Chapter 7 may legally write off some business-related taxes, and put you in a better position to take care of what can’t be written off.
Chapter 13 “adjustment of debts” is often the best way to handle taxes owed from running a business. But not necessarily. Sometimes Chapter 7 “straight bankruptcy” is the better solution. Through a Chapter 7 case you may be able to discharge some or all of your income tax debts. Or maybe it can at least clean up your debts enough so that you can realistically enter into a reasonable payment plan to take care of the remaining taxes.
How to Decide between Chapter 7 and 13
If you own, or recently owned, a failing or failed business, you likely have a more complicated financial situation than people with just consumer debts. You may have heard that the Chapter 13 often deals better with less straightforward situations. But you’ve also heard that this option takes three to five years, and that doesn’t appeal to you. However you might also think that the comparatively quick and straightforward Chapter 7 is not up to the task. But it just might be.
In deciding whether a Chapter 7 is right for you in this kind of situation, the main considerations are the kinds of debts and the kinds of assets you have. We first get into the debt issues, starting today with taxes.
Business Debts in General
Chapter 7 tends to be the better solution if most or all or most of your debts are of the kind that will be discharged—legally written off. That would leave you with little or no debt. Chapter 13 is often better if you have debts that are NOT going to be discharged—especially taxes. That’s because it can give you major leverage over those debts. It protects you from aggressive collections while giving you a reasonable way to pay these special debts.
So let’s look at this in the context of tax debts.
Personal Income and “Trust Fund” Taxes
It seems almost inevitable—business owners running a struggling business almost always owe back taxes. As a small business hangs in there month after month, often there just isn’t enough money for the self-employed owner to pay the quarterly estimated income taxes. And then there’s not enough money to pay the tax owed when it’s time to file the annual tax return. If the tax you owe meets certain conditions, it may be dischargeable. Otherwise it’s not and must be paid.
And if you, the owner, have paid yourself as an employee of the business, you may have withheld employee income tax, Social Security/Medicare, and other withholdings from your paychecks. Same with any other employees. But then maybe you also did not pay those funds to the IRS and the state/local tax authorities. These are called “trust fund” taxes, for which you as the business owner are usually personally liable. Unlike simple income taxes, “trust fund” taxes can never be discharged in bankruptcy.
Why Chapter 13 Might Be Better
If you owe income or “trust fund” taxes Chapter 13 can be better, sometimes much, much better. There are many reasons for this. But the biggest reason is that a Chapter 13 case protects you and your assets for years. In the meantime you pay the IRS and/or other tax authorities based on your actual ability to pay. You don’t have to pay according to the rules and regulations of the tax authorities. Plus you often have the option of paying other higher-priority debts at the same time or ahead of the taxes. This can enable you to hang onto a vehicle or to catch up on child support, for example.
When Chapter 7 Can Work
But you don’t always need that kind of Chapter 13 help. So don’t take the Chapter 7 option off the table without considering it closely. Here are two key considerations.
1. As mentioned above, Chapter 7 can discharge personal income taxes which are old enough and meet some other conditions. That could eliminate your tax debt. That’s especially true if you closed your business a while ago and your taxes are from then. Even if you can only discharge some of your owed taxes, doing so may reduce the amount you still owe to a more manageable amount.
2. Even if you know that you will continue owing income taxes after your Chapter 7 case is done you may be able to negotiate a reasonable payment plan with the tax authorities. Interest, and usually penalties would continue to accrue. A Chapter 13 case would likely avoid both. Keep in mind that the taxing authorities may or may not be flexible about reducing or temporarily stopping your payments if your finances deteriorate. So don’t enter into a tax installment payment agreement unless you have reliable income.
What You Need to Do
Find out from your bankruptcy lawyer whether Chapter 13 will give you any significant benefits other than helping you with your taxes. If not, look closely what would likely happen with your taxes if you filed a Chapter 7 instead. Focus especially on how much you would still owe in taxes after you filed the case. Then get a good estimate of how much each taxing authority would require you to pay each month on that debt. How much interest and penalties would likely accrue over the time it would take to pay it off. And find out how long it would take to pay off the taxes. From this, decide whether you could realistically and reliably pay the amount that would be required each month.
Then in light of all this, after getting the advice of your lawyer, decide whether the simpler Chapter 7 option would work for you.