Chapter 7 and Chapter 13–Newer Income Taxes
Income tax debts that can’t be written off must be paid, either after a Chapter 7 case or during a Chapter 13 one.
The Two Options
Income tax debt can be discharged—written off in bankruptcy—if it meets certain conditions, mostly by being old enough. (See the conditions laid out at the end of our last blog post a couple days ago.) But if those conditions are not met and that tax debt must be paid, either a Chapter 7 “straight bankruptcy” or a Chapter 13 “adjustment of debts” can help tremendously.
A Chapter 7 case would usually discharge all or most of your other debts within about 4 months, so that you could then afford to pay the remaining income tax debt directly. Or in a Chapter 13 case you would pay the taxes along with other creditors in a court-approved payment plan of 3 to 5 years while protected from the IRS/state and from all your other creditors during that time.
When would you choose one option over the other?
The Key Question
There are lots of other considerations that could influence this decision other than your income tax debts. But to the extent the decision would come down to the taxes, it would turn on this question: could you reasonably pay the tax debt that would not be discharged in a Chapter 7 case by making payment arrangements with the IRS/state after discharging your other debts in that Chapter 7 case, or do you need the additional help and protection of a Chapter 13 payment plan?
Under Chapter 7
Your attorney will review your situation and tell you how each of your debts would be handled in a Chapter 7 situation. Most debts would be discharged, so that you would never need to pay them. Some debts, including the more recent income taxes, would not be discharged so that you’d continue to owe them. Other debts you could discharge but may choose not to, such as a vehicle loan if you want to keep the vehicle.
You and your attorney would also put together a monthly budget, from which you would get a close look at how much the Chapter 7 will help you financially month to month. From this you would also discuss what you could reasonably and reliably afford to pay to the IRS and/or the state as soon as the Chapter 7 was finished on the taxes that would not be discharged.
The IRS and most states have monthly payment programs for unpaid taxes, with relatively rigid rules about how to qualify for them, how much the minimum monthly payments would be, what rules you have to follow to stay in compliance, and how much flexibility there might be if your circumstances change while you’re making the payments.
So your attorney will lay this all for you so that you can decide whether you will be able to afford what the taxing authority(ies) will require, within their mandated conditions (such as keeping current on future income taxes), and whether you would be able to pay it reliably and then pay it off within a reasonable time.
If so a Chapter 7 case is likely the better way for you to go. You essentially get a fresh financial start as to everything but your non-discharged taxes, and any other debts you choose to keep paying such as your auto loan and home mortgage (plus occasionally another debt or two that also can’t be discharged).
Under Chapter 13
One big reason the above scenario would not apply to you is if you have other debts that you either can’t discharge or don’t want to discharge, leaving you with not enough cash flow to be able to pay the taxing authorities what they would demand in monthly payments.
A second common reason is that you simply owe too much in nondischargeable taxes so that you either don’t qualify for a tax payment plan, or wouldn’t be able to pay what they would require.
Both of these situations are often handled well under Chapter 13.
First, all your creditors are incorporated into your Chapter 13 payment plan. After a review process the plan is approved by the bankruptcy judge, requiring all your creditors, including the IRS and state, to comply. If you owe child or spousal support arrearage, or are behind on your vehicle loan or home mortgage, the IRS and state may well have to wait or be paid little while these are paid first or at the same time. You do have to pay all non-discharged income taxes within the 3-to-5-year plan, but you usually don’t have to pay any accruing interest or penalties, significantly reducing the total amount to be paid.
Second, the IRS and state have to accept getting paid through Chapter 13 regardless of their normal payment terms and conditions. They can take no collection action whatsoever on the taxes you owed as of the time your case is filed. That includes enforcing any tax liens they recorded before the case was filed, and recording any new liens that they would normally be allowed to do.
The bottom line is that Chapter 13 provides a very flexible and very favorable way to deal with income taxes that can’t be discharged and cannot instead be reasonably paid after a Chapter 7 case.