Chapter 7 is good for preventing a tax lien on a tax that can be discharged. But Chapter 13 works much better on nondischargeable tax debts.
In the last blog post we discussed how a Chapter 7 “straight bankruptcy” would deal with an income tax debt that was old enough and met the other conditions so that it could be discharged—legally written off. We also showed how in that situation filing that Chapter 7 case before the IRS or the Oregon Department of Revenue (ODR) records a tax lien (called a “distraint warrant” by the ODR) makes a huge difference—one that could save you thousands of dollars.
But what if the tax you owe is not old enough or is otherwise cannot be discharged in a Chapter 7 case?
Bankruptcy Options If You Owe a Nondischargeable Tax Debt
If you owe an income tax debt that cannot be discharged, you basically have two options within the bankruptcy world (for example, if you need bankruptcy protection because of your other debts).
First, you could file a Chapter 7 “straight bankruptcy” case to discharge all or most of your other debts and then as soon as that case is over make payment arrangements directly with the IRS and/or the ODR to pay off the remaining tax debt. Hopefully you would have written off enough other debts so that you could afford to make large enough and consistent payments to finish off the tax debt in a reasonable time.
Second, you could file a 3-to-5-year Chapter 13 “adjustment of debts” case and pay off that nondischargeable tax debt, but with more flexibility on the payment terms and with more protection from the IRS/ODR during the payment process. You’d usually also not have to pay the ongoing interest and penalties which would accrue in the above Chapter 7 option.
The Effect of a Tax Lien on a Nondischargeable Tax Debt
A tax debt that is not old enough or doesn’t meet some other condition to allow it to be discharged in bankruptcy must be paid regardless whether or not that tax debt has a tax lien recorded on it.
The difference is that if there is no recorded tax lien, then under Chapter 13, as just mentioned above, interest and penalties would stop being added to the debt as soon as the case is filed. If the Chapter 13 case is completed successfully, any such interest and penalties that would have accrued after the filing date is discharged at the end of the case. Since interest and penalties can add a fair amount to a tax debt over time, this can save you a lot of money and get you out of the tax debt that much faster.
In addition, the penalties that accrued before the Chapter 13 case was filed are treated as a “general unsecured” debt. This means that it is only paid to the extent other such creditors are being paid, which is often very little or even nothing.
But if there is a recorded tax lien on that nondischargeable income tax debt, then it is a secured debt, at least to the extent that you have assets to which the tax lien attaches. Secured debts are entitled to interest under Chapter 13. So under these circumstances you would have to pay interest on that tax debt through your Chapter 13 plan.
Also, because of the tax lien you would not be able to treat penalties that accrued before the Chapter 13 case was filed as “general unsecured” debt, and thus pay little or nothing on those penalties. Instead the tax lien makes that tax a secured debt, again at least to the extent that you have assets to which the tax lien attaches. As a secured debt, the prior-accrued penalties have to be paid in full.
The Difference a Tax Lien Makes Under Chapter 13
So, as long as you have sufficient assets for the tax lien to attach to (to cover the amount of the pre-bankruptcy tax, interest and penalties, plus the future interest), the difference the recorded tax lien makes is that the pre-bankruptcy penalties have to be paid in full, and interest keeps accruing.
That is not nearly the impact of a tax lien on a dischargeable tax debt—potentially turning a debt that does not have to be paid at all in to one that may have to be paid in full. (See our last blog post.) But still, having to pay a large pre-bankruptcy penalty and ongoing interest could add substantially to what you would have to pay into a Chapter 13 plan before it is completed. So even in this situation it is definitely better to file your Chapter 13 case before the IRS/ODR records their tax line, as illustrated by the following example.
Jessica owes the IRS $9,000 and the ODR $3,000 for 2012 income taxes—a total of $12,000. She owes no other taxes for prior or later years. $1,500 of the IRS debt is for penalties, while $500 of the ODR debt is for penalties—$2,000 out of the $12,000 total. No tax liens have been recorded on these taxes. She filed Chapter 13 case and is in a 5-year plan in order to stretch out the monthly payments and make them smaller and affordable.
These taxes not old enough to be discharged. So she must pay the tax and interest that had accrued up to the date of filing–$10,000—in full. Out of the $2,000 in pre-bankruptcy penalties, assuming that she is paying 10% to her “general unsecured” creditors, she would pay $200 of that $2,000. She would pay no ongoing interest and penalties. So she’s paying a total of $10,200 to take care of the tax debt.
If instead the IRS and ODR had recorded tax liens on these 2012 taxes, she would have to pay the $2,000 in pre-bankruptcy penalties along with the $10,000 of tax and pre-bankruptcy interest. This assumes that Jessica had enough assets—such as an otherwise exempt retirement plan, or a set of other assets, disregarding any property exemptions—to cover the tax amount plus pre-bankruptcy penalties and after-bankruptcy interest.
Plus she would have to pay the accruing interest until the entire debt would be paid off, a guestimate of about $1,000. (Currently the IRS interest rate is only 3%, but could go up any calendar quarter.)
So she’d pay a total of about $13,000 to satisfy the tax debt. That’s a difference of about $3,000 because of the recorded tax liens.
That’s much less of a difference than if those taxes were from an earlier tax year and could be altogether discharged. As mentioned above, in that situation you would likely not have to pay anything on that tax a Chapter 7 case if there was no tax lien and you may well have to pay it in full if there was a recorded tax lien. But even with nondischargeable taxes, as in this example, it can make a difference of thousands of dollars, a $3,000 difference here.
The lesson is still that you should see a bankruptcy attorney if you have any substantial tax debt, and to do so sooner rather than later. When you go to see that attorney, he or she would much rather give you good news rather than have to say “if only you would have come in a little earlier.”