Do Debt Collectors Have to Warn You About Tax Consequences?

Many of us are struggling with credit card debt. If you have a delinquent account, a debt collector hired by the original creditor may approach you and offer a settlement. While a settlement may allow you to resolve the creditor's claim for a fraction of what you may owe, it's important to understand the potential legal and tax consequences. A federal appeals court in New York recently addressed the debt collector's role in explaining such consequences to debtors.

Altman v. J.C. Christensen & Associates

Although most debts are governed by state law, a federal statute—the Fair Debt Collections Practices Act (FDCPA)—regulates the conduct of third-party debt collectors. The FDCPA prohibits a debt collector from making “any false, deceptive, or misleading representation or means in connection with the collection of any debt.” For example, a debt collector cannot tell a debtor she may go to jail if she does not immediately pay a debt.

In this case, the plaintiff received a notice containing a settlement offer from a debt collector. The notice claimed the debtor owed about $6,000 on a credit card. The debt collector presented the plaintiff with three options to help settle the debt in full. The first option was a one-time payment representing about 50% of the total debt. The second option was for a series of three payments representing about two-thirds of the debt. The final option was to pay the entire $6,000 over 12 payments.

This is actually a fairly standard settlement offer. But the plaintiff sued the debt collector in federal court, arguing it violated the FDCPA because it did not warn him about the potential tax consequences of some of the options presented. Under federal tax law, a person's gross income includes any “income from discharge of indebtedness.” So let's say you owe someone $1,000. If you make an agreement whereby you pay back $800, and the lender forgives the remaining $200, the IRS considers that $200 taxable income.

With respect to the debt collector's settlement offer, the plaintiff argued it was misleading, as defined in the FDCPA, because it did not disclose any of this. Instead, the letter said the plaintiff would “save” money if he took either of the first two settlement options. For instance, the letter said if the plaintiff made a lump-sum payment of $3,155.43, “That is a savings of 48% on your outstanding account balance.” But that would not account for any tax liability on the amount of the debt forgiven, the plaintiff said.

That doesn't matter, according to the U.S. Second Circuit Court of Appeals, which affirmed a trial court's decision dismissing the plaintiff's lawsuit. In a May 14 opinion, the Second Circuit said the FDCPA does not require debt collectors to make any “affirmative disclosures” regarding tax consequences of settling a debt for less than the full amount. “The fact that a debtor may then have to pay tax on the amount saved is simply not deceptive in the context of what the savings are on a debtor's 'outstanding account balance,'” the Court explained.