Use Bankruptcy to Deal with Income Tax Debts from Your Closed or Closing Business
April 25, 2014
If your business has recently closed or is about to close, you are likely behind on taxes. Here are two good tools to resolve this.
Chapter 7 vs. Chapter 13
The two main bankruptcy options for resolving income tax problems from a business (especially if you do not intend to keep running that business) are Chapter 7 “straight bankruptcy” and Chapter 13 “adjustment of debts.” They each have significant power over income taxes. But the two of them are designed for quite different purposes in general, and deal quite differently with income taxes in particular.
In general Chapter 7 is usually a very quick process for discharging (legally writing off) all or most of your debts, both personal and business debts. Most of the time everything you own is protected through property “exemptions.” But if some asset of yours is not “exempt,” it must usually be turned over to the Chapter 7 trustee to liquidate and pay the proceeds to your creditors. That’s why Chapter 7 is called liquidation bankruptcy, although in most consumer and very small business situations nothing needs to be liquidated. If you are closing a business and there are some remaining business assets, a liquidation bankruptcy is more likely.
Chapter 13 in contrast is a multi-year payment program, which usually focuses on dealing with debts that you either can’t discharge—such as newer income taxes and other kinds of taxes—or don’t want to discharge but need help with—such as a vehicle loan or home mortgage. Chapter 13 comes with many very beneficial features for specific kinds of debts, features not available under Chapter 7. Some of these include “cramdown” of some vehicle loans, “stripping” certain second mortgages, stopping aggressive collection tactics on child support arrearage, and discharging (legally writing off) non-support divorce obligations. Chapter 13 is often a very powerful way of dealing with both special and ordinary creditors in one package.
Chapter 7 and Income Tax Debts, Briefly
If you have tax debts after closing down a small business, a Chapter 7 bankruptcy case would discharge all the debts that can be discharged. Those may include some of your tax debts, specifically older ones which meet certain conditions. Then you would deal directly with the IRS and/or the Oregon Department of Revenue (ODR) (possibly with the help of an attorney or tax accountant) to either pay the rest of the taxes in monthly installments or to negotiate a settlement (called an Offer in Compromise with the IRS and a Settlement Offer with the ODR).
Chapter 13 and Income Tax Debts, Briefly
If you have tax debts after closing down a small business, a Chapter 13 bankruptcy case would deal with all of your debts and all your taxes altogether. Your Chapter 13 plan, which you and your attorney propose and is approved by the bankruptcy court, specifies which taxes are paid how much and when. “Priority” taxes—essentially those newer ones that can’t be discharged—must be paid in full, although usually without any additional interest and penalties; the older “general unsecured” taxes are only paid to the extent there is money left over, often leaving little or even no money for them. Tax liens must be satisfied, although often under better terms than outside of bankruptcy because Chapter 13 provides a convenient forum for valuing the lien and a flexible plan through which to pay it. Throughout the 3 to 5 year course of a Chapter 13 case, you are protected from all collection actions by the IRS and the ODR, as well by other taxing authorities and any other creditors. At the end of the case all taxes (and other debts) that must be paid would have been paid, and the remaining debts are discharged, leaving you owing no taxes and usually owing no debts at all.
The Key Question
In most situations—especially if you’ve been running a business—there would be many factors relevant to choosing between Chapter 7 and 13 other than ones dealing with income taxes. But as far as taxes are concerned, the choice comes down to this key, practical question:
Would the amount of tax that you would continue to owe after completing a Chapter 7 case be manageable enough so that you could reliably make reasonable payments to the IRS and/or the ODR in order to be able to satisfy that tax debt within a sensible time period?
If the answer is yes, then file a Chapter 7 case and deal with the taxing authorities to pay off the surviving tax debt after and outside the bankruptcy case (assuming that there aren’t other reasons pointing you towards Chapter 13). If the answer that key question is no, then file a Chapter 13 case to handle those taxes more safely, more flexibly, more aggressively.
Helping to Answer that Question
Chapter 7 is likely the better option if you don’t need the extra benefits and long-term protection that comes with Chapter 13. Once a Chapter 7 case is done—usually only about three to four months after it is filed—the IRS/ODR can resume collecting on any taxes that were not discharged. So a Chapter 7 only makes sense if you can make arrangements with the IRS/ODR to enter into a monthly payment plan before any collection activity begins. And such a payment plan is only sensible if the monthly payment amount is reasonable, if you have good reason to be confident that you will be able to pay them consistently, and if the length of the repayment period does not drag out so long that the accruing interest and penalties get too large.
People closing a business often owe a relatively high amount of back taxes, and also often have to contend with income instability as they transition to new employment or other sources of income. If that is your situation, Chapter 7 may not be the best idea. Chapter 13 does require a regular source of income, but usually provides for more flexibility than dealing directly with the IRS/ODR.
In a Chapter 13 case, beyond the much greater and longer protection from the IRS/ODR, you would likely pay less per month towards the taxes because usually you would be allowed more generous expenses, leaving less money available for taxes. Also, other important debts—such as a mortgage, vehicle or child support arrearage—can usually be paid ahead of or alongside of the taxes. Furthermore, unlike in the after-Chapter 7 situation, under Chapter 13 penalties would not continue to accrue, and usually neither would interest. As a result, in a Chapter 13 case you would most likely pay less to finish off the tax debt.
Stated simplistically, if you owe income taxes after closing down a business, use Chapter 7 when it will write off enough of your tax debts and/or enough of your other debts so that you can pay or settle any remaining tax debt reasonably. Otherwise use the broader powers of Chapter 13. Be sure to see a highly competent bankruptcy attorney to apply the law to you, as to both taxes and all the other potential factors in making this decision.