The promise to settle all your debts pennies on the dollar sounds like a dream come true for countless consumer and the promise of hundreds of advertisers.  Beware.  There can be major tax consequences to having your debts forgiven.  Once you have your debts canceled, the forgiven balance is considered taxable income on your annual returns.  The IRS, unfairly in my opinion, views the forgiven amount as going from a loan you had to repay to income the moment you didn’t have to pay it back.  There are certain circumstances in which forgiven debt is not considered income and you should speak to a qualified tax professional to see if you qualify or can qualify for one of these special circumstances.  When considering debt forgiveness make sure to consider the effect on your credit score and if it would be the best financial move for you in the long run as well.

WHEN confronted by a letter from the Internal Revenue Service, some people look at is as though they’ve seen a ghost.  BOO!

And when they open certain letters, a few people do see a ghost — or, more accurately, the ghost of a tax return.

When the IRS detects that a person had reportable income but did not file a return, even after much cajoling, it steps in and does the job itself.  Based on what it knows, the agency prepares what it calls a “substitute for return”, a Form 1040 (the generic tax return).  It lists income, calculates the tax due, adds interest and a penalty for failing to file, and sends the recalcitrant taxpayer a bill based on its efforts.

In one way, that may be a relief to procrastinators who just didn’t get around to filing, perhaps for years.  But it often comes at a VERY high price.

Substitute returns are really no substitute for ones that taxpayers could have filed themselves.  That’s because the IRS uses data from only the income side when it creates such a return, which means that it doesn’t include all kinds of items that might offset that income, according to Julian Block, a tax lawyer in Larchmont, N.Y.

The IRS works from W-2 reports of wages paid, filed by employers, and reports of payments to self-employed people from companies that used their services.  The agency also uses reports from financial institutions about interest and dividends paid and reports from brokers about assets sold.  All these things are taxable income.

For self-employed people, in particular, there is often a big disparity between payments received and taxable income, because much of what they receive goes for supplies or salaries or other expenses.  But the IRS will know only the gross payment, and will plug that figure into its return.  It does not even know about the original cost of assets that were reported sold.

In other words, the IRS does not include many of the deductions to which a non-filer may be entitled.  But this doesn’t mean that the IRS is being mean or vengeful or evil.

The IRS is candid that it does not even look for deductions.  In a fact sheet in what it calls the “tax gap” series on its Web site, the IRS warns that a substitute return it prepares is a “basic” one that “will not include any of your additional exemptions or expenses.”

The IRS investigates about a million “non-filer situations” a year.  But it does not prepare a substitute return for everyone that it believes failed to file.  People in the underground economy do not leave a trail that can contribute to such a return, tax experts have been noted as saying.  If those people are caught, they may not get an official printout in the mail.  A visit from someone who dangles handcuffs from a belt is more likely.  And the IRS substitute is not used when a taxpayer has filed a return but the agency believes that he or she failed to report some income.  It has other methods for resolving those issues — often an audit… just what we all have time for!

A taxpayer prompted to action by a substitute return can file the return that he or she should have filed in the first place, and the IRS will adjust the taxpayer’s account accordingly.  The next step, in which taxpayers can claim their exemptions and deductions, can sharply cut the amount due or even yield a refund.  Many nonfilers wouldn’t owe large amounts if their returns were done properly. The IRS fact sheet says its research shows that such failures “could simply be due to procrastination”, as stated by Mr. Eric Bach, CPA.

ONCE a ghost return appears in the mail, simply avoiding it isn’t a viable option. The IRS will send reminders.  If there is no response, it will start collection efforts, based on its calculations.

“The worst thing a taxpayer can do, is not file a return and then continue to ignore the repeated letters from the IRS”, Mr. Bach said.

But taxpayers sometimes do just that, provoked by “fear, paralysis, and denial”, as Mr. Bach has stated it.  “The most important point to remember is that the substitute returns only reflect the income and some some expense information such as mortgage interest because they are required to be reported to the IRS.  These returns are not final.  When the actual return is filed, it supercedes the ‘ghost return’.  This is very important to remember because the actual return will include your itemized deductions that may substantially reduce the IRS’ original assessment.”  In essence, Mr. Bach’s point is, file your returns as quickly as possible if a “ghost return” has been filed to, not only reduce your tax debt and possibly eliminate it, but also to minimize penalties.

Unpleasant as it may be to file  a tax return, and paying the bill to begin with… filing may prove much more appealing than the alternatives.

So your 2010 taxes are done, or they should be if you didn’t file an extension.  But, as we all know, nothing is certain except death and taxes, so you might as well start planning for next year.  While you actually have your 2010 tax forms and documents handy, this is the perfect time to analyze last year’s finances and use those insights to lower your taxes in 2011.   The sooner you get started, the more you can save.  Here are 5 easy steps that you can follow to start your saving:

1. Avoid a Big Tax Refund

You think it’s fantastic when you get a tax refund, right?  Wrong.  A refund is really just the return of a year-long, interest-free loan that you graciously extended to that thrifty spender known as Uncle Sam.  Even with interest rates in the toilet, earning some money is better than none at all, right?

You can do much smarter things with that money, like putting it into a retirement plan or a college savings fund, or maybe paying down outstanding debt.  So if you will be receiving a 2010 refund of more than a few thousand dollars and you’re an employee, adjust your withholding at work.  If you’re self-employed, lower your quarterly estimated tax payments accordingly.

2. Save More in Your Retirement Plan

If you are not maxing out your employer-sponsored, tax-deferred retirement plan, you’re missing out on the single best opportunity to save on taxes.  The idea of saving more may be difficult, especially as the costs of gas and food are soaring.  But if you can squeeze just an extra 1 or 2 percent out of your paycheck and pour that cash into the plan, you’ll reduce your taxable income and your 2011 tax bill.

Doing so might also bring your income under certain thresholds that will let you qualify for bigger tax breaks you’d otherwise miss — such as personal exemptions, itemized deductions, an Individual Retirement Account, the Child Tax Credit, the Child and Dependent Care Credit, and the American Opportunity Tax Credit.

3. Look into Muni Bonds and Funds

If you have money in interest-paying bank accounts, CDs, money market funds, or taxable bonds or bond funds, you could be adding to your tax liability.  High-income taxpayers need to be especially concerned, since their tax liability could rise with the 2012 expiration of the Bush-era tax cuts.  You may want to consider moving some of those taxable savings and investments into tax-free municipal bond funds. (Yes, those same bonds that Meredith Whitney trash-talked on “60 Minutes.”) Since that time, investors have been bailing out of municipal bonds, fearing that states, towns and municipalities could default on their obligations.  That exodus has forced prices down and yields up.

4. Lower Your Mutual Fund Taxes

Now that stock and bond markets have recovered from their bear-market lows, be on the lookout for mutual fund taxable distributions.  A distribution is one of the most aggravating features of a managed mutual fund: You are on the hook for capital gains on the fund’s investments as well as the fund’s tax liability.  You may even be taxed on gains the fund incurred before you owned it!  One way to limit the damage before you invest is to ask the fund company if it will be making a distribution soon.  If the answer is “yes,” hold off buying until afterward.  Or you might invest in funds with low turnover ratios, such as index funds, since they’ll be less likely to throw off taxable distributions.  A turnover ratio below 10 percent is generally tax-efficient.

5. Keep Better Tax Records

Organizing your tax records might not only lower your tax liability, it could help you get rid of the tax-filing headache sooner.  Create a file called “Taxes 2011” and throughout the year toss all your paperwork into it: business receipts; bank, brokerage, and mutual fund statements; W-2s; 1099s; property tax bills; and mortgage interest statements.  Also keep track of your purchase price, commission, and sales price for any investment transactions in 2011.  You’ll be much happier come April 2012.

And while you’re in the organizing groove, now is the perfect time to purge your files of unnecessary statements and documents.  Get ready to shred!