October Tax Season: A Dozen Key Questions about Tax and Bankruptcy–Part 1

The October 15 extended tax filing deadline is now the new April 15 for many Americans. If you owe and can’t pay, here are some solutions.

 

Here are the first half of a dozen of the most important questions and answers about how bankruptcy can help solve your tax debt problems.

The answers here are short. More thorough answers will come in our blog posts during the next several weeks until the October 15 extended tax filing deadline. There will be a full post on each question and answer. Today you get the short answers, but please do come back to get the rest. Or instead just call our office and meet with us to get the answers as they apply to you personally.

1. Will bankruptcy get rid of any income tax debts that I owe?

Both Chapter 7 “straight bankruptcy” and Chapter 13 “adjustment of debts” can “discharge”—legally and permanently write off—certain personal income taxes, ones that meet certain conditions. The main conditions relate to how long ago the tax return for the tax was due to be filed with the IRS or state tax authority, and how long ago that tax return was actually filed.

So if you owe income taxes, and all the taxes you owe are old enough and meet all the conditions, you can discharge and walk away from your entire tax debt. Or if you owe for more than one tax year and some of your taxes meet the conditions and others do not, you can discharge some but will owe the rest. Or if none of your taxes meet the necessary conditions, you cannot discharge any of your taxes. But even then, either Chapter 7 or Chapter 13 would likely give you crucial advantages worth looking into.

2. If a Chapter 7 case would not get rid of all my taxes, when would it still make sense to file one?

Sometimes filing Chapter 7 does make sense even if it leaves you with taxes owing. Although Chapter 13 gives you major advantages with such tax debts, under the right circumstances the simpler Chapter 7 is better.

First, if the remaining tax debt is not huge, and you are discharging a lot of other debts, you may well be able to enter into monthly payment arrangements with the IRS and/or the state to pay off the taxes with reasonable payments over a reasonable period of time. Second, even if the remaining tax debt IS huge, your overall financial circumstances may be appropriate to settle the tax with an “offer in compromise” to the IRS and/or a similar settlement with the state. Third, sometimes, although admittedly rarely, the taxes that you cannot discharge may be paid in full or in part by your Chapter 7 trustee from the proceeds of assets that you surrender to him or her.

3. What advantages does a Chapter 13 “adjustments of debts” case give me with taxes that can’t be written off through Chapter 7?

The extra protections of Chapter 13 can give you much more flexibility on the timing and amount of the payments made on the taxes that can’t be discharged. You can often pay other important creditors—such as an ex-spouse for back child support or your mortgage lender on past due mortgage payments—ahead of or together with the IRS/state. And if your circumstances change and you need to make changes to your payment plan, you are not at the mercy of the tax authorities.

Also, you will usually not need to pay any more interest and penalties on those taxes from the time your Chapter 13 case is filed to its successful completion three to five years later.  You often pay less on the tax penalties that accrued up to the date of filing the case. The recording of a tax lien against your home and other possessions are prevented during that period. And if a tax lien had been recorded before your Chapter 13 was filed, usually the lien can be satisfied and released for less money.

4. Will filing bankruptcy stop the IRS and the state tax collectors from garnishing wages and seizing my assets?

Yes, the “automatic stay,” the federal law that stops all creditors from chasing you the moment your bankruptcy case is filed, applies to the IRS and the state for most purposes just like any other creditor. There are some minor reasonable exceptions—the tax authorities can continue to require you to file a tax return, can “assess” the taxes and tell you how much you owe, and can do an audit to help determine the amount of tax you owe.

But otherwise, from when your case is filed to its completion you do not have to worry about tax garnishment, levies on your possessions, tax lien recordings, or phone calls or visits from the IRS or the state.

5. If I am in a monthly payment plan with the IRS (and/or state), should I still consider bankruptcy?

Often it still makes sense to look at the Chapter 7 and 13 options even if you’ve already gone through the effort of setting up payment arrangements with the IRS/state.

First, if you’ve set up the payments without looking at the other options you would simply be wise to hear about, understand, and choose the best of all your options. Otherwise you may struggle month after month and even year after year to make your tax payments, only to find out many months or even years later that there was a better way.

Second, unless your current monthly tax payments are part of a carefully thought out, long-term financial plan, one that includes your current year’s and future tax obligations, you could easily keep getting further behind when the next tax year rolls around. The IRS/state may even allow you to keep adding to your tax debt for a year or two while increasing the monthly installment payment. But as the interest and penalties on the taxes keep accruing, and the financial pressure from your non-tax debts keep increasing, you may well come to a point that is no longer sustainable.

6. What happens with my tax refund if I file a Chapter 7 bankruptcy while I’m waiting for that refund?

That refund is often protected, but it might not be. It depends on the amount of the refund, the amount of property exemption that can be applied to it (if any), as well as the Chapter 7 trustee’s aggressiveness about requiring you to surrender even a relatively small amount of tax refund. Whether and to what extent your refund is based on an Earned Income Credit may matter as well.

If your refund is not fully protected by an applicable exemption, it may make sense to wait until you receive and appropriately spend that refund before filing your Chapter 7 case.