Business Debt Settlement

Thank you for visiting our website. This article is about business debt settlement and how it actually works.

What Business Debt Settlement Means

Business debt settlement means paying a lender less than the full balance in order to satisfy the account. That's the basic premise of it. It's not a legal status, and it is not a program you technically enroll in. To say business debt settlement is to say that you are now negotiating with a lender and asking them to take a haircut on what they are owed.

The price depends almost entirely on what the creditor believes it can collect if you say no. That framing certainly matters. Most bad outcomes happen because a business owner treats settlement as a product they buy instead of leverage in a case that they are building.

Advance Fees and the Telemarketing Sales Rule

Business debt sits in a legal world that is different than consumer debt. Consumers who settle credit cards often get real federal protection. For example, the FTC's telemarketing sales rule has banned advance fees for debt relief services since October 2010. Under that rule, a company can't collect a fee unless it has settled or changed the terms of at least one debt. In addition, the customer has to agree to the deal, and the customer has made at least one payment under it.

Here's a part that most people often miss when they're contemplating business debt relief or debt relief in general. These debt relief provisions are built around consumers and around telemarketing. Business debt is a different animal altogether. Sales made face to face are exempt from the rules, and work performed by lawyers under state bar rules is governed again differently. So the advance fee protection most people have heard about may not actually apply to a business owner in the same way they assume it would to consumer debt.

Questions to Ask About the Fee Structure

The practical read is very simple, though. Don't assume the fee structure in front of you is either illegal or approved. Ask the tough questions, like who's holding your money, when are the fees earned, and what happens if nothing settles. More importantly, get the answer in writing.

The Personal Guarantee Drives the Discount

Now, for most of what business debt entails, one of the most important issues that you have to think about is what's going on with the personal guarantee. Most small business credit is backed by a personal guarantee. Many of the guarantees are unconditional and perpetual, which lets the creditor sue you without first chasing the company or selling collateral. That single fact drives the discount when settling business debt for less.

If the operating entity is empty and there's nothing there, no one guaranteed the debt and there's no collateral worth seizing, the creditor's realistic path to recovery is close to zero. Having said that, that also means discounts can be deep and significant. But if you signed a guarantee and you own a home with equity, the creditor is not pricing in your business at all; it's pricing in you as the guarantor.

Facts to Pin Down Before Anyone Makes an Offer

Before anyone makes an offer, you have to pin down a few facts:

• who signed and in what capacity
• whether the guarantee is perpetual and unconditional
• what UCC-1 financing statements are on file and in what order

Lien priority will always decide who gets paid first in a liquidation, and creditors will negotiate accordingly.

Merchant Cash Advances and Usury Limits

Now, let's shift focus to merchant cash advances, which is where the leverage usually is. An MCA is written as a purchase of future receivables, not a loan. That structure is the whole point, because a true sale of your receivables is not subject to usury limits.

The LG Funding Three-Factor Analysis

New York State courts have tested this structure rather than just contemplated it. In the appellate division, the Second Department, in the case LG Funding v. United Senior Properties of Olathe, it applied a three-factor analysis in contemplating this exact question:

• was there a reconciliation clause
• was there a finite term
• and does the funder have recourse if the merchant actually files bankruptcy?

Courts since then have paid close attention to wording and the outcome of this case.

If a court is able to characterize the deal as a loan, though, then New York's criminal usury ceiling of 25 percent for most corporate borrowers comes into play, and that is a defense argument that your lawyers can use in court later.

Limits of Recharacterization

Having said that, there are limits. Recharacterization is fact-specific and decided case by case. It is an argument, but it is certainly not a guarantee, and it is not law. It usually is a defense after a lawsuit has been filed rather than a clean win before anyone has filed any type of legal proceedings.

The Confession of Judgment Under CPLR 3218

Another item to think about is the confession of judgment. This too has changed. CPLR 3218 was amended in 2019. Now the confession must state the county where the defendant resided in when it was executed, and it has to be filed there. Confessions that are signed by non-New York residents are no longer enforceable in the state of New York. Having said that, older judgments are still out in the wild, which is why motions to vacate remain an issue rather than ancient history.

Disclosures on Commercial Financing in New York

In addition, regulations have changed, and now New York also requires disclosures on commercial financing. The Department of Financial Services regulations took effect in 2023, and they cover sales-based financing such as merchant cash advances of 2.5 million dollars or less to recipients that are principally in New York. This requires an APR disclosure on all loans or purchases of receivables. Again, a disclosure failure does not automatically erase the obligation. It is one fact among many, and it can shape the negotiation when talking to lenders and probing them for potential discounts.

SBA Debt and the Offer in Compromise

Now let's shift focus to SBA debt and how that's underwritten. SBA-backed loans do not settle willy-nilly. They settle through an offer in compromise using SBA Form 1150 along with financial statements like Form 770. Generally, the agency expects the business to have ceased operating and all collateral available to have been liquidated before it will consider a compromise. Typically, if you want to learn more about the servicing and liquidation standards, you can read SBA's SOP 50 57 series, which is public and worth reading.

Two Points That Stumble Business Owners

Two points usually stumble business owners. First, the personal guarantee will survive the dissolution of the company. Second, if the file is charged off and referred to the Treasury Department for collection, you should expect additional fees added, which will inflate the balance significantly. Here, timing matters more than anything because if it gets sent to Treasury, you are going to pay more money.

The Likely Sequence Once You Stop Paying

What is the likely sequence once you stop paying your business debt? The order is pretty predictable.

1. You miss a payment, then the default allegation occurs.
2. Then demand letters and collection calls occur.
3. Then, if there's a UCC lien on your receivables, notices are going to be sent to your customers requesting them to redirect payment to the lender instead. Same goes for credit card processors. This is often when your cash flow breaks.
4. Then expect a lawsuit.
5. If that lawsuit is not responded to, then it's likely a default judgment followed in New York by a restraining notice under CPLR 5222, a bank levy, and then other subpoenas to find out where your assets are.

Typically, we find that the best settlement window is right before the levy hits. After a freeze, the creditor already holds your cash and your bargaining position drops virtually to zero. Having said that, time cuts the other way as well. In New York, the general limitations period for contract claims is six years, which makes it so that very old paper is cheaper to resolve because lenders are now contemplating the chances of them actually recovering anything at all.

Tax Consequences of Forgiven Debt

One last issue to think about is the tax consequences, which are real and often ignored. Forgiven debt is generally considered income when it comes to business debt settlement. Lenders will report it on Form 1099-C. Section 108 of the tax code does provide exclusions, but the two that matter here the most are bankruptcy and insolvency. Insolvency is measured immediately before the cancellation of the debt using the worksheet in IRS Publication 4681, and it's claimed on Form 982.

If you exclude income this way, you have to reduce your tax attributes in a set order, typically starting with net operating losses and eventually reaching the basis of the actual debt that was forgiven. For pass-through entities, the rule differs by type, and the insolvency test is not applied at the same level for partnerships versus, say, S corporations. At this point, you definitely want a tax advisor who's going to help you before signing the settlement documents, because a good settlement number can turn into an unexpected tax bill.

Bankruptcy and Subchapter 5 of Chapter 11

Now, let's talk about the next door, which is bankruptcy. Settlement can't bind a creditor who refuses to deal with you. Subchapter 5 of Chapter 11, though, can. There is a debt limit that is now in the range of $3 million. If one holdout creditor is wrecking the deal that everyone else is accepting, that is the clearest signal to look at bankruptcy rather than keep negotiating. The threat of filing bankruptcy can also change the settlement math because creditors know a confirmed plan through settlement can pay them now versus a potential bankruptcy where they may not be given any consideration whatsoever.

Things That Move the Number

Having said that, when contemplating business debt settlement, there are a few things that move the number. Creditors will not give you a discount just because the business is struggling. They will discount because collecting looks expensive, slow, and it's uncertain. The facts that move the price in your favor are your cash position, whether collateral exists, and whether the guarantee is enforceable. In addition, if a judgment has already been entered, that can hurt you, but also how strong your contract defense looks, the age of the debt, and whether bankruptcy is credible are all options and variables to consider.

The Reconciliation Clause in the MCA Agreement

One thing that we always ask clients to take a look at before they contemplate any solution is the reconciliation clause in the MCA agreement. Often, most business owners are unaware of this, but it is a very valuable tactic to deal with MCA debt. This is a credible pathway to reduce your MCA debt by asking lenders, based on the contract that they also signed, to lower your weekly and daily debits to match the drop in your revenue.

When Settlement Works and When It Will Fail

Having said all of this, settlement works best when the facts are known before the first phone call and when the offer matches what the creditor would realistically net after fighting and waiting many months or years. It will fail, though, when a business owner negotiates blind, ignores the law, ignores the guarantees, or waits until the accounts are already frozen.

Having said that, all of this is general information, not legal advice, and the outcome depends on the documents in your specific file. If you are looking for a business debt settlement company, here are a few options available to you.

Frequently Asked Questions