student loan is paid back. Payday loans can typically be negotiated, though the specifics depend on your circumstances and the lender.

Credit cards are one of the most common types of debts negotiated through workouts, along with business loans. Credit card companies understand they may never recover the full balance from a debtor in financial distress, so they are often willing to accept a reduced payment rather than receive nothing. If you owe money on multiple credit cards and a business loan, your attorney can negotiate with each creditor individually, using your bankruptcy eligibility as leverage across all negotiations. Each negotiation stands on its own, but the overall strategy is coordinated to resolve all outstanding debts as efficiently as possible.

Collection agencies may also be involved in the process. A bank or creditor sometimes assigns a delinquent account to a collection agency, which then pursues the debtor through letters, phone calls, and other collection efforts. When an attorney gets involved in a workout, the negotiation sometimes takes place directly with the collection agency, though more often the attorney negotiates directly with the original creditor. The presence of a collection agency does not change the fundamental dynamics of a workout negotiation, but it does add another party to the process. Your attorney will determine whether to negotiate with the collection agency or go directly to the creditor based on who has authority to approve a settlement.

Can You Do a Debt Workout Without Hurting Your Credit Score?

Yes. A workout is a private agreement, and your attorney can negotiate terms that prevent negative credit bureau reporting. If the creditor has already reported the debt, the settlement agreement can address cleaning up that record.

You should include a term in the settlement agreement specifying what will be reported to credit bureaus. It is common for workouts to result in no credit bureau reporting at all, leaving the business owner’s credit score unaffected. If the creditor already reported the account as delinquent, the settlement terms can require correction or removal of that report.

This is a significant advantage over bankruptcy, which creates a public record that remains on your credit report for seven to ten years. A Chapter 7 bankruptcy stays on your credit report for ten years, while a Chapter 13 remains for seven years. During that time, the bankruptcy filing is visible to any creditor, landlord, or employer who pulls your credit report. A workout creates no such record, giving you substantially more control over how your financial history appears to third parties.

How Is a Debt Workout Different from Debt Consolidation?

A debt workout reduces the total amount you owe. Debt consolidation combines multiple debts into one loan at the same total balance. The key difference is that a workout involves a discount; consolidation does not.

In a consolidation, you still owe the full amount. Multiple debts are merged into a single loan, sometimes with a lower interest rate or longer repayment period, but no principal is forgiven. The advantage of consolidation is simplicity: you make one monthly payment instead of several, and the payment may be lower than the combined total of the individual debts.

A workout, by contrast, typically settles the debt for a fraction of the original balance, often below 20 cents on the dollar. The total amount you owe is substantially reduced, not just reorganized. A workout typically addresses each debt individually rather than combining them, which means the negotiation process takes longer when you have multiple creditors.

Is a Debt Workout Considered Paid in Full?

It can be, if your settlement agreement includes that language. Including a “paid in full” provision is a best practice that protects you with credit bureaus and prevents future collection attempts on the same debt.

The settlement agreement between you and your creditor should state that the workout payment constitutes satisfaction in full of all amounts owed. This language serves two purposes: it prevents the creditor from pursuing the remaining balance, and it gives you documentation to challenge any credit bureau report showing the debt as not fully paid. This is a best practice for attorneys representing debtors, and you should confirm that your settlement agreement includes this provision before signing.

What Is the 1099-C Form and How Does It Affect a Debt Workout?

A 1099-C is a tax form creditors file with the IRS when they cancel debt. If a bank issues a 1099-C for your workout, the IRS treats the forgiven amount as taxable income. Negotiating whether a 1099-C will be issued is a critical part of any workout agreement.

When a bank cancels $100,000 of debt and you are in a 33% tax bracket, the 1099-C creates a $33,000 tax liability. This is why the tax implications of debt restructuring must be addressed in the settlement agreement. If the workout is properly structured as a resolution of disputed claims rather than a simple cancellation of debt, the creditor may agree not to issue a 1099-C, potentially eliminating the tax consequences entirely.

It is standard practice for banks to file a 1099-C form with the IRS when they cancel debt. The IRS takes the position that because you received cancellation of debt, you must pay tax on that amount. This makes the 1099-C negotiation one of the most important parts of any workout agreement. Your attorney should address this issue explicitly in the settlement terms, either securing an agreement that no 1099-C will be filed or ensuring the settlement is structured in a way that makes the form inapplicable.

The difference between a workout that triggers a 1099-C and one that does not can mean the difference between owing nothing additional to the IRS and owing hundreds of thousands of dollars in income tax. For a business owner settling a $600,000 debt, the tax consequences of getting this wrong can be devastating. This is one of the strongest reasons to work with an attorney rather than attempting to negotiate a workout on your own or through a non-licensed agency.

How Does a Debt Workout Affect Security Clearance and Buying a House?

A workout is a private arrangement that does not appear in court records, so it typically has no impact on security clearances, professional licensing, or mortgage eligibility. This is one of the strongest reasons to pursue a workout over bankruptcy.

If you are seeking a security clearance for government work, law enforcement, the court system, or a position as a bank officer, a public bankruptcy filing can create complications. A workout avoids this entirely because no court filing is involved and the resolution remains between you and the creditor.

The same logic applies to buying a home. A workout is not a public record, and when your attorney negotiates terms that prevent credit bureau reporting, the workout typically does not affect your ability to qualify for a mortgage. You may still need to disclose any outstanding debt on a mortgage application, but it would be whatever the reduced amount is if it has not already been paid off. That is a far better position than explaining a bankruptcy filing to a lender.

This privacy advantage extends to any situation where your financial history is scrutinized. Professional licensing boards, insurance companies, and potential business partners may all inquire about bankruptcies. A workout does not create any public record for these parties to discover. The resolution exists only in the settlement agreement between you and the creditor, and that agreement is a private contract.

Can Businesses, Nonprofits, and Jointly Liable Parties Do Debt Workouts?

Yes. Businesses, nonprofits, married couples, business partners, and anyone with joint liability for a debt can negotiate a workout. Nonprofits face additional state-law requirements that make legal counsel especially important.

Businesses regularly negotiate debt workouts when they cannot pay a loan in full. This is one of the most common scenarios in workout practice.

Nonprofits can also pursue workouts, but you need to be careful because state law may impose additional obligations. If a nonprofit is not able to pay its bills, state law may require the board to report the situation to the attorney general or take other protective actions to avoid creditors being left unpaid without recourse. These additional requirements do not prevent a workout, but they add complexity that makes experienced legal counsel essential. If you are a nonprofit considering a workout, work with an attorney who has experience in both nonprofit governance and creditor-debtor negotiations.

When multiple parties share liability for a debt, such as spouses, business partners, or co-guarantors, the workout typically covers all jointly liable parties. If both husband and wife are on the hook for a debt, it is very common for the workout to involve a settlement covering both spouses’ liability. The same applies to same-sex couples, business partners, and anyone with joint liability. The attorney negotiates a single settlement with the creditor that releases everyone on the debt, ensuring no one remains individually liable after the workout is complete.

How Do You Find the Right Attorney for a Debt Workout?

Hire a licensed attorney in your state who has experience with creditor-debtor negotiations and workouts. Not every bankruptcy attorney handles workouts, so look specifically for someone who negotiates complex debtor-creditor resolutions.

You have three options for negotiating with creditors: do it yourself, hire a non-licensed debt relief agency, or hire an attorney. Non-licensed agencies have poor reputations in this space, and for good reason. They often charge $1,500 or more per month in negotiating fees while offering less expertise and less leverage than a licensed attorney.

A licensed attorney brings two critical advantages. First, the attorney can evaluate whether you qualify for Chapter 7 bankruptcy, which is the most powerful leverage point in any workout negotiation. Second, the attorney can structure the settlement agreement to address tax implications, credit bureau reporting, 1099-C issues, and paid-in-full language that protects you after the workout is complete.

When searching, look for terms like “workout attorney,” “debtor-creditor attorney,” or “debt negotiation attorney” in your state. A bankruptcy attorney who also handles workouts and complex negotiations is often the best fit. Not every bankruptcy attorney does workouts. Some bankruptcy attorneys handle a high volume of straightforward bankruptcy filings, while other attorneys focus on the more complex workout and debtor-creditor negotiations. The latter group is what you want for a workout. They understand the negotiation dynamics, the tax implications, and how to structure a settlement agreement that protects you.

Keep in mind that you should work with an attorney licensed in your state, as debt collection and debtor-creditor law varies by jurisdiction. An attorney familiar with your state’s laws can provide the most effective representation.

How Much Can a Debt Workout Reduce the Amount You Owe?

Substantial reductions are common. A business owner who owes $100,000 can often negotiate a workout settlement for $5,000 to $20,000, typically below 20 cents on the dollar. The creditor accepts the reduced amount because the alternative, bankruptcy, would likely yield nothing.

The size of the reduction depends on two factors: the strength of your bankruptcy alternative and the amount of money you can access for a lump-sum payment. If a business owner owes $100,000 and can credibly file for Chapter 7 bankruptcy for about $2,500 in attorney fees, the creditor faces a stark choice. Accept whatever the business owner can offer, or receive nothing through bankruptcy. In that scenario, it is very common for a bank or creditor to agree to $5,000 or $15,000 as full settlement.

The math works in the debtor’s favor because the cost of bankruptcy is low relative to the amounts involved. If filing for bankruptcy costs $2,500 and eliminates $100,000 in debt, the business owner has no rational reason to pay more than a modest amount above $2,500 to settle the debt through a workout. Creditors understand this dynamic, which is why workout settlements consistently involve substantial discounts.

What Are the Two Main Types of Debt Restructuring?

Your two options are a lump-sum payment at a discount or a payment plan for the full amount. Creditors will typically agree to one or the other, but not both. You will not get a reduced total amount combined with payments over time.

The first type is a fixed lump sum at a substantial discount: instead of owing $100,000, you pay $15,000 within ten days or some other short period. The creditor gets immediate partial recovery, and you are released from the debt entirely.

The second type is a restructured payment plan. You still owe the full amount, but the monthly payment is modified to something you can actually afford. If you were paying $2,000 per month, you might negotiate down to $1,000 per month, possibly with an adjusted interest rate. The total balance does not decrease, but the payments become manageable.

Creditors generally do not combine these two structures. Their position is straightforward: either they want all their money and will accept a payment plan for the full amount, or they want cash now and will give a discount for it. They do not want to give a discount and also extend payments over time. In practice, it is highly unusual, and in many attorneys’ experience unheard of, for a creditor to agree to both a reduced total amount and a payment plan. You should expect to choose one path or the other.

How Can You Avoid Debt Workout Scams?

Use a licensed attorney in your state. Debt relief companies that charge monthly negotiating fees typically cost more and achieve less than an attorney who can leverage your bankruptcy eligibility in negotiations.

A common scam works like this: a company promises to negotiate with your creditors in exchange for a monthly fee of $1,500 or more. You might think this sounds reasonable, but there are two significant problems. First, attorneys typically cost less for the same work. Second, only a licensed attorney can credibly evaluate and communicate whether Chapter 7 bankruptcy is a viable option for you, and that credible threat is the single most important factor in getting creditors to accept a reduced payment.

These companies often lack the legal knowledge to structure a settlement agreement that addresses 1099-C issues, credit bureau reporting, or paid-in-full provisions. They also cannot advise you on whether bankruptcy would be a better option for your specific circumstances. The result is that you pay more for less effective representation. Using an attorney licensed in your state gives you the best likelihood of avoiding these scams and achieving a favorable outcome.

How Does the Workout Negotiation Process Work Step by Step?

Typically, you contact an attorney who reviews your financial situation, identifies available funds for a lump-sum offer, and approaches the creditor with a proposal that frames the workout as a better alternative to bankruptcy for both sides.

The process usually begins when a business owner contacts an attorney to discuss their debt situation. The attorney evaluates the full picture: the total amount owed, the number of creditors, the business owner’s assets, and whether bankruptcy is a viable option. If a workout makes sense, the attorney asks a critical question: what access to money do you have?

If you have no money, no home equity, and no friends or family willing to help, there may not be enough for a meaningful offer to the creditor. But many people do have access to some funds. Friends and family are often willing to help, especially when the alternative is watching the business owner go through bankruptcy. That access to outside funds is what makes the workout possible.

The attorney then approaches the creditor with a proposal. The pitch is straightforward: the business owner would rather pay $5,000 (or whatever the available amount is) directly to the creditor than spend $2,500 on a bankruptcy attorney and go through the bankruptcy process. Bankruptcy gets the creditor nothing. A workout gets the creditor some money. The creditor typically responds by saying they need time to consider the offer and may need to run it by a committee or board.

Once both sides reach an agreement on the payment amount, the attorney drafts a settlement agreement that addresses the payment terms, the 1099-C issue, credit bureau reporting, and whether the payment constitutes satisfaction in full. Both parties sign the agreement, and payment is made according to the agreed terms.

What Happens If a Workout Fails?

If you cannot reach a settlement with the creditor, filing for bankruptcy is typically the remaining option. Without a workout or bankruptcy, the creditor can obtain a judgment and pursue wage and bank account garnishments.

Sometimes a workout negotiation does not produce an agreement. The creditor may refuse the offered amount or demand terms that are not feasible. In that situation, filing for bankruptcy is usually the only way to stop collection activity. Without either resolution, you face a judgment, garnished wages, frozen bank accounts, and ongoing collection pressure that makes it difficult to operate a business or manage personal finances.

The best approach is to speak with an attorney about whether bankruptcy or a workout is right for your circumstances. Sometimes you pursue a workout first, and if negotiations fail, you proceed to bankruptcy as the fallback. This two-step strategy is common: attempt the workout to preserve your credit and privacy, and fall back to bankruptcy only if the creditor will not negotiate reasonable terms.

If you are a business owner facing overwhelming debt, the most important step is understanding your options before the situation deteriorates further. Whether a workout, settlement, or bankruptcy is the right path depends on your specific financial circumstances, the types of debts you carry, and your long-term goals for credit, privacy, and financial stability.

Acting before a judgment is entered against you gives you the most options and the strongest negotiating position. Once a creditor obtains a judgment, they can garnish your wages and bank accounts, which creates ongoing pressure that makes it difficult to operate a business or manage your personal finances. Addressing the situation proactively, ideally with the guidance of an experienced attorney, gives you the best chance of reaching a favorable resolution.

For more on the debt collections process and your options as a business owner, explore our additional resources.

Video Transcript

What is the difference between a debt workout, settlement, and bankruptcy? That’s the question I’m talking about today, as well as a lot of sub questions related to this topic. So here’s the situation. Let’s say you’re a business owner and you borrowed a lot of money in order to grow the business. Maybe it’s an SBA loan, maybe it’s some other sort of bank loan, maybe you’d borrowed money from a private lender. Regardless, let’s imagine that some bad circumstances happen so you can’t repay the loan. One great example of this is COVID. When COVID hit, a lot of businesses just simply didn’t have the revenue to pay their loans.

So at that point, business owners have to figure out what do we do so that the creditors, that’s the people that the business owner owes the money to, don’t come after the business owner and take everything.

So let’s play this out. Let’s say a business owner has a restaurant, that’s a typical example of a business that failed during COVID, and let’s say the restaurant had an $800,000 loan with the bank. Let’s say it’s also through the SBA, that’s the Small Business Administration. The business owner realizes, I can’t pay this debt. And by the way, the business owner might have a couple other loans or debts as well, maybe it’s with a credit card. And so often business owners first think, I guess I need to file for bankruptcy. But that’s not the only option, and so today we’re talking about some of the other options, like a workout or a settlement, and the pros and cons of some of those different options.

I’m Aaron Hall, an attorney for business owners and entrepreneurial companies. I do this channel to provide educational content to business owners. If you don’t already have the free handout that I give out, you can get that at aaronhall.com/free, and that handout has the seven common legal mistakes made by new businesses. Once you get that, I’ll also send you some free videos as a follow-up, explaining some of those sections in the seven common mistakes. So hopefully you can avoid those mistakes yourself, and you can talk with your own business attorney about how to set your company up for success and avoid legal problems that can destroy a company.

All right, the first question is, what is a debt workout? A debt workout is essentially where there’s a debt with a business owner and a creditor, and they decide to work out some sort of settlement or resolution. So often that means either the business owner will pay the debt off over time with individual payments, so a different payment plan than originally was set up under the debt. That’s called refinancing or restructuring the debt. But more often than that, a workout involves a business owner going to the creditor and saying, I’ll pay you a lump sum in exchange for a release from all the debt.

Now you might say to yourself, why would a creditor like a bank allow the business owner to pay off the debt for less than the full amount? An example is probably helpful. So let’s say the business owner borrowed six hundred thousand, and now the business owner says, hey bank, I’ll pay off the debt for fifty thousand dollars. Well, at first glance you might say there’s no way a bank will accept that. But if the business owner has no money left and the only alternative is filing for bankruptcy, the business owner might say, hey bank, I can either file for Chapter 7 bankruptcy, in which case you’ll get nothing, or I have friends and family, or maybe some home equity, that I’m willing to borrow in order to pay you something instead of the full amount.

So now the bank says, or the creditor says, well, would we rather get nothing or $50,000? And in fact, most of the time it’s far less than $50,000, because if a business owner can file for bankruptcy by paying an attorney, say, twenty five hundred dollars, often that’s going to be the best option, unless perhaps the creditor will settle for ten thousand dollars, or perhaps fifteen thousand.

All right, so that’s a debt workout, an example of what a debt workout looks like. Why would you do a debt workout? Well, the benefits of a debt workout are you avoid bankruptcy, you avoid having that public record of bankruptcy, you avoid some of the stress and the time related to filing for bankruptcy.

Why would you not do a debt workout? One really important reason is the tax considerations. If the debt workout involves you being considered relieved or canceled of debt, then you’re going to have a significant IRS bill for the cancellation of debt. Let’s put it this way. Let’s say, for example, you do a workout and you have a six hundred thousand dollar debt that is canceled in exchange for a payment of ten thousand dollars. That means $590,000 was canceled, and from a tax perspective that’s deemed income to you. You will owe the IRS income tax on the five hundred ninety thousand dollars. As you can imagine, that’s going to be well over a hundred thousand dollars in taxes, probably a couple to a hundred thousand or more.

Now, there is a way to do a workout where you don’t have cancellation of debt income attributed to you for tax purposes, and that’s where the amount is in dispute. There are claims that are in dispute, and rather than the debt being canceled, there’s a separate settlement agreement, an agreement that the debt isn’t being canceled, it’s otherwise being resolved through a complex settlement agreement. An attorney who’s experienced in this can explain that to you more, how that works. A CPA can as well. But I’m just highlighting that that is an option available in many circumstances, so you can avoid an income tax bill to the IRS.

All right, we’re talking about the pros and cons of canceling or doing a workout. The other benefit to doing a bankruptcy and not a workout is it’s just kind of clean, and it’s standard. You’re done. You wipe out all debts that are hanging out there, whereas a workout, you’re typically negotiating with creditors on a loan by loan basis, or a debt by debt basis, so it can take a little bit longer to do a debt workout than to just simply file bankruptcy.

All right, who might do a debt workout? Generally it’s going to be a business owner who has a very good reason for why they couldn’t pay, and they’re out of money or they’re almost out of money, and there’s no way they can really pay off the debt, and bankruptcy is a viable option.

When is the right time to do a debt workout? That’s a strategic question to discuss with an attorney. Generally the business owner doesn’t do it too far in advance. They do it when they start to realize, there’s no way I’m going to be able to repay this loan.

What are alternatives to a debt workout? Bankruptcy is one alternative. Another alternative is just to do some settlement where you agree to restructure the loan and pay the full amount, but you’re not getting any sort of discount or favorable terms. And by the way, settlement and debt workout, these terms are often used interchangeably. But bankruptcy is the other significant option that’s very different from a workout or a settlement, because bankruptcy is under the federal bankruptcy code. A debt workout or settlement is simply a contract where the parties agree to a different arrangement regarding the repayment of debt.

How does a debt workout work? Well, typically a client contacts me and I take a look at their situation, and I say, all right, I would recommend, instead of filing for bankruptcy, we go to the creditor and see if we can work out some other arrangement. What other access to money do you have? Now, if the client says to me, I have no other money, I have no home equity, I have no friends and family I can borrow from, well, then there’s really no money they’re going to be able to get to negotiate with the creditor. But often people have friends and family who will help them out, and so that allows me to then say, all right, well, let’s go to the creditor and say, creditor, if you’re willing to accept whatever that dollar amount is, it might even be five thousand dollars, my client would rather pay five thousand to you than two thousand to the bankruptcy attorney and have to go through the bankruptcy process. The bankruptcy process gets the creditor nothing. A workout would get five thousand dollars to the creditor. Creditor, would that be of interest to you? And they typically say, a lot, we’ll have to think about it, we’ll run it by a board, or whatever.

An important part of that negotiation is typically talking about whether there will be a 1099 issued by the creditor, which would be reported to the IRS as cancellation of debt income. In other words, if that 1099 is issued by the bank or the creditor, the business owner will end up being liable for cancellation of debt income. In other words, they’ll have to pay income tax on the amount of money that is canceled or relieved in the workout. So you have to have some resolution of that issue, as well as discussing whether there are any possible claims or counter claims, to have some sort of settlement there. Once the parties have agreed to a settlement, a settlement agreement is resolved, or is drafted, the parties sign it, and then typically payment is made.

You might be wondering the following question: is a workout usually a payment plan or a fixed amount? Usually it’s a fixed amount that has a substantial discount, but I often will discuss both with the creditor. But if, let’s say for example, the debt is eight hundred thousand dollars, well, a thousand dollars a month paid out over time, if there’s interest you’re never going to get that paid back, and if there’s no interest it’s still 800 months. That’s ridiculous. So usually creditors don’t want to promise to pay of a monthly amount. We’re looking at either filing for bankruptcy, or the business owner borrowing from friends and family to pay money to the creditor that the creditor couldn’t otherwise get access to in bankruptcy.

Next question. Can you do a debt workout for student loans? Usually the answer is no, because student loans are usually not forgivable in bankruptcy. You can consolidate the debt, you can work out a different payment plan, but you usually cannot negotiate a discount to get that paid off, because the alternative of bankruptcy is not a viable option for the business owner, and the creditor knows that. So the creditor is just going to wait until that student loan is paid back.

Can you do a debt workout for credit cards? Usually yes. Credit cards are one of the most common types of debts, those along with business loans, that are negotiated, because the credit card company knows they’re probably never going to recover. So if they can get something, it’s better than nothing.

Can you do a debt workout for payday loans? Usually the answer is yes, but it does depend on the circumstances.

What are the pros and cons of a debt workout? The pros are you avoid bankruptcy, and you essentially can resolve your debts for a substantial discount. The cons are that you might have tax liability if it’s not done right, and if you do a workout you’ll probably end up paying more money than you would have if you filed for bankruptcy.

Is a debt workout the same as a debt settlement? Generally yes. A debt workout usually means, hey, we’re trying to work out some resolution between a creditor and a debtor. And a settlement is a broader term related to resolving any sorts of claims, including a debt or breach of contract, that’s out there. But in this context, a debt settlement and a workout are usually used in a real interchangeable manner.

Can you do a debt workout without hurting your credit score? Yes, you can. Now, you may want to have a term in the settlement agreement of your workout regarding what will be reported to the credit bureaus, but it is very common for a workout to occur and nothing gets reported to the credit bureaus, so the business owner’s credit score is not harmed. If the creditor already reported something to the credit bureaus, that might need to be cleaned up, and that would be discussed in the terms of the settlement agreement, or the workout agreement, between the creditor and the business owner.

Are collection agencies involved in a debt workout? Usually a collection agency has been assigned a case from a creditor and is pursuing that debtor. So the bank, for example, might assign the case to a collection agency, and then they’re pursuing that, and they’re sending letters and trying to make a collection on that. When I get involved as an attorney, sometimes I’m negotiating with a collection agency, but usually I’m negotiating directly with the creditor. So yes, collection agencies may be involved in the negotiation process. It depends on the circumstances.

How is a debt workout different from a debt consolidation? A debt workout usually is a substantial reduction in debt. A debt consolidation usually keeps the debt at the same amount, but multiple debts are consolidated together into one large loan, which the business owner or debtor pays off over time. So consolidation usually does not involve any sort of discount in the amount of the loan, or reduction in the amount, whereas a workout usually involves a substantial reduction in the amount of the loan.

How is a debt workout different from a Chapter 7 bankruptcy? In the Chapter 7 bankruptcy, you are relieved of tax obligations related to any debts that are forgiven, and all debts are forgiven except a few exceptions, like student loans and a spousal maintenance and child support. But most other debts are forgiven in bankruptcy. Whereas in a debt workout, you’re actually not filing public bankruptcy. You are instead negotiating a different agreement regarding paying off that debt. There’s no public filing, the bankruptcy code isn’t triggered, and you do need to pay attention to whether the cancellation of any debt will be taxable to the IRS. So again, that’s an important issue to resolve in any sort of settlement agreement between a business owner and the creditor.

Is a debt workout considered paid in full? That depends on the terms of the settlement agreement between the debtor and creditor. In other words, the business owner who owes the debt might work out a settlement agreement with the creditor, like the bank, and it says this constitutes payment in full for all amounts owed. So you certainly can put that sort of language in the settlement agreement, and that is a best practice for attorneys representing debtors, because the debtor may be able to use that with a credit bureau to challenge any report that the debt was not paid in full. So it’s important language to have in a settlement agreement where appropriate.

Are there tax implications for a debt workout? Yes. If the workout results in what is legally considered cancellation of debt, then usually the business owner, that’s the debtor, will owe income tax on the amount canceled. But if the settlement agreement is structured as a settlement of a more comprehensive matter, and maybe claims and counter claims, and it’s agreed that there’s not going to be any 1099 from the bank sent to the IRS because there isn’t a cancellation of debt, usually then that does not result in cancellation of debt income to the debtor.

How does a debt workout affect security clearance? Well, if a person is trying to get a security clearance, maybe you want to be in the CIA or FBI, or work for the court system, or some other sort of security or high confidence type role, maybe it’s being a bank officer, you may be concerned about the public filing of a bankruptcy. A workout is a private arrangement between two parties. It doesn’t get filed with a court, it doesn’t get filed with a bankruptcy office or court, and so because it is a private resolution, it usually will not have any effect on security clearance. That’s an important reason why a workout may be an advantage for some debtors or business owners.

How does a debt workout affect buying a home or getting a mortgage? Usually a debt workout is not as bad as, like, a bankruptcy. It’s not a public filing. It simply is two parties working out a private arrangement regarding a debt, and so usually it’s not reported to the credit bureaus for my clients, because I negotiate that as part of the terms, and it is certainly not otherwise filed publicly. As a result, a workout usually does not have a significant detrimental effect on getting a home or a mortgage. The debt probably needs to be reported to the bank as, like, any other debt when getting a mortgage, but it would be whatever that reduced amount is, if it hasn’t already been paid off. So a workout is usually much better for a person desiring to get a mortgage or buy a home.

How does a debt workout relate to a 1099-C form? Well, if a person does a workout with a creditor like a bank, it’s standard practice for a bank to file a 1099-C form with the IRS, which says the bank canceled debt for this particular debtor, or this particular individual who owed money. When the IRS gets that, they take the position that because you got cancellation of debt, you need to pay tax on that, income tax. If you get a hundred thousand dollars canceled and you’re at a 33% tax bracket, you would have a $33,000 tax bill. So it’s important for you to negotiate with a creditor, or your attorney to negotiate with the creditor, whether a 1099-C form will be filed with the IRS, or whether this is properly structured as not cancellation of debt income, and instead resolution of various other claims and issues between the parties.

Can a business do a debt workout? Yes, businesses generally and regularly do debt workouts when they don’t have the means to pay a full loan.

Can a non-profit do a debt workout? Yes, non-profits can do a debt workout. You do need to be careful, though, because if non-profits are not able to pay their bills, state law may require certain acts, that the board report this to an attorney general, or take some other action, to avoid creditors being stiffed without getting paid. So I’d recommend, if you’re a non-profit and you’re looking at doing a workout, definitely work with an attorney experienced in negotiating workouts.

Can a married couple do a workout? Yes. It doesn’t always have to happen, but if both the husband and wife are on the hook for a debt, it is very common for the workout to involve a settlement for the husband and wife’s liability for that debt, and in that case you usually, the attorney represents both spouses. And this also applies to same-sex couples, to business partners, anybody that has joint liability for a debt. It would be appropriate for the attorney to negotiate a workout with a creditor for all debtors, everybody who has joint liability for that debt.

How do I negotiate with creditors for debt relief? The options are do-it-yourself, hire some sort of non-licensed agency, and there are a bunch of places online, unfortunately they don’t have the best reputations, or hire an attorney. I’d recommend you hire an attorney in your state, and I say that with knowledge that I’m only in Minnesota. I’m licensed in Minnesota, I’m not licensed in those other states. But you’re going to be best served by finding an attorney who’s local to you, who’s experienced in creditor debtor issues and negotiating workouts, because a licensed attorney can cut to the chase with negotiating with creditors. A licensed attorney can also speak with authority on the issue of whether you qualify for a Chapter 7 bankruptcy, and that’s an important talking point when negotiating with creditors.

Often a bankruptcy attorney has experience in workouts, and working with a local bankruptcy attorney who does workouts as well may be a good option for you. Not every attorney does workouts. I should say, not every bankruptcy attorney does workouts. Some bankruptcy attorneys just do a ton of bankruptcies, and other attorneys handle more of the complex workouts and debtor creditor negotiations. That’s the area that I’d want to focus, and sometimes they do deal with bankruptcy. So I think, if I were to type into Google to find an attorney who had helped me, I would look for, like, Iowa, or whatever state you’re in, workout attorney. Maybe you do debtor creditor attorney, something like that.

What are the options for debt restructuring? Your options for debt restructuring are usually either a lump sum payment all at once in exchange for a discount on the total amount owed, or payment over time for the full amount owed. It is highly unusual, in fact I don’t think I’ve ever seen it, where you can negotiate as a debtor, or as a business owner who owes money, a reduction in the total amount and a payment plan over time, because usually creditors say, you know what, either I want all my money now and I’m willing to give a discount for it, or I’ll accept a payment plan for the full amount. But they don’t want to give both.

Can a debt workout reduce the amount I owe? Yes, usually a debt workout involves a substantial reduction of the amount a debtor owes. For example, if a business owner, that’s the debtor, owes a hundred thousand dollars, it would be very common for a workout to reduce that amount to below 20 cents on the dollar, in other words twenty thousand dollars or less. That is in a negotiation. If the business owner owes a hundred thousand dollars, and I’m representing the business owner in negotiating with the creditor like a bank, it’s very common for a bank to say, you know, we’ll agree to five thousand dollars or fifteen thousand dollars, because the alternative is getting nothing for the bank, because the business owner just files for bankruptcy, and business owners can generally do that for about twenty five hundred dollars in fees.

What are the different types of debt workout programs? There are two main types: either a reduction in the total amount owed, paid as a fixed lump sum right away, so instead of a hundred thousand dollar debt it’s a fifteen thousand dollar payment within ten days, or a restructured payment over time, which means if you owed two thousand dollars a month until the whole amount is paid off, maybe you agree to a thousand dollars a month, and maybe there’s an adjustment in the interest rate. So in other words, the creditor is going to agree to either a substantial reduction in the debt in exchange for a lump sum, or keeping the debt for the total amount and just the monthly payment is modified, so that the debtor, the business owner, can actually afford those payments.

How can I avoid debt workout scams? Well, unfortunately there are a lot of scams out there. The bottom line is, I’d recommend using an attorney licensed in your state. That’s going to give you the best likelihood of avoiding a bunch of these internet scams. By the way, you’re probably wondering, what does an internet scam look like for debt relief or debt workout? Usually the company will make promises that say, in exchange for you paying us a monthly negotiating amount, so let’s say it’s fifteen hundred dollars a month, we will negotiate with your creditors. Now you might think, what’s wrong with that? Isn’t that a good deal? There are really two problems with it. One, attorneys will usually cost much less than that. And second, attorneys have far more knowledge and leverage to negotiate a better deal for you, because the attorney can speak to whether filing for Chapter 7 bankruptcy is a viable option for you.

So my recommendation is to speak with an attorney about whether bankruptcy or a workout is best in your circumstances. And sometimes you pursue a workout if possible, and you might ultimately find you can’t work out a resolution with the creditor, so you have to file for bankruptcy. If you can’t settle with the creditor, often the only option is to file for bankruptcy, because otherwise you end up with a judgment over your head, they’re garnishing wages, they’re garnishing bank accounts, and it just feels like harassment. It’s hard to get out from that sort of debt without filing for bankruptcy.

So today I talked about what are business owners supposed to do when they’re overwhelmed with debt, and what are the differences between a workout, a settlement, and a bankruptcy. I do these educational videos to help educate business owners on topics to discuss with an attorney in their state. This is a free video provided online. If you have questions, you’re welcome to ask them in the comments section below. I’ll do my best to use those comments and questions in future videos, and address the questions that people raise.

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I’m Aaron Hall, an attorney for business owners and entrepreneurial companies. You’re welcome to check out some of the other videos I have on related topics for business owners, either by the description below or otherwise in this channel.