Dealing with taxes from a failed business through a bankruptcy—that sounds complicated. But I’m going to keep it simple here. What are your basic options if you owe taxes after closing down a small business?
You have two choices (once it’s clear that you need to file a bankruptcy because of the amount of your debts):
1. File a Chapter 7 case to discharge (legally write-off) all the debt that you can, perhaps including some of the taxes, and then deal directly with the taxing authorities about the remaining taxes.
2. File a Chapter 13 case to discharge all the debt that you can, perhaps including some of the taxes, and then pay the remaining taxes through that same Chapter 13 case.
In real life, especially after a messy situation like the shutting down of a business, many factors usually come into play in deciding whether a Chapter 7 or 13 is better for you. But focusing here only on the taxes, it comes down to this core question: Would the amount of tax that you would still owe after completing a Chapter 7 case be small enough so that you would reliably be able to make reasonable arrangements with the Internal Revenue Service (or other applicable taxing authority) to satisfy that obligation within the following two years or so?
Chapter 13 protects you from the collection powers of the taxing authorities during the usual three to five years while you are fulfilling your obligations under the case. You should be in a Chapter 7 case only if you don’t need that protection. That means your attorney needs to be able to tell you 1) what tax debts will not be discharged in a Chapter 7 case, and 2) what payment or other arrangements will you likely be able to make to take care of those remaining taxes.
How reliably anyone can predict how a particular taxing authority will respond about a surviving tax debt depends on the circumstances. For example, the IRS has some rather straightforward policies about how long a taxpayer has to pay off income tax obligations below a certain amount. In contrast, predicting whether or not the IRS will accept a certain “offer-in-compromise” can be much more difficult to predict. If you cannot get rather strong assurances that you will be able to reasonably handle what the taxing authorities will require, you may well be better off within the protections of Chapter 13.
Not only does Chapter 13 give you protection from the tax authorities, you would likely be permitted to pay less to them per month towards the not-discharged taxes. That’s because your living expense budget in a Chapter 13 case will likely be more reasonable than when you’re dealing directly with the IRS after a Chapter 7 case. Furthermore, unlike the after-Chapter 7 situation, penalties would not continue to accrue, and in most cases neither would interest. As a result, in a Chapter 13 case most likely you would pay less money to finish off the tax debt.
Again, the bottom line: once you know how much tax debt will survive a Chapter 7 case, do you have a reasonable and reliable means of paying it off or settling it within about two years? If so, do the Chapter 7 case. Otherwise, take advantage of the greater protection and likely more reasonable budgeting in Chapter 13.