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How Bankruptcy Handles Income Taxes You Must Pay, through a Chapter 13 Case

If you owe taxes that don’t qualify for being written off in bankruptcy, how exactly would these taxes be paid under Chapter 13?

In this series of blog posts on taxes, we’ve made a big distinction between those income taxes that qualify for “discharge”—for being permanently written off in bankruptcy—and those that don’t. We’ll again briefly summarize the difference in a moment. The big question is how to deal with those income taxes you owe that don’t qualify for discharge? Specifically, how does Chapter 13 “adjustment of debts” help in this?

When Chapter 13 Is Necessary

Chapter 7 “straight bankruptcy” is quick and relatively clean. Your debts that can be discharged—income taxes or otherwise—are discharged usually in a matter of only three months or so. Often all your debts are discharged, leaving you with a completely clean slate. But if you owe some debts that can’t be discharged—such as recent income taxes—you must then deal directly with the creditor—the IRS or state tax authority—to pay or otherwise deal with those surviving debts. You have to do so quickly, usually again only about three months after a Chapter 7 case is filed, because that’s when the protection from creditors ends in most Chapter 7 cases.

Commonsensically, if all the income taxes that you owe can be discharged, then Chapter 7 is what you need (at least as far as your taxes are concerned). Or even if not all but most of your income taxes qualify for being discharged, leaving only relatively little owing, Chapter 7 may be fine if you can take care of that remaining tax through a manageable monthly payment program with the IRS and/or the state tax authority.

A Chapter 13 becomes necessary and worthwhile when those taxes that you still owe are too large and unmanageable. That’s especially true if you have other important debts that you need to pay as well—a home mortgage or child support arrearage, or a vehicle or co-signed obligation—that would be impossible to pay if the IRS/state got what they wanted when they wanted it.

Chapter 13 gives you tremendous flexibility in making payments to the IRS/state, and gives you protection from the IRS/state in order to be able to exercise that flexibility.

Income Taxes that Don’t Qualify for Discharge are “Priority” Debts

So what taxes don’t qualify for discharge and so may encourage you into a Chapter 13 case?

Although there are some conditions that seldom apply (and so we’ll disregard here), if an income tax you owe doesn’t meet either of the following two conditions you cannot discharge that tax:

  • if the tax return for the tax was due less than 3 years before the bankruptcy case is filed, including any extensions; or

  • if the tax return for the tax was submitted to the IRS/state less than 2 years before the bankruptcy case is filed.

To illustrate, if you were to file a bankruptcy case on July 1, 2015, you would not be able to discharge an income tax for the 2012 tax year because the tax return for that tax would not have been due (even without an extension) until April 15, 2013. That’s less than 3 years before July 1, 2015, the bankruptcy filing date, thus not meeting the first of the conditions above.

Or if you were to file a bankruptcy case on the same July 1, 2015 filing date, you would not be able to discharge an income tax for the 2011 tax year, if the tax return for that tax was submitted to the IRS/state on December 31, 2013 (obviously late). That’s less than 2 years before July 1, 2015, the bankruptcy filing date, thus not meeting the second of the conditions above.

Income tax debts that don’t meet either of these conditions could not be discharged in a Chapter 7 case and would be treated as a “priority” debt in a Chapter 13 case.

Priority debts are treated very differently than other debts under Chapter 13. Priority debts must be paid in full during the 3-to-5-year life of a Chapter 13 case (instead of being paid partially, or little, or nothing).

The Advantages of Paying “Priority” Income Tax Debts through Chapter 13

We’ve mentioned that the major advantage of paying nondischargeable income taxes through Chapter 13 is you get flexibility under protection.

Specifically:

  • How much you pay per month towards all your creditors, including the priority tax, is based on your budget, not on the requirements of the IRS/state.

  • It doesn’t matter how much the tax gets paid each month—or even if it gets paid anything at all during certain months (or even sometimes for many months or a year or two), as long as the tax is earmarked to get paid in full by the end of the Chapter 13 case (a maximum of 5 years).

  • Accordingly, other important creditors can get paid in part or sometimes even in full before the priority taxes are paid. That can be tremendously important if you are behind on child or spousal support, or need to catch up on a vehicle loan or mortgage arrearage.

  • Usually you don’t pay any interest or penalties on the tax during the Chapter 13 case—which takes away the need to pay it quickly and can significantly reduce how much you need to pay before the tax is paid off.

  • If the IRS/state recorded a tax lien before you filed the Chapter 13 case, the bankruptcy court provides a very efficient and favorable forum to value and pay off that lien.

  • Not only is the IRS/state forbidden to act directly to collect its tax from you throughout the life of the Chapter 13 case, it can’t apply indirect pressure by recording tax liens or use virtually any other enforcement mechanism.

In our next blog post we’ll show how this all works through the example of a hypothetical taxpayer who owes a lot of taxes that can’t be discharged. Please visit us again after Monday morning for this.

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