The potential for having the amount you settle considered taxable income and the damage to your credit are the two main drawbacks to debt settlement. However, only the unpaid balance is taxable, and then only at your normal tax rate.
The forgiven balance is usually considered taxable income by the IRS, although if you meet the IRS’ definition of insolvency, at the time of your debt settlement, you may not have any tax obligation for the forgiven debt. Seek advice from your tax adviser on Cancellation of Debt Income, and be sure to ask about IRS Form 982, the form that is used to excuse your requirement to declare the forgiven debt as income. In addition, the fact that you reached a settlement will be noted on your credit report. Even if you have to pay taxes on the settlement, it is far cheaper than having paid back the debt in full. Say, for example, you owe $10,000 and settle the debt for $7,000. You may have to pay taxes on the $3,000 you saved, if you are not eligible to use the Form 982, but that is far less than paying back the full $3,000.
Your credit will also be harmed because, during your debt settlement program, you are not making monthly minimum payments to your creditors. This results in delinquencies appearing on your credit report which lower your credit score. The experience can also be stressful, since you may get collections calls and could even be sued. You have to balance those concerns out against the significant savings.