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Understanding the Tax Consequences of MCA Bankruptcy

Merchant cash advances (MCAs) can provide quick capital for small businesses, but they also come with risks. If your business struggles and you can’t make payments, you may consider bankruptcy. However, bankruptcy does not make MCA debts disappear. You need to understand the tax consequences to make the best choices.Our financial services company, Delancey Street, helps business owners navigate complex situations like MCA bankruptcy. We have an easy process and assign an expert to each client. Call us at 212-210-1851 to discuss your options.

Taxable Income from Canceled Debts

If you file for bankruptcy and your MCA debts are discharged, technically you have taxable income. The IRS considers discharged debts as income because you originally got cash and now don’t have to pay it back.

• For example, if you owed $100,000 to MCA lenders and the court canceled your obligation to repay through bankruptcy, the $100,000 is treated as taxable income for that year.

The concept seems unfair, but it aligns with the general principle that loan proceeds are not taxed, while forgiven loans or discharged debts are.

• Businesses take loans expecting to repay them. If they don’t have to repay because of bankruptcy, the IRS views it as untaxed income.

The good news is the canceled debt usually does NOT create an actual tax payment obligation. You can exclude canceled debts from taxable income if you meet certain qualifications.

Excluding Canceled Debts with Bankruptcy

The most common way to avoid taxes on discharged MCA debts is using the IRS’s bankruptcy exclusion.

• If your MCA debts are canceled in a Chapter 7 or Chapter 11 bankruptcy, the canceled amounts are not included as taxable income.
• For Chapter 13, you need to distinguish between the debts that are paid back versus canceled. The canceled portion is excluded while the paid portion is not.

So if your MCA lender accepts 20 cents on the dollar through a Chapter 11 restructuring plan, the remaining 80% canceled is excluded from your taxes.The bankruptcy exclusion only applies to canceled debts that were incurred before filing bankruptcy. New debts taken or reaffirmed after filing still count as taxable income if later canceled.

Other Tax Exclusions

Beyond the bankruptcy exclusion, the IRS offers two other potential ways to avoid taxes on canceled MCA debts: the insolvency exclusion and the qualified business debt exclusion.

Insolvency Exclusion

The insolvency exclusion allows you to avoid taxes on canceled debts if your total liabilities exceeded total assets right before the cancellation.

• To qualify, you need to demonstrate insolvency with a certified public accountant’s (CPA’s) evaluation of assets and debts.
• The amount of canceled debt that you can exclude is limited to the amount by which you were insolvent. If you were insolvent by $50,000 when $100,000 of debt was canceled, you can only exclude $50,000 from taxable income.

Insolvency exclusions can get complicated in terms of reporting assets, debts, and ownership interests. Work with a tax professional to determine if you qualify.

Qualified Business Debt Exclusion

The qualified business debt exclusion allows you to avoid taxes if over 50% of the canceled debt came from operating your business.

• The debt needs to be incurred in connection with business operations, not just personal loans that happened to be spent on the business.
• For the exclusion to fully apply, your business assets need to be less than the canceled business debts. If not, there are formulas to determine what portion qualifies for exclusion.

Consult with a tax attorney or CPA to assess if your situation fits the criteria. The qualified business debt exclusion can eliminate tax liability, but the criteria is narrow.

Reporting Discharged Debts on Tax Returns

If your canceled MCA debts meet one of the exclusions above, you avoid tax liability but still need to properly report it. The IRS requires submitting:

• Form 982 to show which exclusion you used and the amount being excluded

• Form 1099-C received from the MCA lender detailing the canceled debt

If you don’t receive a 1099-C, you must provide your own statement with the filing. Confirm documentation of the canceled debt so you can prove meeting an exclusion.

You must file even if expecting no tax liability from the discharged debt. This reporting allows the IRS to verify appropriate use of the exclusions.

• Failure to file can result in penalties or the IRS determining none of the exclusions apply and the canceled debts count as taxable income.

The Tax Impacts of Settling MCA Debt

If you want to repay part of your MCA debts instead of fully discharging them, you may be able to negotiate a settlement. This can minimize bankruptcy impacts on your business. However, settled or partially paid debts have different tax implications than discharged debts.

• With bankruptcy, unpaid balances qualify for tax exclusion. With settlements, anything repaid is viewed as taxable income if later canceled.

For example, let’s say you settle an MCA debt of $100,000 by agreeing to pay $30,000 as full satisfaction. If you eventually default on the $30,000 settlement, that $30,000 then counts as taxable COD income. The original $70,000 unpaid does not because it was already settled.

• If you had fully discharged the $100,000 debt through bankruptcy instead of settling, the entire $100,000 could be tax excluded.

Settling MCA debts can still be smart business-wise, but know it limits tax exclusion eligibility compared to bankruptcy options.

State Tax Policies Vary

The bankruptcy and insolvency exclusions described above all relate to federal income taxes. States set their own tax policies related to discharging debts which may or may not align with federal rules.

• Some states automatically exclude discharged debts from taxable income similar to federal, while others tax canceled debts regardless of bankruptcy.
• Some states follow federal exclusions only in certain situations, like if directly related to operating the business.
• Many states have not comprehensively addressed taxability of discharged debts, creating uncertainty.

Unfortunately state taxation of canceled MCA loans is a gray area lacking clear precedents. Consult with tax experts familiar with your state’s regulations when assessing options. Tally the total federal and state tax costs of bankruptcy alternatives when deciding what path to take.

Strategic Use of Multiple Exclusions

Since different tax exclusions have distinct qualifications, it may be possible to utilize more than one for various portions of your debt.

• For example, you might exclude 50% under the qualified business debt exclusion, 25% based on insolvency levels, and 25% through the standard bankruptcy exclusion.
• Apply exclusions in the order that maximizes tax relief rather than stacking exclusions to exceed 100% of the debt.
• Getting multiple exclusions requires thorough documentation and calculations supporting each aspect.

The strategic use of combined exclusions requires experience with tax law and precedent. Work closely with legal and accounting professionals if attempting to maximize tax relief this way.

Getting Help with the Tax Impacts

Taxes related to MCA loans and bankruptcy can get extremely complex. The exclusions and state-by-state variability create plenty of ambiguity.Our financial services team includes tax attorneys, CPAs, and other experts who can help you understand the consequences of each option and build a customized strategy. We take an empathetic approach and make sure you understand each choice’s pros, cons and uncertainty.If you have merchant cash advance debts and struggle to pay them back, don’t wait to seek help. Call Delancey Street at 212-210-1851 or contact us online get tailored advice and clarity on the tax repercussions of bankruptcy. Know your options so you can make fully informed decisions from both business and tax standpoints