the survival of your business depends on having a solid financial plan, which means streamlined record-keeping, consistent financial analysis and, perhaps most importantly, cash flow management. The problem I typically see in small businesses is lack of knowledge about the most efficient and effective way to handle the accounting side of things
Sometimes things happen in life that are outside of our control. Medical bills, job loss, and catastrophic uninsured damage to a home are just a few things that could happen to each and every one of us. When unwelcome events like these happen it may make paying bills harder and can ultimately lead to losing a car or house in exchange for debt forgiveness. Although you would be relieved of your obligation to pay back your debt, there is another party waiting in the distance to collect; the IRS.
What is Cancelled Debt and How is it Reported?
Cancellation of Debt "COD" income, as the IRS defines it, is any debt for which you are personally liable, which is forgiven or discharged for less than the full amount owed. The debt is considered canceled in whatever amount remains unpaid. Creditors are responsible for reporting cancelled debt to taxpayers for amounts $600 or greater on form 1099-C. Taxpayers who receive COD income (regardless of whether or not they receive a 1099-C) must report the cancelled debt on their income tax return and pay income tax for the amount forgiven.
What to Do if You Receive COD Income
Like anything else tax related, don’t ignore any tax forms you receive, including a 1099-C. Remember, anytime you receive a tax document from a third party, there is a very high likelihood that the IRS has also received a copy. The IRS is expecting that you will report all tax information, and if you don’t, they’ll correct your return for you and throw on some penalties & interest for their trouble. Even if you don’t receive a 1099-C, you are still responsible for claiming any COD income on your return.
There are however some exceptions and exclusions as to when COD income is taxable (listed below). Visit the IRS website for more information about each.
Exceptions (do not reduce tax attributes)
1) Gifts, Bequests, Devises, and Inheritances
2) Student Loans
3) Deductible Debt
4) Price Reduced After Purchase
5) Home Affordable Modification Program
Exclusions (may reduce tax attributes)
3) Qualified Farm Indebtedness
4) Qualified Real Property Business Indebtedness
5) Qualified Principal Residence Indebtedness
Before you get too excited, it’s important to understand that the exceptions and exclusions listed above exist in a very narrow set of circumstances and the rules have changed numerous times over the last decade. Discuss any tax ramifications with your tax advisor if you have any COD income. I will go into more detail on two of the most common types of COD income in the next section.
Mortgage Relief and Consumer Credit
The most common types of COD income include Qualified Principal Residence Indebtedness and consumer credit. For taxpayers whose primary homes are foreclosed or sold in a short sale, they are required to report COD income, but may not be responsible for paying income tax on the COD income they receive (effective through December 31, 2016 as of the time of this writing). This is thanks to the Mortgage Forgiveness Debt Relief Act of 2007. The good news here is that there is talk (as of the time of this writing) to extend the Qualified Principal Residence Indebtedness relief permanently for all future years.
For consumer credit (such as credit cards), taxpayers can almost always expect to pay income tax on any COD income they receive, unless one of the exceptions or exclusions from the above section apply. In instances where a car or boat is repossessed and a loan is forgiven there may also be tax consequence. These are common examples of when taxpayers are blindsided. Remember this if you ever need to negotiate with your credit card company to reduce an amount due.
One more note of caution. Although there are exceptions and exclusions at the federal level, some states may still require that income tax be paid on COD incomeregardless of the federal exclusion. Again, consult with your tax advisor to whether this pertains to your situation or not.
How Much Will I Owe?
If you find yourself faced with a situation where you know you’ll have to pay tax on COD income then it might be wise to plan ahead. COD income is taxed at your marginal income tax rate. So for example, a taxpayer with COD income of $10k in a 15% tax bracket (plus state) will face at least $1,500 in additional income tax related to the COD income. In a separate example, if you had a car with a $20k note on it and you returned the vehicle worth $18k and were forgiven for your debt, only the $2k difference would be taxable at your marginal tax rate. What these examples tell us is if you’re going to attempt to have debt cancelled or forgiven, it would be ideal to do it as early in the year as possible to afford you more time to save up to pay your tax bill.
Debt forgiveness has more than just an income tax effect. It can also impact your credit score. Sometimes it may make more sense to get out from under a loan rather than try to endure the hardship of paying it back. In those cases, COD income and lower credit scores may be worth the trade-off. However, given all of the adverse consequences of debt forgiveness, taxpayers should consider debt forgiveness as a strategy only as a last resort.
I hope this was informative to readers. It’s not common that taxpayers receive COD income but it is a growing trend and more people are finding themselves faced with the issue. Feel free to leave comments or questions below!
Happy New Year everyone! I’m sure there are many aspiring entrepreneurs out there looking to start their own business in 2017. To help them get started, I am sharing five of the most common mistakes I have observed small business owners make.
#1 Improperly Organizing Their Business
Every business needs to be legally organized somehow, whether as a sole proprietorship, an LLC, a partnership, or some other way. My advice is to keep it simple, at least in the beginning. Consider what you are going into business to do. Are you a young guy mowing lawns on the side just to make a couple of extra bucks? Or are you a seasoned attorney looking to provide legal advice to clients? Every business is different and therefore would benefit from a different legal structure.
Often times, businesses benefit from keeping things simple in the beginning. Certain structures carry significant administrative requirements which can be time consuming and costly, outweighing the benefits they provide. Instead of picking an overkill option from day one, consider drawing out a one-year, two-year, and three-year plan so you know when it might make sense to have an elaborate business structure. You can always reorganize your business down the road without sacrificing what you have worked so hard to build. Spend the time and money to consult with a trusted attorney to help you evaluate all of your options and make the best decision.
#2 Doing Everything Themselves
All small business owners are guilty of this at some point, me included. They want complete control over everything and do everything themselves because they think no one else can do it as well; but that’s just not true. You should do as much as you can for as long as you can, but once you start to feel the pressure, you should consider hiring someone to help you out. Even using a virtual assistant or part-time administrative assistant can save you stressful hours of work that are not usually related to building your business or making you money. It’s also a wise decision to find a trusted attorney and CPA to assist you with your business, no matter how small your operation is. Face it, you don’t know everything and the more help you can get in the beginning the fewer mistakes you will make in the long-term.
#3 Not Setting Up Accounting From Day One
Not to be biased, but every small business needs an accounting system. Even if it’s just a spreadsheet in Google Sheets, it’s better than nothing at all. Preferably, every small business owner would use an accounting platform like QuickBooks Online or Wave. I commonly find that owners are too busy to even setup accounts with these services, let alone do the work. How can you make informed decisions if you don’t know the financial status of your company? You can’t. You will only get so far before you come to the realization that an accurate accounting of your business’s financial activity is a common theme of successfully run businesses. Do yourself a huge favor and start with an accounting platform from the first day. Spreadsheets are a good Band-Aid, but eventually you will need to upgrade.
#4 Misunderstanding Business Taxes
Business taxes and individual taxes are two different worlds. The rules are often completely different, and the IRS has done a stellar job at preventing taxpayers from being able to abuse the code in either world. There are circumstances where your business taxes may be just an extension of your personal taxes, but when they are not, you must file the appropriate forms on-time. Failing to file, or filing late, can bring very stiff penalties.
Regardless, the results of your business taxes are typically reported on your personal return somehow. If you ignore filing for your business you may find yourself having to amend previously filed individual returns just to report business income. In addition, many business owners get caught up with constantly trying to minimize their tax liability year-after-year and never plan, failing to consider the long-term effects of their decisions.
Questions about depreciating assets in full in their first year, reasonable salaries for the owners, and business tax credits for specific industries are just a few examples of how a tax professional can help you. Doing it yourself may not be the wisest choice and working with the right CPA may seem costly in the beginning, but if they are a true business partner, then the mistakes they prevent you from making will more than make up for their fees and likely save you more in the long run.
#5 Failing to Network/Market Properly
Networking is critical from a business development standpoint. If you fail to network or market your product or service effectively to the right audience, then you’re wasting your time and losing out on precious revenue. Take some time to read up on industry-related marketing strategies and listen to podcasts to gain insight on how you can best package and sell what you offer to the right audience. Learn from those who came before you to save time and money. Reach out to those you follow in your community for business advice. You can have a million dollar idea but if you’re in front of the wrong target audience it’ll never sell well. Remember, you are in business now and at the end of the day that also makes you a salesman. Perfect your pitch and make sure you’re spending the right amount of time with the right people.
I would love to hear what mistakes other business owners have made, or have heard about in the business community. Post your stories in the comments section below!