How Bankruptcy Handles . . . Income Taxes that Your Ex-Spouse Was Required to Pay but Is Now Paying through a Chapter 13 Bankruptcy Case

When it’s good for you that your ex-spouse is filing a Chapter 13 case, and how to keep it good.

 

This blog post follows up on our last one of a couple days ago. There we introduced what happens when your ex-spouse is required by your divorce decree to pay some joint income tax debt, but fails to do so and then files a Chapter 13 “adjustment of debts” bankruptcy case.

Let’s pick up where we left off. We finished by saying:

[If your ex-spouse] has filed a Chapter 13 case and all the joint taxes are of the kind that has to be paid in full, then his or her filing the Chapter 13 case may be a great thing for you. Not only is he or she required to pay those taxes before completing the case, but most likely Chapter 13 will enable him or her to avoid paying some OTHER debts in order to make it possible to pay the taxes in full.

An Example

Let’s bring this to life with an example.

Lisa and Larry got divorced 6 months ago, jointly owing $8,000 in 2012 federal income taxes. Their divorce decree requires Larry to pay this entire tax debt, since the divorce court judge determined that those taxes were owed mostly because he increased his payroll exemptions and spent the extra take-home money on himself, all without telling Lisa. They had (and still have) lots of other debts besides the taxes but they each owe all those separately.

As explained before, the divorce decree does NOT erase Lisa’s obligation to the IRS. It just means that between the two of them Larry is legally obligated to pay it. So if Lisa were ever made to pay part or all of the tax debt, she would have a claim against Larry for reimbursement.

So Larry files a Chapter 13 case. The 2012 tax debt is a “priority” debt that he has to pay during the course of his 3-to-5-year Chapter 13 case. That’s because the tax return for that tax was due on April 15, 2014 (or October 15, 2014 with an extension), much sooner than 3 years ago as of the writing of this blog post (among other potential reasons).

So Larry has to pay off that tax in order to successfully complete his Chapter 13 case. And since he wants to write off (“discharge”) a bunch of his other debts and won’t get to unless he gets to the end of his case, he’ll be highly motivated to take care of those taxes. Furthermore, as we said in our quote above from our last blog post, he’ll usually get a break on paying those other debts while he is paying the taxes, likely only paying a portion of those other debts, and often only a small portion. So he should be better able to focus his financial resources on the taxes, making more likely that he’ll pay them off.

So what can go right and what can go wrong in this picture?

The Chapter 13 Bankruptcy of Your Ex-Spouse Does Not Protect You

We made this point in our last blog post but let’s remind you for the purpose of our example: Larry’s Chapter 13 case—which prevents the IRS from chasing him (except in limited ways through the bankruptcy court), does not stop the IRS from chasing YOU.

You might think that the IRS should be happy to get paid by Larry within his Chapter 13 case. But there’s a number of very good reasons that the IRS would often not just let Larry pay the taxes, which we’ll touch on in a moment. But just realize here that the IRS will probably not simply disregard Lisa, mostly because she continues to be legally liable on the debt, and the IRS (like any creditor) would rather get paid from two sources instead of relying on just one.

If the Chapter 13 Case Does Not Complete Successfully

Even with the incentives mentioned above, Larry may simply not pull it off. A Chapter 13 case involves proposing a formal payment Plan, getting it approved through the bankruptcy court, and then making the payments required, again for 3 to 5 years. It would probably be in Larry’s self-interest to get through it successfully, but all kinds of things can happen to make that not happen.

Indeed, that is one of the reasons that the IRS doesn’t just sit back and wait for Larry to pay the tax and not make Lisa pay it as well in the meantime: they know Larry may or may not end up completing his Chapter 13 case. They don’t want to sit around and risk that happening.

Of course to whatever degree Larry doesn’t pay off the joint tax debt in his Chapter 13 case, Lisa will have to pay.

Chapter 13 Does Not Usually Require Payment of All Interest and Penalties

Larry would most likely be required to pay only part of the tax penalties and accrued interest that were owed at the time his Chapter 13 case was filed. And, unless the IRS had recorded a tax lien before he filed his case, and that lien attached to assets with value, Larry would not be assessed any ongoing interest.

That does NOT mean that the interest and penalties would not continue to be added to the tax debt by the IRS. But if Larry finished his Chapter 13 case, HIS obligation for that accrued interest and penalties would be “discharged,” forever written off. And guess who would be left owing those accrued interest and penalties? That’s right: Lisa.

What’s the Non-Filing Ex-Spouse to Do?

1. Sometimes the IRS WILL hold off on collecting against the non-filing ex-spouse, for example, if Lisa qualifies as being uncollectible. Or, she qualifies for “innocent spouse” or “equitable” relief.

Then if Larry does indeed complete his Chapter 13 case, he will pay off the lion’s share of the tax debt, leaving Lisa only with the interest and penalties, which would be comparatively small (given the IRS’s current low 3% interest rate). And furthermore she may not have to pay even that for the reasons just cited.

2. If instead the IRS chooses to aggressively pursue Lisa for the tax, she could file a Chapter 13 case herself. The good news is that would get her protection from the IRS. And just like Larry, she would be obligated to pay the 2012 tax in full, or at least whatever portion Larry doesn’t pay.  

The bad news is that, if Larry does finish his case, one of the obligations that he can “discharge” is his divorce decree-based obligation to Lisa to pay the tax. That obligation can’t be “discharged” in a Chapter 7 “straight bankruptcy” case, but it can under Chapter 13.

But Lisa may not care all that much about that because of the protection that Chapter 13 gives her. She may even need a Chapter 13 case to deal with her own debts, so that dealing with the tax debt is only part of the benefit she gets.

Dealing with Joint Income Tax Debt in Two Chapter 13 Cases

How does it work in practice for Lisa, to be obligated to pay the full amount but then actually only as much as Larry doesn’t pay? That can get rather awkward, because of course nobody can tell the future to see whether Larry, for example, will pay the tax debt in full (at least the tax itself without interest and penalties) by completing his Chapter 13 case. It doesn’t seem fair or necessary to require Lisa’s Chapter 13 case to put a payment plan together for paying the tax in full if Larry is already scheduled to do so. After all, that $8,000 tax debt only needs to be paid once, not twice.

So if Lisa files a Chapter 13 case after Larry files one that shows he’s paying the tax in full, it’s actually unclear how the IRS and the bankruptcy courts would deal with that situation in any particular situation. If would likely be dealt with differently in different regions of the U.S. and in different courts. They all follow the federal Bankruptcy Code, but there can be major variations in how something like this is handled. An experienced bankruptcy attorney would likely have encountered similar situations in the past and would guide Lisa on how to best deal with this situation under her unique circumstances.