Tax Season: Clearing Up the Most Important Mix-ups about Bankruptcy and Income Taxes

Income taxes CAN be discharged under Chapter 7. Chapter 13 can be great with taxes BUT sometimes is neither necessary nor the best option.

 

Bankruptcy and income taxes are two often very complicated areas of law. No wonder there’s a lot of confusion where these two intersect. Let’s clear up some of the most important confusion. 

Bankruptcy Discharges—Completely Writes Off—Income Taxes

Bankruptcy cannot discharge even a dime of your income taxes unless the particular tax at issue meets every one of a series of conditions. Sometimes that can mean that a particular person filing bankruptcy will discharge all other debts but will not be able to discharge any of his or her taxes. And sometimes—rarely—a person will never be able to meet the necessary conditions for discharging a particular tax debt. From these kinds of situations, income taxes may have gotten the inaccurate reputation that they can never be discharged in bankruptcy, when that is simply not true.

We’ll address the particular conditions that have to be met to discharge a tax debt in an upcoming blog post. But let’s start with this clear principle that bankruptcy can and often does forever discharge income tax debts.

Bankruptcy Discharges Income Taxes in Both Chapter 7 and Chapter 13

When the conditions are met for discharging income taxes, they can be discharged under either Chapter 7 “straight bankruptcy” or under Chapter 13 “adjustment of debts.” The same prior conditions apply to both Chapters.

What odd—and no doubt quite confusing—is that a discharge of an income tax debt in Chapter 7 can have the very same financial result as under Chapter 13. Or it can have a very different result! Say, what!?

Under Chapter 7, debts that can be discharged—whether medical bills, credit cards, OR dischargeable income taxes—are almost always paid nothing. That’s because in a huge majority of Chapter 7 case, none of the creditors receive anything through the bankruptcy procedure because everything the debtor owns is “exempt”—protected. So the bankruptcy trustee receives no assets to “liquidate,” and so has nothing to pay any of the creditors.

Under Chapter 13, debts that can be discharged—again, whether medical bills, credit cards, or dischargeable taxes—are often paid a percentage of what is owed. That percentage can be quite low—5%, 10%—depending on a myriad of factors. In many jurisdictions the percentage can even be 0%—nothing is paid on the dischargeable (“general unsecured”) debts. In that situation the financial result is the same as under Chapter 7—in both cases the dischargeable tax is paid nothing and the debt is completely discharged.

But in some Chapter 13 cases the general unsecured debts—including the dischargeable income tax—are paid a substantial percentage of the amount owed—60%, 70%, or more. In rare cases, the amount paid can even be 100%. So in these situations, in contrast to being paid nothing under Chapter 7, under Chapter 13 the dischargeable tax may need to be paid in full or close to it.

The key point is that while you may be able to discharge a tax in both Chapter 7 and Chapter 13, what this means in the latter case can vary greatly.

Chapter 13 Is Often the Best Way to Deal with Tax Debt, but Sometimes Chapter 7 Is Better

If you owe taxes which DON’T meet the conditions for discharge, then paying those taxes through a Chapter 13 case gives you many advantages (some of which were mentioned in our last blog post). In a nutshell, you have much more control over the payment terms, you generally don’t have to pay ongoing interest and penalties, and you are protected from the IRS’s and the state taxing authority’s collection tactics throughout the payment period.

But it is a fallacy that if you owe income taxes that can’t be discharged, you necessarily need the extra protection and other advantages of Chapter 13. Chapter 7 may not only be adequate, it can be significantly better in many circumstances.

If you have some dischargeable taxes as well as some that can’t be discharged, filing a Chapter 7 case can discharge the rest of your debts along with the dischargeable taxes. That may well leave you in a good position to make comfortable monthly installment payments on the surviving taxes directly to the IRS and/or the state, after the Chapter 7 case is completed.

If your taxes can’t be discharged, simply discharging your other non-tax debts in a Chapter 7 case may leave you in a position to make direct payments on the taxes afterwards, as stated immediately above.

Or in either of these situations you may not be left in a position to make installment payments, but instead may be eligible to enter into a settlement with the IRS/state—potentially saving a lot of money.

Finally, in an “asset” Chapter 7 case—the unusual situation in which the debtor owes something that is not exempt and thus is surrendered to the trustee for sale and distribution to the creditors—an income tax that cannot be discharged may be paid in full or in part through the trustee’s distribution. That tax is a “priority” debt that must be paid in full in such a distribution before the “general unsecured” creditors receive anything. Then if and to the extent some of that tax is left unpaid, that can either be paid through monthly payments or resolved through a settlement with the IRS/state.

In all of these situations, resolving the taxes and overall debt problem through Chapter 7 instead of Chapter 13 could potentially be much simpler, cheaper, and quicker.

 

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