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How Bankruptcy Handles Paying Both Income and Withholding Taxes for a Business Owner through Chapter 13

If you owe too much in taxes, a Chapter 13 case can protect your small business while you write off some and pay some of the taxes.

Two weeks ago we explained how a Chapter 13 three-to-five-year “adjustment of debts” case can help a business owner who owes both income taxes and employee withholding taxes deal with both kinds of taxes, while continuing to run the business.

But better than explaining that, today we’ll show how it actually works, through the following example.

Our Hypothetical Taxpayer

Tiffany owns a lamp shop, and has for 12 years. She owns it as a sole proprietorship—in her own name, not as a corporation or partnership. Business was very slow during the Great Recession, when she fell behind on her income taxes from not paying enough estimated quarterly taxes to the IRS and her state tax agency. Then two years ago her financial situation was made even difficult because of being injured from a serious vehicle accident. She usually hires a part-time salesperson, but during much of 2013 she had to have this employee work full-time to keep the store open during the time she couldn’t work at the store.

As a result Tiffany owes state and federal income taxes of $10,000 for 2011, $10,000 for 2012, and $2,500 for 2013, and $5,000 a total of $27,500, plus employee withholding taxes of $7,500 for the four quarters of 2013. In addition she owes $25,000 in medical bills and $75,000 in credit cards and other unsecured debts, totaling $100,000 in these unsecured debts.

In the midst of all these financial pressures, she also fell 10 payments behind on her home mortgage, totaling $15,000 in arrears.

With the improved economy the store is profitable again, and with her injuries healed Tiffany is running the store, now without needing an employee. But the IRS and state are very aggressively pursuing her for the back taxes, and she has just been sued by a collection agency on $10,000 of the medical bills. Her home mortgage company is threatening foreclosure.

Effect of a Chapter 7 “Straight Bankruptcy”

If Tiffany were to file a Chapter 7 case, the “automatic stay” that goes into effect immediately when the case is filed would stop the lawsuit on the medical debt. The “discharge”—legal and permanent write off—about 3-4 months later would likely wipe out all her medical bills and likely all the other “general unsecured” debts.

Since she submitted her 2011 income tax returns to the IRS and state on April 17, 2012, that year’s due date, if her Chapter 7 case would be filed after April 17, 2015, more than 3 years later, she could very likely discharge the $10,000 she owes for that. But that would still leave her with the $10,000 in income taxes for 2012, $2,500 for 2013, $5,000 for 2014, plus the $7,500 in withholding taxes, a total of $22,500 in taxes.

During the 3-4 months that a Chapter 7 case normally takes, the “automatic stay” would also protect her and her business and personal assets from the IRS and the state tax agency, but this protection would end after that and the IRS/state would be free to pursue her and her business assets for collection of the $22,500. Plus, in a Chapter 7 case the bankruptcy trustee would try to get assets out of her business to pay Tiffany’s creditors, and it may or may not be possible for her to exempt all her personal and business assets from the trustee’s reach, including such assets as her receivables, customer lists, and the store brand. Plus, the trustee may have the power to shut down the business to avoid any potential day to day casualty liabilities for operating it.

While normally her home mortgage company would be willing to agree to a “forbearance” agreement—extra monthly payments for a year or so to catch up on the mortgage—Tiffany would not be able to catch up on the $15,000 she’s behind given what the IRS/state would require her to pay on the remaining income and withholding taxes.

The Chapter 13 Solution

If Tiffany instead filed a Chapter 13 “adjustment of debts” case, her business and personal assets would be protected from the trustee, even if they were not fully covered by the available property exemptions. The trustee would not be trying to shut down the business, but rather wanting it to survive and thrive in order to pay the creditors as laid out in the Chapter 13 payment plan.

And her business and personal assets would be protected from the IRS and state as well by the “automatic stay,” not just for 3 or 4 months but rather for the 3 to 5 years that the Chapter 13 case would likely take to complete. Tiffany would have that period of time—a maximum of 5 years—to pay the $22,500 in income and withholding taxes, based not on whatever payment schedule that the IRS and state would demand but rather on what her budget would allow. As long as her court-approved plan showed that she was paying the $22,500 “priority” debts within the 3-to-5-year period, she could pay certain other debts—such as her home mortgage arrearage—ahead of the taxes.

Throughout her Chapter 13 case the IRS/state could not record a tax lien on her business, home, vehicle and other assets. They could not levy on her receivables or inventory, take money out of her business “till” or checking account, or call or write her demanding payment. So Tiffany’s life would be much calmer.

The IRS/state would not continue adding steep penalty and interest charges—assuming they hadn’t recorded tax liens before the Chapter 13 case was filed, thus reducing what Tiffany would have to pay to clear the tax debts.

Her mortgage company could not start the threatened foreclosure. Tiffany would make her regular monthly mortgage payments, which the mortgage company could not refuse to accept (on the basis that she was behind on her payments), and she would likely have the length of her Chapter 13 plan to catch up. But without pressure from the IRS/state, and without having to pay them interest and penalties, her plan would catch up on her mortgage relatively quickly.

Tiffany’s Chapter 13 Plan

Based on her business and personal budget, Tiffany can afford to pay $750 per month to all of her creditors—the taxes, medical and other regular unsecured debts, AND her mortgage arrearage. That is her Chapter 13 plan payment. Out of that amount, $600 is earmarked to catch up on the home mortgage, accomplishing that in 25 months. Almost all of the rest of the money goes to pay the $22,500 in taxes that could not be discharged in a Chapter 7 case. Her attorney gets $1,500, the portion she did not pay before her case was filed, and the Chapter 13 (who administers the case and distributes her payments to the creditors) gets about 5% of whatever flows through the plan.

Assuming Tiffany’s income does not go significantly up or down during the course of the case (if it does, the $750 play payment can be adjusted), it will take a little more than four and a half years to complete her plan. Since all the money during that time will go to the non-dischargeable income taxes, the withholding taxes (none of which is dischargeable), the mortgage arrearage, and her attorney and trustee fees, nothing would be left for the other debts. So she would not have to pay anything on those other debts (the 2011 income taxes, the $25,000 in medical debts, and the remaining $75,000 in credit cards and such). (The possible exception to this is if during the first 3 years of her case her income increased enough to pay the “priority” taxes and mortgage arrears off and still leave something to go to these “general unsecured” debts.)

After the four and a half year or so of her case, all her remaining debts would be discharged. She would be current on her home mortgage, current on her income and withholding taxes, and—other than her home mortgage debt itself—Tiffany would be debt-free.