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How Bankruptcy Handles Both Income Taxes that Can Be “Discharged” and Those that Can’t, through Powerful Chapter 13

If you owe older and newer taxes, how can you write off all or most of the older and be protected while affordably paying off the newer?

In our last blog post we asked whether Chapter 7 or Chapter 13 is better if you owe some income taxes that can be written off (“discharged”), but also some that can’t be discharged, (Tax debts can be discharged mostly because they’re older, or can’t mostly because they’re newer.)

Chapter 7 “straight bankruptcy” usually quickly discharges those taxes that can be, in a matter of only 3 or 4 months. If that’s the only or almost only kind of income taxes you owe, Chapter 7 is likely better for you, at least tax-wise. But Chapter 13 “adjustment of debts” gives you incredible flexibility if you owe a lot of taxes that can’t be “discharged.” If so, Chapter 13 will give you the flexibility and protection you would likely need.

So what if you owe both kinds of taxes.

Last time we showed what Chapter 7 can do. In a nutshell, you and your attorney would seriously consider Chapter 7 if the income tax debt that survives it can be handled in one of the ways we described. For example, if the amount of taxes not discharged is relatively small and can be paid off in a reasonable time through a very manageable monthly payment plan directly with the IRS/state, then you don’t need the extra flexibility and protection that Chapter 13 provides.

So what is this extra flexibility and protection we keep talking about?

The Flexibility of Paying Nondischargeable Income Taxes through Chapter 13

If you are left with some income taxes owing after you finish a Chapter 7 case (because the tax debt doesn’t meet the conditions for discharge—again likely because it’s too new), the terms under which you will have to pay off that tax are dictated by the IRS and/or state taxing authority. Those terms may be just fine for you—the IRS in particular has in the last several years adopted some relatively easy payment terms, allowing repayment of taxes to be stretched out over quite a long span of time, thus bringing down the monthly payment.

But interest and penalties keep accruing, and of course they accrue more as you stretch out the repayment plan further. And if because of the payments you must make on your tax debt you fall behind on the current year of taxes, that would jeopardize the terms of your tax payment plan. So you can certainly fall into a vicious cycle in which you’re falling behind instead of getting on top of your tax debts.

Chapter 13, In Contrast…

Chapter 13, first, usually stops the accruing of tax interest and penalties. (A possible exception is if a tax lien has been recorded against you—see our series of 4 blog posts about a month ago focusing on tax liens.) The freezing of interest and penalties reduces how much you have to pay to get out of that tax debt. Plus when you’re not paying ongoing interest and penalties, that gives you more flexibility to pay it slower, and more flexibility even to pay other creditors ahead of the tax debt.

Second, under Chapter 13 you pay your nondischargeable tax debt based on your own actual budget, not on what the IRS or state dictates. That allows you to pay less each month—again without the detriment of interest and penalties accruing in the meantime. And as just mentioned, it allows you to pay other even more urgent debts—like a vehicle or child support arrearage—ahead of the IRS/state. Your Chapter 13 Plan can even have you pay nothing on the tax debt for a time while such other debts are paid first. That’s flexibility that of course the taxing authorities would not tolerate outside of Chapter 13.

The Protection You Get While Paying Off Nondischargeable Income Taxes through Chapter 13

The flexibility we’ve just described is made possible because the IRS and/or state are legally prevented from pursuing you or your income or assets while you are in your 3-to-5-year Chapter 13 plan. The protection you get in a Chapter 7 case that lasts usually only the 3-4 months while it is active, almost always lasts the full multi-year length of a Chapter 13 case. As long as you follow the Plan that you and your attorney propose and the bankruptcy court approves, that protection will continue.

Conclusion about Chapter 7 vs. Chapter 13 If You Have Both Kinds of Tax Debt

Simply put, file a Chapter 7 case if you have a reasonable way to take care of your non-dischargeable taxes when your Chapter 7 case is finished—through an installment payment plan directly with the IRS/state, a settlement with them, or by qualifying for their temporary uncollectable status (if you are borderline destitute and/or they determine that they can’t get anything out of you). But if you don’t have a good way to take care of the tax debt that won’t get discharged under Chapter 7, pay that nondischargeable tax through the tremendously flexible and protected shield of Chapter 13.

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