Tax Day 2015: The 10 Most Important Ways Bankruptcy Helps Deal with Your Tax Debt
April 15, 2015
If you owe back taxes, bankruptcy can help, in many unexpected and powerful ways.
We finish this blog series about taxes with this summary of the most important benefits of filing bankruptcy if you owe taxes:
1. Bankruptcy CAN legally and permanently write off (discharge) income taxes.
Income taxes can be discharged, just like a credit card or medical bill—you just need to meet some special conditions that only apply to taxes. Most of the conditions just require waiting long enough. Although there are some other potential conditions that seldom apply, mostly you just need to wait two years after you file the pertinent tax return, AND at the same time have to wait three years after the date that tax return was originally due.
2. Filing either a Chapter 7 “straight bankruptcy” or a Chapter 13 “adjustment of debts” will immediately stop an IRS or state garnishment/levy on your paycheck, bank account, or other assets.
The IRS and state tax agencies are bound by the “automatic stay” just like any other creditor. The “automatic stay” is the part of bankruptcy law which forbids a creditor from taking any further collection action against you or your assets the moment your bankruptcy is filed. That protection usually lasts as long as the bankruptcy case lasts, generally about 3 to 4 months with a Chapter 7 case and about 3 to 5 years with a Chapter 13 one.
3. If you owe income taxes that do not qualify for discharge (usually because they are not old enough), Chapter 13 allows you to pay those off based on your reasonable budget.
Instead of being bound by the requirements and regulations that the IRS and state impose on you if you deal directly with them, under Chapter 13 your monthly payment to ALL of your creditors is mostly determined by what you can afford to pay. And the income taxes that you have to pay are paid out of that monthly payment. Although you have to pay the nondischargeable taxes in full by the end of the Chapter 13 case, you payment plan may well pay another important creditor or two ahead of the taxes, if they are more urgent—such as to catch up on a vehicle loan, pay child support arrears, and such. This kind of flexibility can be extremely helpful.
4. Chapter 13 provides a very good procedure to get a tax lien either released or paid based on the value of the asset(s) to which the lien attaches.
Outside of Chapter 13, recorded tax liens give the IRS/state a great amount of leverage and power over you. But Chapter 13 evens the playing field by providing an efficient way to determine the value of whatever you own that the tax lien attaches to, if any. For example, if a tax lien was recorded against your home but you currently have no equity in it, you can get a bankruptcy court determination that the tax lien attaches to nothing and is thus worthless. That way you get the lien released without paying anything to do so. Or if the lien does attach to something you own but not much, you won’t have to pay much to get the lien released.
5. Chapter 13 protects you from the IRS/state throughout its 3-to-5-year life.
Chapter 13 is able to deal with all your income taxes—both those that can be discharged and those that can’t—effectively because the IRS/state is prevented from taking any action against you throughout the 3 to 5 year length of a case. It is because of this protection that you have the payment flexibility mentioned above without the IRS/state being able to take action against you. Also, if your circumstances change, that ongoing protection allows you to amend your Chapter 13 plan to account for those changes, without the IRS/state having much say about it.
6. Through a Chapter 13 plan you can avoid paying your other debts so that you can afford to pay the taxes that you can’t discharge.
Income taxes that can’t be discharged are “priority debts” which have to be paid in full before most of your other debts—the “general unsecured” ones—are paid ANYTHING. So you both have to and get to pay less or nothing to most of your creditors so that you can pay the taxes.
7. If you owe both income taxes that can be discharged (usually older ones) and those that can’t (usually newer ones), a Chapter 7 is appropriate if you can comfortably make payments on the taxes you would still owe.
The IRS in particular has a relatively convenient payment program for past due taxes—if you qualify for it based on how much you owe and other conditions. If the taxes you owe that can’t be discharged are relatively small, it can make sense to file a relatively simple Chapter 7 case, discharge all or most of your debts—maybe including your older tax debts—so that you could afford to pay off the remaining tax debt(s) directly to the IRS/state within a reasonable time period—instead of filing a Chapter 13 case.
8. Filing a Chapter 7 case can be a good way to set yourself up for an Offer in Compromise with the IRS or a similar settlement program with the state.
If you have a significant amount of tax debt that won’t get discharged in bankruptcy, more than you can afford to pay in monthly payments directly to the IRS/state after your Chapter 7 case is finished, and you also can’t afford to pay them through a Chapter 13 case, you may be able to negotiate a settlement of that remaining tax debt. The IRS and state do in the right circumstances acknowledge that you simply don’t have the means to pay the taxes you owe. Be sure to get experienced advice about this, because predicting whether an Offer in Compromise or state settlement will get approved is difficult and takes an attorney or accountant experienced in this specific kind of work.
9. If you have/had an employee and owe unpaid employee withholding taxes, those can never be discharged but CAN be paid over time under Chapter 13 while you and your business in continuously protected from the IRS/state (if your business is a sole proprietorship).
The “automatic stay” protects your business and business assets as well as your personal ones under Chapter 13, as long as you and the business are the same legal entity (the business is not formally organized as a corporation, limited liability company, or such). Then you can use Chapter 13 to catch up on unpaid employee taxes essentially the same way as nondischargeable income taxes, even though the IRS/state otherwise tend to be very aggressive about collection of these so-called “trust fund taxes.”
10. You can discharge more of your income tax debts through wise pre-bankruptcy planning.
Because income taxes can generally all be discharged if you just wait long enough after their tax returns were due and after the tax returns were actually submitted to the IRS/state, it sometimes makes sense to wait to file bankruptcy until more of your taxes can be discharged—or even until all of them can be. But this can be a delicate process. You don’t want to delay filing bankruptcy only to find out that you could not discharge a tax that you had expected to. And as you wait to file you will likely be under pressure from other creditors, as well as likely from the IRS and/or the state themselves, and you will need the help of an attorney to keep them at bay. You may also need ongoing shifts in your game plan as your circumstances change. This can be complicated, and absolutely should not be done without competent professional help.