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Tax Season: The Benefits of Filing a Chapter 13 Case Before the Recording of a Tax Lien

Chapter 13 can prevent tax liens, which can be very detrimental. IF one IS recorded, Chapter 13 deals with it better than does Chapter 7.


Two blog posts ago we showed you the hugely detrimental effect of a recorded tax lien on a tax debt that could otherwise have been discharged (legally written off) in bankruptcy. Then in the last blog post showed how a Chapter 7 “straight bankruptcy” would treat a dischargeable tax debt WITHOUT a recorded tax lien, and then how it would treat that same tax debt WITH a prior recorded tax lien (not very well!). Today’s post is about how Chapter 13 “adjustment of debts” handles both situations. Chapter 13 is often generally the better option if you have income tax debts, especially if you owe more than one year of tax debt, or have other more complicated tax situations. Its better handling of tax liens is an example of that.

Dischargeable Taxes in Chapter 13 WITHOUT a tax lien

Under Chapter 13 if you do not have a recorded tax lien, an income tax that meets the conditions for discharge (generally, its tax return was due more than 3 years ago, and you actually filed it more than 2 years ago), would be treated like all your other “general unsecured” debts—medical bills, credit cards and such. That tax debt would be added to the pool of your “general unsecured” debts, usually not increasing the amount you would pay during the course of your case. The tax would be paid whatever percentage all your “general unsecured” debts are being paid—often not much or even nothing—and then would be discharged at the end of your successful Chapter 13 case.

The reason this type of tax debt would usually not add anything to the amount you have to pay under Chapter 13 is that in most cases the total amount paid to ALL the “general unsecured” creditors does not increase with an increase in amount of “general unsecured” debts. A specific amount is paid to that pool of creditors, with that amount simply distributed to more creditors. So adding the dischargeable tax debt to your other “general unsecured” debts results in a reduction in the percentage of each debt being paid, again because the same dollars are simply being spread out over more debts. 

For example, if a Chapter 13 case requires plan payments of $300 per month for 3 years going to all creditors, a total of $10,800, of which $4,000 is going to pay off a vehicle and $5,000 to more recent income taxes, that would leave $1,800 to pay to the “general unsecured” debts. (For the sake of simplicity this disregards any attorney or trustee fees.) If there is $20,000 of credit card and medical debts, that $1,800 would result in the debtor paying 9% of that $20,000. But if he or she also owed $6,000 in older tax debts which met the conditions for being discharged, that $6,000 would be added to the $20,000 in “general unsecured” debts, with that pool now totaling $26,000. The same $1,800 available for those debts would thus result in about 7% of that $26,000 being paid—the same amount of money spread out over more debts.

The rare exceptions—where adding a dischargeable income tax to your “general unsecured” debts would increase the amount you pay into your Chapter 13 plan—would be if your plan requires you to pay 100% of your “general unsecured” debts, a fixed percentage, or to pay a certain relatively large dollar amount in order to protect non-exempt assets. But these are rare. Usually a dischargeable tax without a recorded tax lien does not increase the amount you must pay in your plan.

Dischargeable Taxes in Chapter 13 WITH a tax lien

If a tax lien has been recorded against a tax which otherwise would have been discharged, you are usually significantly better off under Chapter 13 compared to Chapter 7.  Although the immediate legal effect of the tax lien is the same, Chapter 13 gives you a number of practical advantages, often saving you both money and worry.

In a Chapter 7 case you are left to fend for yourself after your bankruptcy is over to negotiate with the IRS or state taxing authority about how much to pay and under terms, or order to get them to release the tax lien on your property. They have a lot of leverage in this situation. In contrast, under Chapter 13 you have an efficient and fair forum—the bankruptcy court—to settle these matters. It provides a handy way of to determining the value of your assets to which the tax lien attaches, and thus how much you have to pay.

Also, instead of being at the mercy of the IRS/state about the terms of paying that amount, you have a convenient mechanism—your Chapter 13 plan—through which to pay it. It’s not only convenient, it puts you much more in the driver’s seat: you and your attorney propose how much the lien needs to be paid, and that’s the way it happens unless the IRS/state object. It’s usually not worthwhile for them to do so.

Importantly, throughout the Chapter 13 case you have the protection of the “automatic stay.” This prevents the IRS/state from taking any collection action against you or your assets, taking away one of their main sources of leverage in other circumstances.

Then once you pay the court-approved value of the tax lien and successfully reach the end of the Chapter 13 case and get the discharge of your debts that occurs then, the IRS/state are legally obligated to release the tax lien. Any unpaid portion of the tax is discharged, the lien is released, and you are completely free of that tax.

The Bottom Line

If you owe any income taxes eligible for discharge, by the very nature of the conditions for discharge those taxes are relatively old. So if the IRS/state has not already recorded a tax lien, there’s a good chance that it will do so soon. Although Chapter 13 handles tax liens often much better than Chapter 7, a tax lien will usually still require you to pay more, and often much more, into your Chapter 13 plan before it is completed. Since there’s likely such a big adverse effect on you if a tax lien is recorded before you filed either a Chapter 7 or a Chapter 13 bankruptcy, you would be wise to look into these options right away if you owe any taxes, especially ones eligible for discharge. 


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