Business Debt Settlement Pros and Cons: 5 Tradeoffs That Matter in Practice

Thank you for visiting our website. This article is about business debt settlement, the different pros and cons, and the trade-offs that matter that actually manifest in practice.

Most articles that you read about business debt settlement on the internet are going to talk to you in two different lists: good things on the left, bad things on the right. That framing, unfortunately, is pretty useless because settlement is not a good or a bad thing. It's a trade-off. You're giving up something to get something in exchange, and the question is whether that exchange makes sense for your specific bank account, your creditors, and your paperwork.

In this article, we're going to talk about the five trade-offs that actually decide the outcome of whether this is good or bad. Each trade-off has a mechanism behind it, and each one changes depending on the facts you bring to the table.

Now, obviously, if you're reading this article, most of the time you're reading this because you've got unsecured business debt, such as a merchant cash advance, and you're trying to figure out how to get rid of the situation. You started off with one merchant cash advance, but now suddenly you've got multiple merchant cash advances that are all stacked up. Pretty soon, the daily debits are exhausting your bank account. You can't even keep up with them. Your bank account is floating between red and black. You're lucky if the bank account doesn't end balance on any given day, and on some days you're actually afraid because payroll runs out of that account that day, vendor payments, and more.

The first trade-off: is the discount worth your distress?

Here's the uncomfortable part of the whole thing. A creditor is going to give you a discount when collecting the full balance looks uncertain or looks very, very expensive. If you're a business owner that's paying on time, you give the creditor absolutely no reason to move towards giving you a potential discount. So the leverage really comes from giving the creditor a good reason to offer you a discount.

The leverage that produces a 40 to 60 percent business debt reduction will come from documentation that shows your business revenue has slowed or stopped. That's the basic trade. You're buying a discount with a default, potentially.

The sequence is fairly predictable

The sequence is fairly predictable, though. Your payments slow down, your accounts move to a collections or legal desk. Often, if you do default, many contracts let the business lender accelerate the full balance immediately. On secured commercial debt, a UCC financing statement may already be on file with the state, and now the creditor has a reason to enforce it.

Often some creditors will negotiate within weeks. Others will file a lawsuit first and then talk to you later. Every lender is different, and they each have their own policies.

How much cash you can actually put on the table

What changes the result, though, is how much cash you can actually put on the table. Settlement is typically a liquidity event, not a payment plan. A creditor is agreeing to take 45 cents because 45 cents is available now. Often many of these predatory MCA lenders are going to lend that money back out on the street at 100 to 200 percent APR. So even though they're only collecting half of their potential balance, they're able to make that money back within a year, probably less.

If your plan is to accumulate that cash slowly over many months while the account is in a default status, you are exposed for that entire accumulation period. This is the single most common failure pattern we see. And this strategy is used by business debt settlement companies. And it's also been documented in consumer-side complaint data. Lawsuits are often filed while the borrower is still saving towards the offer. The same mechanics apply to business debt accounts, but often faster because commercial creditors are very quick and not slowed down by consumer collection statutes and laws.

The second tradeoff: who's released

A settlement will release the balance, but it won't necessarily release the people who guaranteed it or the liens. This is the difference between a good settlement and a bad settlement, and it's entirely a legal drafting issue.

Personal guarantee

A business settlement agreement will generally resolve the company's obligations. It does not, however, automatically resolve a personal guarantee. Courts have generally treated unconditional guarantees as a separate contract with their own obligations. Settling the principal debt itself does not extinguish it by itself. Parties can agree that the guarantor is released, but it has to be written down and memorialized in the settlement agreement. If the release only names the LLC, the guarantor can still be pursued for the other portion.

Liens

Liens, however, work the same way. Under Article 9 UCC, there is no remaining obligation and no commitment to give more. Once there is no remaining obligation and no commitment to give more, a debtor can send the secured party a signed demand for a termination statement. The secured party generally has around 20 days to file the termination or send you one that you yourself can file. This is essentially the default rule and a common practice. And states vary, so it's important to check your state's laws.

The practical thing is that the terminations are not automatic. If nobody sends the demand, a stale UCC filing can sit in the public record and very quickly block your next financing. Often many term loan providers and banks will do a quick UCC search before offering you any terms on your next financing deal.

So the real question to ask about any proposed business debt settlement agreement is just not how much; it's:

• who's released

• whether the guaranty is named

• whether all liens are getting terminated

• whether attorney fee claims are being waived

• and more importantly, whether the creditor can sell the remaining balance to a third party later

A cheap settlement with a very, very narrow release can be worse than an expensive one with a full release for all parties involved.

The third item: forgiven debt being considered taxable income

When debt is canceled, it's generally considered income. That is typically the baseline rule. When a lender is discharging $600 or more after an identifiable event, it will generally file a Form 1099-C and send you a copy.

Insolvency

There are exclusions, and insolvency is the one most businesses look for. Insolvency here means liabilities exceed the fair market value of assets immediately. If you qualify, you can exclude the canceled amount up to the extent you were insolvent, and anything above that will be considered income.

The exclusion, though, is not automatic. It will generally require a Form 982. In addition, you'll need documents that support the numbers. Typically, we recommend you speak to your CPA before taking any steps in this direction.

Tax attributes

Here's the thing that people often miss: excluding the income usually requires reducing your tax attributes by the excluded amount. Net operating losses, credits, and asset basis get cut, so the tax benefit is often a deferral rather than a disappearance altogether. You could protect it this year and give up the deductions later.

Entity structure matters too

The other factor is that entity structure matters too. Under guidance provided by the IRS, the insolvency test is applied at the S corporation level for S corps and at the partnership level for partnerships. Two owners in the deal can have two different outcomes.

Some merchant cash advances are written as a purchase of future receivables rather than loans. If the contract is truly a purchase, the tax characterization of a reduced buyback is an argued fact right now rather than settled. It's important you treat this as an open question for your tax CPA professional and not a strategy.

The next consideration: the regulatory space it occupies

The next consideration to think about is how business debt settlement operates and the regulatory space it occupies. The federal advance fee ban most people have heard about comes from the FTC's telemarketing sales rule. The issue is this mostly applies to consumer debt relief. It prevents for-profit consumer debt relief companies that sell by phone from collecting fees before a debt is actually settled or restructured, and at least one payment has to be made under the new agreement.

The rule was really built for consumers and unsecured consumer debt. The rule does contain a broad business-to-business exemption, but it's still being tinkered with. State debt settlement licensing statutes have also followed a similar pattern. Virginia and Tennessee, for example, are written around services provided for consumers.

Upfront fees on commercial debt work

The consequence for you is simple. Upfront fees on commercial debt work are generally not prohibited the way they are for consumer debt relief. That's not automatically bad. Real commercial debt negotiation takes work before any dollars actually save, but it'll shift the burden to you and you have to know the engagement terms. For example, where is your money being held? What happens if the business debt settlement company is unable to get a good outcome for you?

The things worth pinning down are very straightforward:

• whether the fees are being earned per settlement or a charge regardless of the outcome

• who is holding any reserve funds and in whose name are those funds held

• what happens to your money if the program ends early

• what happens if a lender sues you during the process

• and whether or not litigation defense is included in your bill

Ask for all of these answers in writing before signing, and don't take someone's word over the phone because it's not legally sufficient.

Not all business debt settles on the same track

It's important to realize that not all business debt settles on the same track. Settlement is strongest when it comes to unsecured business debt obligations where the creditor's realistic recovery is uncertain or null and void. Merchant cash advances, for example, unsecured lines of credit, and business credit cards fit that description.

SBA loans

SBA loans, however, do not. Under the SBA's servicing and liquidation guidance, an offer in compromise is generally considered only after the business has ceased operating and all collateral has been liquidated. In order to do this, you need to file the SBA Form 1150 along with required statements. Borrowers with a temporary cash flow problem are not the intended candidate for this program.

Secured equipment debt and payroll trust fund taxes

Secured equipment debt is another caveat which behaves differently as well. In this situation, because it's collateralized debt, the lender can simply take the collateral and sell it. Another example of a caveat would be payroll trust fund taxes, which are a separate world entirely handled through procedures by the IRS rather than negotiation.

If you try to mix all of this into one settlement plan, you could end up with a partial solution for many items but no complete solution.

So what does all of this add up to?

Business debt settlement is a great strategy for the right business. It trades legal exposure and tax consequences in exchange for a smaller number and a faster exit.

It really does work when a few facts line up, such as:

• you have real cash available

• your debt is genuinely unsecured

• and you can get releases that cover the guarantors and clear the liens

If you're looking for a program that can either reduce your debt by 40 to 60 percent or a program that will put you into a longer term and improve your cash flow, Business Debt Settlement could be the right fit for you.