By now you’ve probably started receiving your tax-related forms.
Most of you will receive form W2, which is sent by your employer and memorializes your income earned for tax year 2013.
Some of you, like me, will receive one (or several) 1099s. A 1099 is sent to people who do contract work as a non-employee.
[Read: Tax Tips for 1099ers]
And some of you will unfortunately receive form 1099-C.
What is a 1099-C?
A 1099-C is a tax form sent by your credit card issuer. The 1099-C represents debts that have been forgiven by your creditors, which is why the form is also called a “cancelation of debt.”
This form is sent when you settle debts with your creditors, or they’ve proactively chosen to no longer attempt to collect a debt.
Creditors are required to report any unpaid principal balance to the IRS when they no longer attempt to collect the debt.
So, if you had a balance of $5,000 canceled by a creditor, they will report that balance to the IRS for tax year 2013.
The 1099-C is often a surprise to consumers because they thought after they settled a debt with their credit card issuers that their troubles were over.
According to the IRS, “If a taxpayer received form 1099-C, all canceled debt will be included on Form 1040, line 21, Other Income.”
And while I’m not a tax expert, it sure sounds like you’ll be paying taxes on the canceled amount since it’s considered income.
How this affects your credit reports.
With respect to credit reporting, debts that have been canceled or settled are NOT paid in full. They’re settled in full, and there’s a big difference between the two terms.
Settlements do show up on credit reports and they are considered derogatory because the loan or obligation went into default.
That type of negative item can remain on a credit report for up to seven years.
[Read: 7 Record-Keeping Tips That Will Make Tax Time a Breeze]
An account that has been settled, or “canceled”, will have to be reported as having a zero balance. There is nothing due on the account despite that fact that it wasn’t ever paid off.
As such, reporting that there’s a balance due (or past due) would suggest that the creditor still has the right to collect on the debt, which they do not.
And while having the account shown as having “zero balance due”, it does not negate the fact that it can hurt your credit scores.
The bottom line.
Still, in the grand scheme of things, settling a debt may be a smart move.
Owing $10,000 on a credit card and paying only $2,500 to settle it definitely works in your favor, even with a tax obligation on the forgiven $7,500.
[Read: Should You Walk Away From Your Taxes?]
You’ll net out ahead despite the fact that receiving a 1099-C is likely going to be a surprise.
If you hired a debt settlement company to assist with your settlement offers, then you paid them a large chunk of change to do something that you could have done on your own for free.
And, it’s very likely they didn’t mention the fact you’d be receiving a 1099-C and that settling a debt would create a taxable event, like selling stock or selling a bond.
John Ulzheimer is the Credit Expert at CreditSesame.com, and a credit blogger at SmartCredit.com, Mint.com, and the National Foundation for Credit Counseling. He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry. The opinions expressed in his articles are his and not of Mint.com or Intuit. You can follow John on Twitter here.