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Bankruptcy by Example: Even If You’re Already in a Tax Installment Payment Plan, Consider the Benefits of Bankruptcy

If you owe income taxes, and other debts, and are paying the taxes in monthly payments, here are 4 reasons bankruptcy may be better.

1. You May Be Able to Discharge—Forever Write Off–Some or All of The Tax Debt in Bankruptcy.

Under installment payment programs with the IRS and Oregon Department of Revenue (ODR), you have to pay all your income taxes, penalties, and interest. That all may work out for you just fine, if you can afford to pay what is required and to do so consistently, while not falling behind on other obligations.

However, if you file a Chapter 7 “straight bankruptcy” case or a Chapter 13 “adjustment of debts” one, you may not have to pay your taxes, interest and penalties at all. Or you may pay some but not all.

In most cases an income tax can be discharged under Chapter 7 if two main conditions are met:

1) its tax return was due (including any extension) more than 3 years before the Chapter 7 case is filed, and

2) that tax return was actually submitted to the IRS/ODR more than 2 years before your Chapter 7 case is filed.

That means that as of now income taxes for the 2010 tax year, and earlier, are likely dischargeable if you file a Chapter 7 case.

2) The Accrued Penalties, and The Ongoing Interest and Penalties, Can Add a Huge Amount to What You Must Pay.

Under the IRS and ODR installment payment programs you must pay all tax penalties and interest. The penalties and interest keep on accruing until the debt is completely paid off. The IRS in particular lets you stretch out your payments under its installment payment plan for up to six years. But because you have to pay all the ongoing tax penalties and interest, the longer you extend the payments—in order to keep the monthly payments manageably low—the more you’ll pay in interest and penalties. So it will take you that much longer to finish paying the old taxes.

However, under Chapter 7, if a tax qualifies for discharge, you don’t have to pay any interest or penalties either.

Under Chapter 13, the taxes that don’t qualify for discharge have to be paid, but in most cases the previously accrued penalties need to be paid little or nothing. And usually no more interest or penalties accrues after the Chapter 13 case is filed. These benefits can significantly reduce the amount you have to pay even on the more recent taxes that can’t be discharged.

3) If Your Financial Circumstances Change so You Can’t Pay Your Monthly Payments to The IRS/ODR, You’re at Their Mercy.

If you’re paying the IRS and/or the ODR under an installment agreement and had to change the payment amounts, whether you could do so would depend completely on their regulations and discretion.

However, if the tax was dischargeable under Chapter 7 you would no longer owe the tax at all; it would be long gone by the time you have any later financial changes. And if you discharged some taxes but not all, and so had to pay some on an installment plan, you’d have more flexibility later if your finances would change because you’d have less tax to pay. Maybe by that time, you would have already paid off that remaining tax debt.

Under Chapter 13 how much you pay to all your creditors, including to the IRS/ODR, are based on your “disposable income,” the money you have left over after paying your allowed expenses. So when your income or expenses change so that your “disposable income” changes, your Chapter 13 payment plan can usually be changed accordingly. And this happens while you’re protected from the IRS/ODR being able to take any collection action against you. It can only do so after asking the bankruptcy judge for permission, which usually only happens if you are not responsibly following the legal procedures. You are NOT under the mercy of the tax collectors.

4) An IRS/ODR Installment Payment Plan Does Not Make Sense if As a Result You Aren’t Making Meaningful Progress on Your Taxes, and On Your Debts Overall.

If your tax payment plan is enabling you make good progress towards paying off your back taxes while also keeping up with CURRENT taxes, and if you are making progress towards becoming debt-free, then that tax payment plan makes sense.

But if not, the payment plan is likely just helping you slip further and further behind. When this year’s tax return due date arrives do you again owe taxes so that you need to add more tax debt to your payment plan? The IRS in particular now “allows” you to get as much as $50,000 in debt to them, with up to 72 months to pay it. You can see how this could result in a vicious cycle in which you are constantly struggling to pay the taxes—and ongoing interest and penalties—of the prior couple years, so that you can’t pay enough taxes for the current tax year, repeating the cycle.

If you’re in that vicious cycle you likely are looking for a way to escape it. And if you’re not there yet but are on the brink of that cycle, you’d be wise to find a way to avoid it. So it makes sense to look into how the bankruptcy options could help you.

Our Example

Consider Larry, who tried to run a business from 2008 until 2011 while he couldn’t find employment. During this time he didn’t have enough money to meet his absolute minimum living expenses, plus pay his debts, plus his quarterly estimated taxes. So he didn’t pay enough estimated taxes, and fell behind.

Larry owes $2,000 in combined income taxes to the IRS and ODR for 2010, on which he’s been making installment payments to them. He also owes $4,000 for 2011, of which $1,000 is penalty (for failure to file the tax returns on time and to pay on time); $3,500 for 2012, of which $500 is penalty; and $3,250 for 2013, of which $250 is penalty. This totals $12,750 to the ODR and IRS. He is currently paying $400 per month to the IRS and $200 per month to the ODR towards these tax debts.

Larry has been in monthly payment plans with the IRS and ODR for nearly three years, and through them he recently paid off his 2009 income taxes, and 2008 earlier. Unfortunately, he expects to owe another $3,000 for2014 based on his income and tax withholdings so far this year. His $600 in monthly tax installment payments is forcing him to not withhold enough from his paychecks so that he can meet his absolutely necessary expenses (but barely) month by month.

Besides these taxes, Larry owes $25,000 in credit card debt, mostly accrued during the time he was running his business. He pays $500 each month on this debt. He has not had money to maintain his vehicle, has avoided going to the doctor and dentist when he should have because he doesn’t have money for the co-pays and deductibles, and buys the cheapest food possible to survive. Understandably, he feels buried under debt and sees no way out.

But after seeing a bankruptcy attorney, Larry decides to file a Chapter 13 case, and does so on October 20, 2014. As a result this is what is happening:

  • He stopped paying the $600 in the tax installment payments and $500 on the credit card debt each month.

  • He changed his tax withholding to increase them by $250 per month so that he’ll stop falling behind in the future.

  • He and his attorney are proposing, and the bankruptcy judge is expected to approve, a Chapter 13 plan with $450 monthly payments, based on his income and allowed expenses, to last three years. This gives him $400 more each month for living expenses, so that he can now afford to maintain his car, go to the doctor and dentist, and buy decent groceries.

  • In his Chapter 13 case, Larry will pay nothing towards his $2,000 in 2010 income taxes because these meet the conditions for discharge—its tax return after extension was due no later than October 18, 2011 (because of a holiday and a weekend), and his case was filed more than 3 years later. He will also pay nothing towards the penalty portion of his more recent taxes.

  • Instead he will pay the tax and prior accrued interest in full—that where the bulk of the $450 monthly plan payments will go.

  • He will not need to pay any ongoing interest or penalties on any of the taxes.

  • He filed a partial year tax returns as of the day he filed his Chapter 13 case, in order to include in his Chapter 13 payment plan the taxes owed in 2014 up until that point. His new increased withholding means that he will owe no taxes for the remaining part of this year, or future years when he files his tax returns.

  • After 36 months in his Chapter 13 case, Larry will have paid off the tax and pre-existing interest portion of his 2011, 2012, 2013 and partial year 2014 tax debts, as well as any Chapter 13 trustee fees and his attorney fees. All the rest of his debts—the remaining tax debts and credit cards, will have been paid nothing, and will be discharged. He will be tax-debt free, and totally debt free. He will be totally free of his vicious cycle.