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

People running shops often ask: should I go for debt settlement on my merchant cash advance debt? It can cut your balance and stop the debits. But there are five big tradeoffs.

• First, stopping payment can trigger default and a lawsuit.
• Second, other funders and some customers get pulled into your case.
• Third, the fees charged by the settlement firm eat into the savings.
• Fourth, the forgiven debt can get taxed.
• Fifth, most settlement firms can’t defend you in court.

Settlement works only when backed by real legal leverage.

The way settlement works is you stop making payments to the funder. You instead make payments into a special account at the settlement firm. They use the money to settle with the funder. At least that’s how it’s supposed to work. Meanwhile, the funder sees you’ve stopped paying. It might sue you and get a judgment. That can put a lien on your shop. It doesn’t take a long time to end up in court. Many lenders see even one missed payment as an ”event of default”. That means the entire balance can be due right away. If you have a confession of judgment, the funder can get a court judgment very quickly, without a trial. Then they can freeze bank accounts. The CFPB says debt settlement companies often ask you to stop paying. That can really hurt your credit scores and get you sued. But the settlement firm isn’t the one being sued, you are.

Paying a smaller amount into a firm’s account instead of the daily debits can feel better for a while. But the simple act of redirecting payments away from the funder into the firm’s account can be a breach of your contract. MCA funders sue borrowers to get judgments far more often than banks do. With several stacked MCAs, defaulting on one can set off a ”cross-default” clause in all of them. That can let each funder freeze your bank account at the same time. Suddenly you don’t have cash on hand for payroll or to pay your vendors.

A UCC 9-406 notice can be a surprise too. That’s where the funder tells your customers or your card processing company that your receivables belong to it. That means they need to pay the funder not you. Then your cash flow dries up. That can harm your reputation too. Vendors may stop extending terms. So you may not be able to buy goods or supplies to keep running your shop.

Say your $100,000 MCA debt gets settled for $60,000. That sounds like a lot saved, right? But then the settlement firm takes a big share of the savings. The firm might charge $15,000 upfront to sign up, and $1,000 a month administration fee for 12 months, or $12,000. Then it takes 35% of the $40,000 “saved”, or $14,000. You still owe the funder $60,000, plus the firm $41,000, or a total of $101,000. That’s more than the original debt. And that doesn’t count the damage to your credit, or legal fees if the funder sues you.

A lot of MCA settlement firms do charge fees up front. They’ll claim the fee is an ”administrative” charge, or they call it an ”enrollment” fee. No matter what the fee is called, it’s still a fee.

Canceled debt usually gets counted as taxable income. That’s true whether or not a Form 1099-C gets sent out. If you’re a sole proprietor, you’ll report that income on Schedule C. If you were insolvent right before the debt got canceled (liabilities more than assets), you get to report the canceled debt on Form 982. That lets you exclude some or all of it from your income. The catch is the forgiven debt lowers your tax “attributes” like NOLs or your property’s tax basis. For an S corporation, the insolvency exclusion gets used at the company level. For a partnership, the insolvency exclusion gets used partner by partner. So a solvent partner can’t use it at all.

Most MCA settlement firms aren’t law firms. They aren’t allowed to defend their clients in court. That can leave you vulnerable if the funder goes for a lawsuit. They often tell you to get a lawyer, which adds to the cost.

Real Legal Leverage

Often, MCAs are really just usurious loans in disguise. Lawyers can use New York law to challenge the contract. If it’s an illegal loan, the whole debt may be unenforceable. If that’s the case, funders are a lot more likely to take 40 cents on the dollar.

If debt settlement doesn’t fit, you might look into Subchapter V bankruptcy for a small business. The law sets the debt limit at $3,424,000 in cases filed on or after June 21, 2024. You don’t have to pay quarterly U.S. Trustee fees, like you would in a regular Chapter 11. You have a shorter deadline to file a reorganization plan than in regular Chapter 11.

If you do go with settlement, warning signs include when a firm guarantees you’ll get 50% or 80% cut off your debt. Some funders never settle. If a firm tells you to stop talking to your funder, watch out. An escrow account they control is another red flag. Talk to an experienced attorney before you stop payments or sign anything.

Overall, if you’re drowning in MCA debts, keep in mind that there’s no safe shortcut. Any approach that ignores legal exposure is a disaster waiting to happen. The goal is to protect both business and personal assets. That can mean not agreeing to a settlement unless it’s backed up by real legal leverage.