If you’ve struggled to keep a business open but have now decided to close it, and you owe taxes, here’s how to deal with them.
The Two Bankruptcy Options
Let’s assume that you have closed or are about to close a business because it was just not succeeding financially. As happens so often in these situations, you owe a lot of income taxes. What are your options in dealing with your tax debts?
You have two basic options within bankruptcy:
File a Chapter 7 “straight bankruptcy” case to discharge (legally write-off) all the debts that you can. That may include some of your tax debts. If those tax debts are old enough and meet the necessary conditions, you may even be able to discharge all of them. Taxes can be discharged in bankruptcy like other debts, although they have to meet a number of special conditions. To the extent that any taxes are not discharged, you will need to address them. With little or no other debt left, you may well have the cash flow to be able to pay reasonable monthly installment payments. If not, you may be able to negotiate a workable settlement significantly reducing the amount of tax to pay.
File a Chapter 13 “adjustment of debts” case to deal with all your debts. That involves putting together a partial-payment plan, including all your debts, including all taxes. That payment plan may include the discharge of your older tax debts. You would then pay the rest of your tax debts through a 3-to-5-year payment plan. Throughout this time you’d be protected from collection actions by the IRS/state and all other creditors.
The Key Question
Choosing between Chapter 7 and Chapter 13 as far as taxes can be summarized in one key question. Would the amount of tax that you would still owe, after completing a Chapter 7 case and discharging your debts including tax debts, be small enough so that you could reliably make reasonable payments to the IRS/state which would satisfy that obligation within a sensible time period?
Answering this Question in Favor of Chapter 7
Chapter 7 is likely the way to go if you don’t need the long-term protection that comes with Chapter 13. Once you complete a Chapter 7 case the IRS/state can resume collection activity on the taxes that were not discharged. You don’t want that to happen. So a Chapter 7 makes sense only if you can afford the required installment payments on the surviving tax balance. Or it makes sense if you can settle the tax debt on terms you can live with. So, if you arrange to pay installment payments:
those payments need to be reasonable in amount,
your circumstances should be stable enough so that you have sensible confidence that you will be able to pay them consistently, and
the length of time you would be making payments does not stretch out so long that the interest and penalties get too high.
Your lawyer can reliably tell you which tax debts would and would not be discharged in a Chapter 7 case. So you’d have a very good idea how much in taxes you’ll still owe afterwards.
The next step is determining what the IRS/state would require you to pay in monthly payments, or possibly would accept in settlement. Your bankruptcy lawyer will give you advice about this, or may instead refer you to a tax collection/settlement specialist.
Once you know the likely monthly installment payment amount, then you need to consider whether that’s an amount you could consistently pay.
If so, Chapter 7 is likely more appropriate.
Answering this Question in Favor of Chapter 13
If you could not afford the anticipated tax instalment amout, then Chapter 13 is likely better because it gives you much more flexibility and protection.
Under Chapter 13 the protection from the tax authorities usually lasts 3 to 5 years. That’s in contrast to only 3-4 months under Chapter 7.
Plus, you would likely pay less per month towards the not-discharged taxes in a Chapter 13 case. That’s because the amount of expenses you are allowed (to get to the amount you can afford to pay) would likely be larger than the IRS/state would allow after a Chapter 7 case.
Also, other important debts—such as mortgage and vehicle arrearage—could usually be paid ahead of the taxes. And penalties and interest would usually not continue to accrue in a Chapter 13 case. Whereas they do continue to accrue on not-discharged taxes under Chapter 7. As a result, in a Chapter 13 case there’s a good chance you would pay less money to pay off the tax debt.
File a Chapter 7 case when that will resolve your tax situation adequately. Otherwise use the broader powers of Chapter 13.
Be aware that many factors other than taxes affect whether a Chapter 7 or 13 is better for you. So be sure to see a highly competent bankruptcy lawyer to apply these principles to your own unique circumstances.