When faced with overwhelming debt, it’s important to understand the options available to you for getting out of it. Debt can be a heavy burden, and it’s easy to feel overwhelmed and uncertain about what to do next. However, there are several different paths you can take to manage your debt and move toward financial stability.
Three common approaches to managing debt are debt workout, debt settlement, and bankruptcy. While each of these options can help you regain financial stability, they work differently and have different implications. It’s important to understand the differences between them so that you can make an informed decision about which path is right for you.
A debt workout is an agreement between you and your creditors to work out a repayment plan that is more manageable for you. This can involve reducing the amount of interest you pay on your debt, lowering your monthly payments, or even temporarily suspending your payments altogether. Debt workouts are typically negotiated directly between you and your creditors or through a debt counseling service.
One advantage of a debt workout is that it allows you to keep control of your finances and avoid the negative impact of more drastic options like bankruptcy. Additionally, a debt workout can help you avoid some of the fees and penalties associated with defaulting on your debts.
However, it’s important to keep in mind that a debt workout will typically require you to make regular payments over an extended period of time, which can be a challenge if your income is limited. It may also negatively impact your credit score, as your creditors may report your debt as “not paid as agreed” until the debt is fully repaid.
Debt settlement is an agreement between you and your creditors to settle your debts for less than what you owe. This can be an attractive option for people who have a large amount of debt but cannot realistically pay it off in full. Debt settlement companies negotiate with your creditors on your behalf, often resulting in a reduced amount that you owe. You then pay the reduced amount to the settlement company, which distributes the funds to your creditors.
The main advantage of debt settlement is that it can help you get out of debt more quickly and at a reduced cost. It can also help you avoid bankruptcy, which can have a significant negative impact on your credit score and financial future. However, it’s important to work with a reputable debt settlement company to avoid scams and ensure that your creditors are willing to negotiate. Additionally, debt settlement will typically have a negative impact on your credit score, as it involves not paying your debts in full.
Bankruptcy is a legal process that allows individuals and businesses to discharge their debts and start fresh. There are several different types of bankruptcy, but the most common for individuals are Chapter 7 and Chapter 13 bankruptcy.
Chapter 7 bankruptcy involves liquidating your assets to pay off your debts. Some assets are exempt, meaning you get to keep them, while others may be sold to pay off your creditors. Once the assets have been sold, the remaining debts are discharged, meaning you no longer owe them.
Chapter 13 bankruptcy, on the other hand, involves creating a repayment plan that allows you to pay off your debts over a period of three to five years. Once the repayment plan is complete, any remaining debts are discharged.
Bankruptcy can be a difficult process, and it can have a significant negative impact on your credit score and financial future. However, it can also be an effective way to get out of overwhelming debt and start fresh.
Managing debt can be a complex and challenging process, but understanding the differences between debt workout, debt settlement, and bankruptcy can help you make an informed decision about which option is right for you. Each option has its own advantages and disadvantages, and it’s important to carefully consider your circumstances and financial goals before making a decision.
In this video, you will get answers to these questions:
- What Is a Debt Workout?
- Why Would You Do a Debt Workout?
- Why Would a Creditor Like a Bank Allow the Business Owner to Pay Off the Debt for Less Than the Full Amount?
- Who Might Do a Debt Workout?
- When Is the Right Time to Do a Debt Workout?
- What Are Alternatives to a Debt Workout?
- How Does a Debt Workout Work?
- Is a Workout Usually a Payment Plan or a Fixed Amount?
- Can You Do a Debt Workout for Student Loans?
- Can You Do a Debt Workout for Credit Cards?
- Can You Do a Debt Workout for Payday Loans?
- What Are the Pros and Cons of a Debt Workout?
- Is a Debt Workout the Same as a Debt Settlement?
- Can You Do a Debt Workout Without Hurting Your Credit Score?
- Are Collection Agencies Involved in a Debt Workout?
- How Is a Debt Workout Different from Debt Consolidation?
- How Is Debt Workout Different from a Chapter 7 Bankruptcy?
- Is a Debt Workout Considered Paid in Full?
- Are There Tax Implications for a Debt Workout?
- How Does a Debt Workout Affect Security Clearance?
- How Does a Debt Workout Affect Buying a House?
- How Does a Debt Workout Relate to a 1099-C Form?
- Can a Business Do a Debt Workout?
- Can a Nonprofit Do a Debt Workout?
- Can a Married Couple Do a Debt Workout?
- How Do I Negotiate with Creditors for Debt Relief?
- What Are the Options for Debt Restructuring?
- Can a Debt Workout Reduce the Amount I Owe?
- What Are the Different Types of Debt Workout Programs?
- How Can I Avoid Debt Workout Scams?
- What Does an Internet Scam Look Like for Debt Relief or Debt Workout?
What is the difference between a debt workout, settlement, and bankruptcy? That is the question I am talking about today, as well as a lot of sub-questions related to this topic.
So here is the situation: let’s say you are a business owner, and you borrowed a lot of money in order to grow the business. Maybe it is an SBA loan; maybe it is some other sort of bank loan. Maybe you 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 to do so that the creditors, those are 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 is a typical example of a business that failed during COVID. And let’s say the restaurant had an $800,000 loan with the bank, and let’s say it is also through the SBA. That is 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 of other loans or debts as well. Maybe it is with a credit card. And so often, business owners first think, I guess I need to file for bankruptcy, but that is not the only option. And so today, we are 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 am 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 will 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.
What Is a Debt Workout?
A debt workout is essentially where there is a debt between 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 is called refinancing or restructuring the debt. But more often than that, a workout involves a business owner going to the creditor and saying, “I will pay you a lump sum in exchange for a release from all of the debt.”
Why Would a Creditor Like a Bank Allow the Business Owner to Pay Off the Debt for Less Than the Full Amount?
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 $600,000, and now the business owner says, “Hey, bank, I’ll pay off the debt for $50,000.” Well, at first glance, you might say there is 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 seven bankruptcy, in which case you will get nothing or I have friends and family or maybe some home equity that I am 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 is far less than $50,000 because if a business owner can file for bankruptcy by paying an attorney, say $2,500, often that is going to be the best option unless perhaps the creditor will settle for $10,000 or perhaps $15,000. All right, so that is 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 are 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 $600,000 debt that is canceled in exchange for a payment of $10,000; that means $590,000 was canceled. And from a tax perspective, that is deemed income to you. You will owe the IRS income tax on the $590,000. As you can imagine, that is going to be well over a hundred thousand dollars in taxes. Probably two 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 is where the amount is in dispute. There are claims that are in dispute, and rather than the debt being canceled, there is a separate settlement agreement, an agreement that the debt is not being canceled; it is otherwise being resolved through a complex settlement agreement. An attorney who is experienced in this can explain that to you in more detail and how that works, and a CPA can as well. But I am 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 are 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 is just kind of clean and it is standard. You are done. You wipe out all debts that are hanging out there. Whereas a workout, you are 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.
Who Might Do a Debt Workout?
Generally, it is going to be a business owner who has a very good reason for why they could not pay, and they are out of money, or they are almost out of money, and there is 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 is 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 that there is no way they are 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 are 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 is very different from a workout or a settlement because bankruptcy is under the federal bankruptcy code. A debt workout or a 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, “Alright, 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 is really no money they are 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 are willing to accept whatever that dollar amount is.” It might even be $5,000. “My client would rather pay $5,000 to you than $2000 to the bankruptcy attorney and have to go through the bankruptcy process. The bankruptcy process gets the creditor nothing. A workout would get $5,000 to the creditor. Creditor, would that be of interest to you?” And they typically say, “Well, 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 the cancellation of debt income. In other words, they will 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 counterclaims to have some sort of settlement there. Once the parties have agreed to a settlement, a settlement agreement is drafted, the parties sign it, and then typically, payment is made.
Is a workout usually a payment plan or a fixed amount?
Usually, it is 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 $800,000, well, a thousand dollars a month paid out over time. If there is interest, you are never going to get that paid back. And if there is no interest, it is still 800 months. That is ridiculous. So usually, creditors don’t want a promise to pay a monthly amount. We are looking at either filing for bankruptcy or the business owner borrowing from friends and family to pay money to the creditor that the creditor could not otherwise get access to in bankruptcy.
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, and 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 are probably never going to recover. So if they can get something, it is 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 a tax liability if it is not done right. And if you do a workout, you will 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 are trying to work out some resolution between a creditor and a debtor.” And a settlement is a broader term related to resolving any sort of claim, including a debt or breach of contract that is 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 are pursuing that, and they are sending letters and trying to make a collection on that. When I get involved as an attorney, sometimes I am negotiating with a collection agency, but usually, I am 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 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 Debt Workout Different from a Chapter 7 Bankruptcy?
In a Chapter 7 bankruptcy, you are relieved of tax obligations related to any debts that are forgiven, and all debts are forgiven, except for a few exceptions, like student loans and spousal maintenance and child support. But most other debts are forgiven in bankruptcy. Whereas in a debt workout, you are actually not filing public bankruptcy, you are instead negotiating a different agreement regarding paying off that debt. There is no public filing. This 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 is 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 the 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 is important language to have a settlement agreement where appropriate.
Are There Tax Implications for a Debt Workout?
Yes, if the workout results in what is legally considered a cancellation of debt, then usually the business owner, that is 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 counterclaims, and it is agreed that there is 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 is being a bank officer. You may be concerned about the public filing of 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 is an important reason why a workout may be an advantage for some debtors or business owners.
How Does a Debt Workout Affect Buying a House?
Usually, a debt workout is not as bad as bankruptcy because it is not a public filing. It simply is two parties working out a private arrangement regarding a debt. And so usually, it is 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 like any other debt when getting a mortgage, but it would be whatever that reduced amount is if it has not 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 is 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 are at a 33% tax bracket, you would have a $33,000 tax bill. So it is important for you to negotiate with a creditor, or your attorney to negotiate with a 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 do not have the means to pay a full loan.
Can a Nonprofit Do a Debt Workout?
Yes, nonprofits can do a debt workout. You do need to be careful, though, because if nonprofits 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 would recommend if you are a nonprofit and you are looking at doing a workout, definitely work with an attorney experienced in negotiating workouts.
Can a Married Couple Do a Debt 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, usually, the attorney represents both spouses, and this also applies to same-sex couples, to business partners, and 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 doing it yourself, hire some sort of non-licensed agency, and there are a bunch of places online, and unfortunately, they don’t have the best reputations or hire an attorney. I would recommend you hire an attorney in your state. And I say that with knowledge that I am only in Minnesota. I am licensed in Minnesota. I am not licensed in those other states, but you are going to be best served by finding an attorney who is local to you, and who is 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 is 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, and 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 is the area that I would want to focus on, and sometimes they do deal with bankruptcy. So I think if I were to type into Google to find an attorney who would help me, I would look for like “Iowa Workout Attorney” or whatever state you are in, and 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 have 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 is 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, $20,000 or less. That is, in a negotiation, if the business owner owes a hundred thousand dollars and I am representing the business owner in negotiating with the creditor, like a bank, it is very common for a bank to say, “You know what? We’ll agree to $5,000 or $15,000.” 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 $2,500 in fees.
What Are the Different Types of Debt Workout Programs?
There are two main types. Either a reduction in the total amount owed is to be paid as a fixed lump sum right away. So instead of a hundred thousand dollars debt, it is a $15,000 payment within ten days or a restructured payment over time, which means if you owed $2,000 a month until the whole amount is paid off, maybe you agree to a thousand dollars a month, and maybe there is 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 would recommend using an attorney licensed in your state. That is going to give you the best likelihood of avoiding a bunch of these internet scams.
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 is $1,500 a month, we will negotiate with your creditors. Now you might think, what is 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 are garnishing wages, they are garnishing bank accounts, and it just feels like harassment. It is hard to get out of that sort of debt without filing for bankruptcy.
So today I talked about, “What are business owners supposed to do when they are 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.
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I am Aaron Hall, an attorney for business owners and entrepreneurial companies. You are 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.