October Tax Season: If Chapter 7 Does Not Write Off My Income Taxes, Why Still File One?

Chapter 7 “straight bankruptcy” may be worthwhile if it gets rid of your other debts and leaves you able to manage your taxes.

 

Chapter 7 vs. Chapter 13

As we’ll cover in our next blog post, Chapter 13 “adjustment of debts” can give you major advantages in dealing with tax debts (as well as with many other kinds of special debts). But Chapter 7 can be much cleaner. It can—in some circumstances—get you out of tax debt, and out of debt overall, faster and for less money than Chapter 13.

Consider this example. Let’s say you owe the IRS income taxes for two tax years, one in the amount of $5,000 which meets the conditions for discharge—legal write-off—and a newer one in the amount of $2,500 which does not. Under Chapter 7 you would almost always not have to pay anything on that $5,000. (See our last blog post on the conditions needed to discharge an income tax debt.) And the discharge of that tax—and of your other dischargeable debts—would be effective in usually less than four months.

In contrast, under Chapter 13 that $5,000 dischargeable tax would be lumped in with your other “general unsecured” creditors. It would only be discharged if and when you successfully completed the 3-to-5-year payment plan, during which you may be required (but not always) to pay a portion of that tax.

You would likely have more flexibility under Chapter 13 in paying off the other $2,500 that could not be discharged, and you’d likely not have to pay any ongoing interest and penalties. But you may not need that flexibility, and the interest and penalties may be relatively small. Instead, after completing a Chapter 7 case the IRS would quite likely allow you to make $150 monthly payments on that $2,500, assuming that you could afford that after discharging your other debts. That $2,500 plus interest and penalties would be paid off in about a year and a half.

Under these facts, being free of the $5,000 tax debt and being completely debt free except for the remaining $2,500 tax just a few months after filing bankruptcy would likely be much better than being only a few months into a 3-to-5-year Chapter 13 case at that point. And you’d be debt-free AND tax free only about 18 months later, instead being still a year or two or three from finishing a Chapter 13 case.

The Scenarios Where Chapter 7 May Make Sense

There are three broad scenarios where you should seriously consider filing Chapter 7 even if it leaves you owing taxes.

1. When Chapter 7 Leaves You with Manageable Tax Debt

The example we just gave illustrates this first scenario. This can also happen even if none of your income taxes meet the conditions for discharge. What’s crucial is that enough of your other debts are discharged so that you left with enough money to enter into a payment plan to pay off the taxes reliably and within a reasonable period of time.

This requires good legal advice about what taxes will not be discharged, and how much the IRS/state will require in monthly payments on those taxes, as well as how much you will likely be able to afford each month to pay them.

2. When Chapter 7 Leaves You with Completely Unmanageable Tax Debt

Even if the remaining tax debt is way too large to be able to enter into a payment plan with the IRS/state, your overall financial circumstances may make you a good candidate for settling the tax with an “Offer in Compromise” with the IRS and/or a similar settlement with the state. Your after-bankruptcy situation would have to continue to be very challenging, enough so to show the taxing authorities that they would not benefit from trying to get more money out of you than your settlement proposes.

To go this route requires good legal advice about how likely the IRS/state would accept a settlement of the tax debt. Frankly this advice is difficult to provide—predicting the response of the IRS/state to a particular settlement offer is often not easy. Your bankruptcy attorney may or may not need to refer you to a tax accountant or tax attorney who has substantial experience in representing taxpayers on these kinds of settlements.

3. When the Chapter 7 Trustee Will Pay Your Taxes through Your Non-Exempt Assets

In an entirely different scenario (although they could overlap with the two above ones), the taxes that you cannot discharge may be paid in full or in part by your Chapter 7 trustee out of the proceeds of assets that you surrender to the trustee.

This requires the following:

1) Assets that you own which are not protected by property exemptions, and which you are willing to surrender to the trustee. You either don’t want the assets any more (such as business equipment from a defunct business) or they are just not worth keeping (such as a boat) considering what it would take to do so, such as paying off the trustee or filing a Chapter 13 case.

2) No “priority debts” other than the tax that you want to be paid, or at least none of higher “priority.” If and when the Chapter 7 trustee has assets with which to pay creditors, by law they are paid in a very specific order. So you can predict reasonably well whether the intended tax debt is going to be paid, as long as the trustee does in fact decide to liquidate the unprotected assets as expected.

Practically speaking, when assets get liquidated—especially by a third party like a bankruptcy trustee—they often generate less money than expected, especially if there are any costs involved in that process (storage costs, sales commissions, and such) to set off against the sale proceeds. The trustee is also entitled to a fee. So this may not be the most efficient way to pay on a tax debt. And if it is only partly paid, you have to be ready to deal with the rest of the tax debt yourself, either by making arranging to make payments to the IRS/state or by negotiating an Offer in Compromise/settlement.

 

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