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Bankruptcy Timing: Filing in 2016 to Write Off More Income Taxes with Chapter 13

Jan. 4, 2016

With Chapter 13 you may have to pay some part of the taxes that you could just discharge under Chapter 7, but it may be worth it.

Last week just before New Year’s Day we showed how to discharge (legally write off) more of your tax debts (likely for the 2012 tax year) under a Chapter 7 “straight bankruptcy.” Today we show how that’s done under the Chapter 13 “adjustment of debts” form of consumer bankruptcy.

Dealing with Income Tax under Chapter 13

The most direct way bankruptcy deals with older income taxes is by quickly discharging them in a Chapter 7 case. As long as the tax meets the conditions for discharge, under Chapter 7 you would simply not legally owe the tax at all usually within about 4 months after filing the bankruptcy case.

But there are many circumstances in which a Chapter 13 case would be better for you than Chapter 7. Some of these circumstances involve income taxes and some so not.

You may owe some older income taxes which meet the conditions for discharge and some more recent income taxes that do not and so need to be paid. If the taxes that have to be paid are large, it’s often safer and/or saves you money by dealing with all of your taxes in a Chapter 13 case.

Or you may need a Chapter 13 case for reasons other than your income taxes, such as to save your home from foreclosure or to deal with a child support arrearage. Chapter 13 gives you extraordinary tools for dealing with these and a number of other special situations. It may be worth a potential disadvantage on the income tax side to have the advantage of those tools to meet your most important goal(s).

Dischargeable Taxes under Chapter 13

Be aware that the same rules apply to Chapter 13 that apply to Chapter 7 about which income taxes can be discharged. In most situations you can discharge older income taxes through Chapter 13 by meeting the following two conditions. The date of the bankruptcy filing must be both:

1) at least 3 years after the pertinent tax return was due (plus any time for extensions), and

2) at least 2 years after the tax return was actually submitted to the IRS or state tax agency.

Some other possible conditions very seldom come into play—when there is tax litigation, offers in compromise, and other relatively rare procedural complications.

So most of the time if those two conditions are NOT met the tax must be paid in full, and Chapter 13 provides some very helpful advantages in doing so. But if those conditions ARE met, what happens to those taxes in Chapter 13?

What Happens to Dischargeable Taxes under Chapter 13

Simply put, income taxes that meet the conditions for discharge are lumped in with the rest of your “general unsecured” debts and paid whatever percentage those other debts are paid. Those taxes may be paid something or they may be paid nothing. Even if they are paid something, that may not increase what you have to pay during your Chapter 13 case. Let us explain what we mean.

0% Chapter 13 Plans

In many but not all parts of the country the bankruptcy court will approve a Chapter 13 payment plan in which all the money you pay goes to certain special creditors—those with debts secured by collateral and/or liens and those with “priority” debts that must be paid in full. That leaves nothing available during the length of the plan for the rest of the creditors—the “general unsecured” ones. Since income taxes that meet the conditions for discharge are in that “general unsecured” category, nothing is paid to them during the 3-to-5-year plan. If the case reaches a successful conclusion—mostly by all the plan payments being paid—then at that point all the dischargeable taxes are in fact discharged, without having being paid anything.

Chapter 13 Plans Which Aren’t Paid Any More in Spite of the Dischargeable Taxes

Even if when a Chapter 13 plan is designated to pay the “general unsecured” debts some percentage of what you owe, the fact that you have dischargeable income taxes often does not increase the money you would pay during the life of your plan. That’s because in many Chapter 13 cases you have only so much available to pay to all of your “general unsecured” debts. Adding your dischargeable income taxes to the “general unsecured” debts just reduces how much the rest of those debts are paid, without increasing the amount you pay.

An Example

Consider if you owe $30,000 in other “general unsecured” debts—credit cards and medical bills, for instance, and $10,000 in older income taxes that meet the conditions for discharge, a total of $40,000 in “general unsecured” debts. Assume that based on your income and expenses you have enough in your budget each month to pay into a Chapter 13 plan enough to catch up on a home mortgage, pay your vehicle loans, and pay off $15,000 in more recent “priority” income taxes that do not meet the “dischargeability” conditions and so must be paid in full. In addition, you have a little more “disposable income” adding up to a total of $5,000 over the entire course of the payment plan.

In this situation, the existence of the $10,000 in dischargeable income taxes would not affect the amount you’d have to pay into your Chapter 13 plan. Without these taxes, the available $5,000 would be distributed among the other $30,000 in “general unsecured” debts, thereby paying those about 17% of the amount owed ($5,000 divided by $30,000). When you add in the taxes, that same $5,000 would now be divided by $40,000, thereby paying about 12.5% of the amount owed. The amount paid to the “general unsecured” debts is not changed ($5,000); that money just gets distributed among more debts.

Either way, at the successful completion of the Chapter 13 the unpaid part of the “general unsecured” debts—including the $10,000 in taxes—would be discharged, forever written off.

Income Taxes Owed for 2012

This is all relevant to now particularly if you owe income taxes for the 2012 tax year. If so, you would meet the first of the above two conditions by waiting to file your Chapter 13 case until after April 15, 2016. That’s because at that point 3 years would have passed since that tax return was due.

This assumes you were not granted an extension to file that tax return. If an extension to file the return was granted to October 15, 2013, you’d have to wait to file the Chapter 13 case until after October 15, 2016 to meet this 3-year rule.

As to the second of the above two conditions, you’d meet it by waiting to file your Chapter 13 case until at least 2 years had passed since you submitted your 2012 tax return to the IRS/state. If you filed that return by the (non-extended) due date of April 15, 2013 then you would have already met this 2-year condition in April of last year. But you could have submitted the tax return a full year late—by April 15, 2014—and still meet this 2-year condition.