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Bankruptcy by Example: Write Off Some of Your Income Taxes Owed, and Settle the Rest

Nov. 8, 2014

Do you owe too much in taxes to pay them in monthly payments, can’t write them off under Chapter 7, and can’t afford a Chapter 13 case?

Installment Payment Plan, Chapter 7, or Chapter 13

If you are behind on your income taxes, you may be able to take care of them by entering into a monthly payment plan directly with the IRS or Oregon Department of Revenue (ODR). That works if you can afford to pay what they require, and if it doesn’t just resolve the immediate problem without dealing with your overall financial challenges. (See last week’s blog post called “Bankruptcy by Example: Even If You’re Already in a Tax Installment Payment Plan, Consider the Benefits of Bankruptcy.”)

The taxes you owe may all meet the conditions for writing them off (“discharging” them) in a Chapter 7 “straight bankruptcy” case. Or if you owe for more than one tax year, some of your tax debts may meet the conditions for discharge and some may not. Those conditions mostly relate to when the tax returns for the taxes at issue were legally due to be filed, and when those tax returns actually were filed. A Chapter 7 case may well make sense if all or most of the income taxes you owe can be discharged.

Another option, especially if you have a lot of taxes that cannot be discharged under Chapter 7, is a Chapter 13 “adjustment of debts” case. This gives you up to 5 years to pay the taxes that would not be discharged under Chapter 7, plus usually lets you avoid paying any ongoing interest and penalties, along with a series of other potential benefits.

None May Be Work for You

But maybe an installment plan directly with the IRS and/or the ODR just won’t work because you don’t have the money in your budget that they require you to pay.

Maybe your taxes are too new or otherwise don’t qualify to be discharged under Chapter 7 case. Or maybe some of them do qualify but you’d still be left owing other taxes you could not afford to pay. Then it might make sense to wait until all or most of your tax debts do qualify for discharge, and hold off on filing the Chapter 7 case until then. But that can take several years and you often can’t wait because of pressure from the IRS or the ODR, or from your other creditors.

Or maybe all the extra advantages of Chapter 13 still do not solve your tax problem. Under Chapter 13 you are required to have reasonably consistent income, and you may not. There are maximum secured and unsecured debt amounts, which your may exceed. Or you may simply not be able to pay what it requires—full payoff within 5 years of all “priority” debts, including those income taxes that can’t be discharged.

The Bankruptcy-and-Tax-Settlement Option

One possible way out of this conundrum is this: file a Chapter 7 case to discharge whatever taxes that you can, if any, and all the other types of debts that you can, and then extend formal offers to the IRS and/or the ODR to settle the remaining tax for substantially less than you owe them.

The IRS settlement procedure is called Offer in Compromise. The ODR one is simply called “Settlement Offer.”

The IRS says “[w]e generally approve an offer in compromise when the amount offered represents the most we can expect to collect within a reasonable period of time.”

The ODR says:

To qualify for a settlement offer you must [among other things]:

  • File and pay all taxes on time for the next three years.

  • Show that you cannot sell assets or borrow against them to pay your tax debt.

  • Show that you don’t have enough monthly income or assets to pay your tax debt in full.

Predicting Whether a Tax Settlement Offer Will Be Accepted by the IRS/ODR

It is not easy to predict whether the IRS and/or ODR will accept your offer to settle your tax debt. For example, the IRS refers to standards as vague as the following:

We consider your unique set of facts and circumstances:

  • Ability to pay;

  • Income;

  • Expenses; and

  • Asset equity.

Pretty vague. There’s definitely a fair amount of discretion involved on the part of the IRS/ODR with settlement offers.

Figuring out whether a particular offer will be accepted requires the judgment call of an experienced attorney or other tax professional. Ask your bankruptcy attorney whether he or she regularly negotiates IRS Offers in Compromise and/or ODR Tax Settlements. If not, get referral from him or her to a tax attorney or accountant who does.

An Example

Diane owes the IRS and the ODR together $30,000—$10,000 for tax years 2010 and earlier, and $25,000 spread between 2011, 2012 and 2013. She was in a car accident in late 2013, sustained serious injuries, and just qualified for Social Security disability. She’s 61 years old, and is not expected to be able to work again because of her disability. In a few years when Diane qualifies for Social Security retirement benefits, they will replace her disability benefits. She has no other present or anticipated income, and no assets beyond her modest household goods and personal effects.

The one exception is that she has a personal injury lawsuit filed on her behalf from the vehicle accident, and Diane expects to receive $10,000 from that after attorney fees. These lawsuit proceeds will be protected—“exempt”—from her creditors.

She also owes $35,000 in medical bills not covered by insurance plus $50,000 in credit cards and other “general unsecured” debts.

Diane’s various creditors likely could not force her to pay anything given her lack of unprotected assets and income, except possibly the tax collectors. But she decides to file a Chapter 7 bankruptcy for her peace of mind going forward, and to discharge her older tax debts. Through her bankruptcy she discharges her $85,000 in medical bills and credit cards and such, as well as the $10,000 in income taxes for 2010 and earlier. These taxes qualify for discharge by meeting the necessary conditions, including being at least three years beyond that year’s tax return filing due date.

This leaves her, just three months after filing the Chapter 7 case, with no more debts except the $25,000 owed to the IRS and the ODR for the more recent taxes. She offers to settle this debt with the IRS and ODR by paying them most of the $10,000 she has received in the meantime from her personal injury lawsuit. Her settlement offers are accepted, since they truly have no reasonable means of getting paid anything more. Diane is now totally debt-free.