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How Bankruptcy Handles Income Taxes You Simply Can’t Afford to Pay

If you owe taxes that can’t all be written off in bankruptcy, and you don’t have the money to pay the rest, what can you do?

The Usual Role of Chapter 7 and Chapter 13 If You Owe Income Taxes

The way income taxes are usually handled in bankruptcy is as follows:

  1. If the taxes you owe meet the conditions for being discharged (written off) in bankruptcy (generally, older income taxes), then file a Chapter 7 “straight bankruptcy” case to get rid of that tax debt quickly.

  2. If the taxes you owe don’t meet the conditions for discharge (generally, newer income taxes), then file a Chapter 13 “adjustment of debts” case to pay those taxes under very flexible terms and while being protected from the IRS/state and your other creditors.

  3. If you owe both kinds of income taxes, file a Chapter 7 case if you will be able to pay off the surviving taxes through a reasonable installment plan directly with the IRS/state, or file a Chapter 13 case if you’ll need its flexibility and protection in paying off those surviving taxes.

But what if you can discharge some of the tax debts but simply can’t afford to pay anything on the surviving taxes, either directly to the IRS/state on an installment plan or through a Chapter 13 case?

Seemingly Stuck Without Options

Although the IRS’s installment payment program has gotten more and more flexible in the last several years, it continues to have limitations in qualifying for it, and comes with serious conditions. Most importantly, it requires full payoff of the tax debt, including ongoing interest and penalties, through a strict program of monthly payments.

So, if in spite of discharging some of your tax debts and presumably a bunch of other debts through a Chapter 7 case you are still left with no money beyond your bare bones living expenses, then the IRS installment payment program will do you no good.

And state income tax programs are usually even less flexible than the IRS one, with some, for example, requiring payoff in just a year instead of the IRS’s current 6-year period.

Similarly, although Chapter 13 can stretch out payments longer—especially on the state tax debts—and can usually stop accruing tax interest and penalties, Chapter 13 itself has requirements that make it not appropriate for everyone. You must have a regular source of income, and enough “disposable income” (income beyond your reasonable expenses) to pay off the non-dischargeable taxes within 5 years. If you have no “disposable income” at all, or virtually none, then the Chapter 13 option will do you no good.

A Solution Out of This Conundrum

If you have some tax debt that meet the conditions for discharge and some that don’t, but you won’t be able to pay off the latter through either an installment program or Chapter 13, consider doing the following:

  1. File a Chapter 7 case to discharge the taxes that do qualify for discharge, as well as whatever other debts you can discharge.

  2. Then do one of the following for the remaining taxes that survive the Chapter 7 case:

    • Submit an Offer in Compromise to the IRS (or a similar settlement offer to the state);

    • See if you qualify for uncollectable status with the IRS/state.

Offer in Compromise/State Settlement

The main issue in making a settlement with a taxing agency is whether the agency can be convinced that the money you’re offering, even if relatively little, is no less than it would receive if it acted aggressively to collect against you during the period of time that it could legally do so. If you do not have regular income from work or other forms of income the IRS/state can reach, and have negligible assets, the taxing agency(s) can hopefully be convinced that anything they receive in settlement would be more than the nothing they’d get otherwise.

The work you and your bankruptcy attorney put into preparing your Chapter 7 documents for filing with the bankruptcy court gives you a running start in preparing your settlement offer to the IRS/state.

“Currently Not Collectible” Status

The IRS is authorized (as are most state taxing entities) to report a tax debt as “currently not collectible.” That removes that tax account from active tax collection process at least temporarily. The account is reviewed for reactivation if the income on your annual tax returns increases by a certain amount, as set at the time the account was determined to be “currently not collectible.”

For individual taxpayers, the primary way to have your tax debt be declared “currently not collectible” is by meeting the hardship test. You qualify if you have “insufficient income to make any payment without causing hardship.” The IRS defines “hardship” for this purpose as being “unable to pay reasonable basic living expenses.”

Once a hardship determination is made, the IRS is legally required to release any levy it may have on your wages and to not issue a new one.

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