I read an article today from amNY.com about a hairdresser in New York who went to a debt referral agency called “Debt Choice.” They put her in touch with an attorney that does debt settlement negotiation. The firm was Seidelman Law Firm and the hairdresser ended up filing for bankruptcy in order to get real relief!

The Seidelman firm basically has the person pay them money every month that they deposit into a trust account and when they accumulate enough money, they try to work out a negotiated reduced debt amount in exchange for a lump sum payment. Unfortunately, the hairdresser was confused and thought the program worked like credit counseling where creditors agree not to pursue collections (at least that’s the story) and take smaller payments each month. After months of making payments to the Seidelman firm, the credit card company that had continued to accumulate interest and late charges sued her. She went from a $16,000 balance on a credit card to over $27,000 when they finally sued her.

The hairdresser ended up filing for bankruptcy. Bankruptcy, of course, offered her the only true relief. The point of the article was to expose the truth about “bankruptcy alternatives.” The fact is that credit counseling, debt settlement negotiations, etc… do not save your credit from negative reports. They aren’t “cheaper” than bankruptcy. They can’t force creditors to do things they don’t want to do. Even a representative from the Federal Trade Commission cited in the article, Frank Dorman, points out that debt settlement is “very risky.” In the end, you may or may not get a deal with your creditors and meanwhile your credit is “shot.” Even the Seidelman law firm on its website acknowledges as much.

Be careful, anything other than bankruptcy is riskier and doesn’t offer any guarantee of relief from debt.

It’s very common for potential bankruptcy clients to ask me why bankruptcy is better than credit counseling. There are a number of reasons and today’s post is not going to explore them all. Today’s post is going to discuss a report from the IRS about credit counseling agencies.

The IRS (go to the IRS’s website at www.irs.gov to view the entire report) announced more steps to insure credit counseling agencies comply with the law. Over the past two years, the IRS has been auditing 63 credit counseling agencies. These agencies represent more than 1/2 of the revenue in the industry. 41 of the audits have been completed representing approximately 40% of the revenue in the industry. All of the audits…all 41 of them…resulted in revocation, proposed revocation or other termination of tax-exempt status!!

To me this isn’t surprising. I’ve often told my clients to be wary of credit counseling agencies who claim to be representing their best interests. IRS Commissioner Mark Everson reported that “over a period of years, tax-exempt credit counseling became a big business dominated by bad actors.” He went on to say that the IRS examinations “substantiated that these organizations have not been operating for the public good and don’t deserve tax-exempt status. They have poisoned an entire sector of the charitable community.”

Credit counseling agencies were found to have failed to provide the level of public benefit required to qualify for tax exemption. They offered “little or no counseling or education” and “appeared to be primarily motivated by profit.” In many instances the IRS found that these agencies “served the private interests of related for-profit businesses, officers or directors.”

The IRS is taking two additional steps in an attempt to stop these abuses. First, the IRS is issuing expanded guidance, including legal standards for exemption and factors considered by the IRS in its reviews of these organizations, and is sending compliance inquiries to each of the remaining 740 known tax-exempt credit counseling agencies not already under audit.

In addition, the IRS has tightened up its review of new applications by credit counseling firms for tax-exempt status. Since 2003, 100 applications have been reviewed, but only three have been approved.

This is important information every consumer should know, especially those of you considering credit counseling as a viable option to help you get out of debt.

I hope all of you had a Happy Thanksgiving! Over the holiday, I read some interesting articles debating the value of credit counseling requirements that are part of the bankruptcy reform legislation. Some people are happy about these new requirements because they feel credit counseling offers debtors alternatives that they would not have been offered without credit counseling. Others see these requirements as yet another obstacle that must be overcome before debtors can obtain true debt relief.

The US Trustee’s office is required to review programs offered by any agency seeking to be approved as a pre-filing credit counseling provider and as a post-filing educational course provider. The US Trustee requires companies, among other things to demonstrate extensive credit counseling experience, be bonded, and offer a bona fide counseling session (though the session could be over the phone or on-line and not necessarily done in person). The US Trustee’s office requires any company seeking to be approved to go through an extensive application process highlighting its experience and conducts a detailed review of its programs. This review and approval process is meant to insure that debtors are receiving good information from reputable, independent companies that are focused on providing a service to the public and not profit motives.

At first glance, it appears that the legislation is attempting to insure that debtors are getting helpful information from companies that have the debtor’s best interests at heart. However, many other people don’t see it that way. The Editor and Publisher of Privacy Times, a Washington newsletter that covers the information world, Evan Hendricks (according to the Lincoln Journal Star) sees something missing. “They say they’ll advise (potential filers) of all their options,” he said. “But some of those are legal options, and credit counselors are not licensed to practice law.” He feels that the motives of some of the credit counseling agencies are in meeting the needs of creditors, particularly large, financial services companies. “It looks like a way to discourage people from filing bankruptcy and places someone between the consumer and their legal representative,” he said.

Credit counseling agencies admit that they are partially supported by creditors who benefit when someone arranges a payment plan as opposed to filing for bankruptcy. However, more than half of their budgets typically comes from fees paid by clients. Typical credit counseling fees vary, but are usually around $50 for a single debtor and $60 for a couple for both the pre-filing counseling and the post-filing educational session. The US Trustee requires that agencies who are approved also offer services “without regard to ability to pay” insuring that some debtors can obtain the services without cost, but that is typically handled on a case-by-case basis and is up to the credit counseling service provider to determine on its own.

The question, though, is whether or not the counseling helps to educate debtors, as it was intended? Or, is it simply another barrier to debt relief? Credit counseling advocates say that they don’t steer potential bankruptcy filers away from bankruptcy. They insist that they discuss all sorts of financial issues with debtors. Obviously, the initial information a credit counselor asks the debtor is about income and monthly living expenses. But, credit counselors insist they also look at all of the debtor’s assets, liabilities and net worth as opposed to just money management issues. Credit counselors insist debtors will benefit because they will better their knowledge of financial matters. Credit counseling advocates don’t believe consumers have bettered their knowledge in the past.

From my perspective, I always viewed my job as a counselor exploring bankruptcy options with potential clients to review ALL options. As their attorney, or potential bankruptcy attorney, I have ethical obligations to review all of these things credit counselors say they are exclusively able to review. I also have legal obligations to make sure bankruptcy is in my potential client’s best interests. I don’t believe a credit counselor is more qualified than I am in analyzing my potential client’s financial situation. In fact, I believe attorneys are better qualified, have had more training, and have more obligations to potential clients than credit counseling agencies do. Obviously, Congress feels that credit counseling agencies offer a better exploration of these issues than attorneys. I strongly disagree with this conclusion.

Also, as one staff attorney from the National Consumer Law Center pointed out that the credit counseling and debtor education requirements are not selectively imposed on debtors who are considering bankruptcy because of financial mismanagement. While many people find themselves considering bankruptcy because of bouts of financial irresponsibility and mismanagement, there are a lot of debtors who are considering bankruptcy because of circumstances that had nothing to do with financial mismanagement or irresponsibility. Health issues, divorces, and unexpected layoffs have caused many more people to file for bankruptcy than simple financial mismanagement. As John Rao of the National Consumer Law Center (as quoted in the Lincoln Star Journal points out: people “caught in a divorce or with health problems will have to go through a lot more hoops to get relief, which is not fair.” As I see it, people considering bankruptcy because of these issues don’t benefit at all from “education” or “counseling” because education and mismanagement was never the problem.

For the people who are considering bankruptcy due to uncontrollable, unforeseen, and unplanned health and marital problems, the credit counseling and debtor education requirements serve only to put up roadblocks to relief don’t provide any benefit. There is no individual benefit to the debtor, nor does the requirement in any way benefit society’s interest in reducing the need for bankruptcy.

Sometimes I get calls from people asking me about the benefits of debt settlement over bankruptcy. My answer, as always, depends on the individual’s situation, but usually bankruptcy is going to be the best way to go. Let me explain.

Let me make it clear that I’m not talking about consumer credit counseling when I use the term “debt settlement.” I’m talking about someone hiring an attorney to act on his behalf to contact creditors and negotiate settlements directly with the creditors. I’m not talking about contacting a credit counseling agency that negotiates lower interest rates and administers a “debt repayment plan” or “DRP.” I’m referring to negotiating the entire account at a percentage on the dollar.

Not everyone is a candidate to negotiate a settlement with creditors. Negotiating settlements requires the payment of a lump sum of money. If you are a person that doesn’t have any access to some cash, then you are not a candidate for debt settlement negotiation. You’ve got to have access to some cash, obviously your access to cash would not have to be enough to pay off 100% of your balances. If you could do that, you wouldn’t need any help. I’m talking about a situation where you might have a family member who can give you a limited amount of money, or maybe you have a pension plan you could take some money out in the form of a loan. No matter the source, you have to be able to get your hands on some cash that you can use to pay lump sum payments to your creditors for the negotiated amount.

A “lump sum” payment could be a payment over two or three installments in a relatively short amount of time, so it may consist of more than one payment, but you’re not going to be able to get a creditor to reduce it’s principal balance and eliminate the interest if you are proposing to pay payments over 5 years or something, the creditor would just as soon force you to file for bankruptcy than agree to that. The point is that you must be able to get the cash to the creditor in a very short amount of time, usually within 30-45 days.

If you are a person who could qualify for a debt settlement negotiation because you have some quick access to a limited amount of cash, then you can sometimes have your debts successfully negotiated down to $.35-.70 on the dollar. Every creditor is different as far as how much they are willing to take so there isn’t going to be a set result you can count on. That’s one of the disadvantages of debt settlement. If all your creditors agree and the last one won’t take any settlement, that can often blow your plans out of the water and force you to file for bankruptcy anyway, after you’ve wasted thousands of dollars paying the other creditors. So, there is a risk associated with settling the debts. No one can guarantee you the result and you’re just trying to get the best deal you can. The bottom line is you can expect to have to pay around $.50 on the dollar so you’ll need enough cash to cover that.

Also, what many people don’t realize is that the portion of the debt you don’t pay back to your creditors you must include on your tax return as taxable income, arguably, in the year of the settlement. Thus, if you negotiate an average of 50% settlements, you actually are paying that 50% to the creditors directly AND you are paying the IRS taxes on the “forgiven” portion at your tax rate. Also, depending on how much debt is involved the amount of the “forgiven” debt could be high enough to bump your tax bracket up forcing you to repay more.

Debts you discharge in bankruptcy are NOT taxable income. Also, bankruptcy, even a Chapter 13 repayment plan, doesn’t require you to come up with lump sums of money. Bankruptcy also can FORCE creditors to accept payments involuntarily, whereas a settlement negotiation requires the creditor to voluntarily agree. For these reasons, in most situations, filing bankruptcy is going to be better than negotiating a settlement.