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The Most Basic Concept in Bankruptcy: Debts

The most practical questions you likely have if you are considering bankruptcy is what it will do to each of your debts. Will you still owe anything to anybody? What about debts you want to keep like a vehicle loan or mortgage? How to handle special debts like income taxes and child support?

To understand bankruptcy you need to understand debts. One of the most basic principles of bankruptcy is that it treats all creditors in the same legal category the same as all the other creditors in that category. So the first step in understanding debts is to understand the three main categories of debts. Not everybody has debts in each of these categories, but lots of people do. At the end of this blog, you should be able to at least start dividing your debts among these three categories. From there, bankruptcy and how it deals with each of your creditors will start making more sense.

The three categories are “general unsecured debt,” “secured debt,” and “priority debt.”

Secured Debts

All debts are either secured by collateral or not. Whether or not a debt is secured is often very straightforward, such as with a vehicle loan in which the vehicle’s title specifies your lender as the lienholder. That lien on the title, together with the documents you signed with that lender, gives that lender certain rights as to that collateral, such as the right to repossess it if you fail to make payments.

In the case of every secured debt, there is a legally prescribed way to attach the debt’s collateral to the debt. In the case of the vehicle loan, the lender and you have to jump through certain hoops for the lender to become a lienholder on the title. If those aren’t done right, the vehicle might not attach as collateral to your loan.

Debts can be fully secured or only partially secured. If you owe $10,000 on a vehicle worth only $8,000, the debt is only partially secured—secured as to $8,000, and unsecured as to the remaining $2,000 of the debt.

Debts can be voluntarily or involuntarily secured. Examples of the latter are judgment liens on your home, IRS income tax liens on all your personal property, and a mechanic’s or repairman’s lien on a vehicle that’s been repaired and the repair bill not paid.

General Unsecured Debts

All debts that are not legally secured by collateral are simply unsecured debt. And “general” unsecured debts are simply those which do not belong to any of the categories of “priority” debts (discussed below). So general unsecured debts are the default category—if a debt is not secured and not a priority debt, it’s a general unsecured one. They include every imaginable type of debt or claim. Common ones include most credit cards, essentially all medical bills, personal loans without any collateral, bounced checks, most payday loans (although those sometimes have collateral), unpaid rent and utilities, balances left over after a vehicle is repossessed, many personal loans, and uninsured or underinsured motor accident claims against you.

Sometimes debts which were previously secured can become general unsecured ones, and vice versa. An example of the first: once you’ve surrendered all the collateral—such as a vehicle on a vehicle loan—any remaining debt is general unsecured. And an example of the second: a general unsecured medical bill can become secured after a lawsuit is filed against you and a judgment entered, resulting in a judgment lien attached to your real estate.

Priority Debts

Just like it sounds, priority debts are special ones that the law has selected to be treated better than general unsecured debts. In fact, there are very specific levels of priority among all the priority debts.

It’s all about who gets paid first (which often means who gets paid at all). This comes up in two main ways.

First, most Chapter 7 cases don’t involve the trustee receiving any of your assets for distribution to your creditors. But in those cases where there are non-exempt assets, the priority creditors are paid in full before the general unsecured ones receive anything. And the higher priority creditors are paid in full before the lower priority ones.

Second, in a Chapter 13 case, your formal plan has to show that you will pay all priority debts before the completion of your case, and then you must in fact do so before you are allowed to finish it.

The most common priority debts for consumers or small business owners are the following, in order starting from the highest priority:

• child and spousal support—amounts owed as of the time of the filing of the bankruptcy case

• the administrative costs of the bankruptcy case—trustee fees and costs, and in some cases attorney fees

• wages and other forms of compensation owed to employees—maximum of $10,000 per employee, for work done in the final 180 days before the bankruptcy filing or close of business, whichever was first

• certain income taxes, and some other kinds of taxes—some are priority but others are general unsecured if they are old enough and meet some other conditions

In the next blog I’ll get more into how debts in each category are treated in Chapter 7 and Chapter 13.

 

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Business Litigation Worth Fighting About in Bankruptcy

The closing of your business, followed by your personal bankruptcy filing, often ends threatened or ongoing business litigation against you. But here are three situations where that litigation could well continue regardless of the bankruptcy.

What is No Longer Worth Fighting About

Most debts or claims against you at the time of your bankruptcy filing are resolved for all legal purpose by the filing of your bankruptcy case. Now there is no longer any benefit for the creditor to initiate previously threatened litigation or to continue the pending litigation. If you filed a Chapter 7 bankruptcy case, most if not all of your business and personal debts which you want to discharge will in fact be discharged. The creditors will either receive nothing or will receive a pro rata portion of any of your non-exempt assets. If you filed a Chapter 13 case, your creditors will receive whatever your court-approved plan provides, often pennies on the dollar of whatever you owe. There is usually not much worth starting or continuing to fight about.

What IS Worth Fighting About

But there ARE some types of debts or claims that DO still need court resolution. In these situations the creditor or adversary would likely get permission from the bankruptcy judge to either continue the pending litigation or initiate it.

1) Determining the Amount of a Debt

If a debt or claim is being discharged in a no-asset Chapter 7 case, the amount of that debt makes no practical difference. But in an asset Chapter 7 case, in which the bankruptcy trustee is anticipating a pro rata distribution of assets to the creditors, the amounts of all the debts need to be determined in order for that distribution to be fair to all the creditors. Same thing occurs in Chapter 13 cases in which the creditors are being paid a portion of their claims but not in full, since the amount of any allowed claim affects the distribution received by all the creditors.

Usually disputes about the amount of a the claims are resolved in bankruptcy court, by the creditor or trustee objecting to a proof of claim filed by the creditor. But in relatively complex disputes, especially ones already pending in another court, , the bankruptcy court may allow the amount of the debt to be resolved in that other court.

2) Potential Insurance Coverage of the Debt

If a claim against the debtor is potentially covered by insurance, then often all the affected parties want the dispute to be resolved. Issues needing resolution include whether the debtor is liable for damages, whether those damages are covered by the insurance, and whether the policy limits are enough to cover all the damages or instead leaves the debtor personally liable for a portion. Examples include:

• vehicle accidents involving the business’ employees or owners, especially those with multiple drivers

• claims on business equipment damaged by fire or flood

• various business losses potentially covered by your business owner’s policy, such as an employee’s embezzlement, or an injury to a non-employee on the business premises

In these situations the bankruptcy court will likely give permission for the litigation to proceed outside of bankruptcy court, with appropriate conditions about not pursuing the debtor for any amount not covered by insurance.

3) Nondischargeable Debts

The biggest fights about business-related debts arise when a creditor or claimant argues that its debt or claim should not be discharged in the bankruptcy case. This challenge goes to the heart of the bankruptcy case—the debtor’s desire to get a fresh start without being burdened any longer by the debts connected to the failed business.

These discharge fights apply to both Chapter 7 and Chapter 13. In the past, Chapter 13 did not allow creditors to raise many of the kinds of challenges to the dischargeability of debts allowed under Chapter 7. But the major 2005 bankruptcy amendments for the first time opened the door in Chapter 13 to many of those same challenges. Because Chapter 13 is often a better solution for debtors who have closed a business (for example, it is often a better way to deal with certain business-related debts such as nondischargeable taxes), in the last few years there have been a significant number of dischargeability challenges by creditors in Chapter 13.

 

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A Big Benefit to Owing Lots of Business Debt: Skip the “Means Test” and Qualify for Chapter 7

If you owe more business debt than consumer debt, then you avoid not only the “means test” but also some other roadblocks to a successful post-business Chapter 7 bankruptcy case.

What’s the “Means Test” and Why it Matters?

Bankruptcy law says that if your income is more than a certain amount, you have to pass a “means test” to be able to go through a Chapter 7 case successfully. One way to avoid this “means test” is by having less income than the permitted “median family income.” But the “median family income” amounts are relatively low. If your income is at all above the applicable median amount, you have to go through the “means test,” with a significant risk of being forced into a 3-to-5-year Chapter 13 payment plan instead of three-month Chapter 7 “liquidation.”

Debtors with More Non-Consumer Debts than Consumer Debts

You can skip the “means test” altogether if your debts are NOT “primarily consumer debts.” This way you could be eligible for a Chapter 7 case even if your income is above the median level. Indeed, you avoid other kinds of “presumptions of abuse” as well, not just the formulaic “means test,” but also the broader “totality of circumstances” challenges. Congress has seemingly decided that if your debts are mostly from a failed business venture, you should be permitted an immediate Chapter 7 “fresh start,” regardless of your current income and expenses.

What is a “Consumer Debt”?

The Bankruptcy Code defines a “consumer debt” as one “incurred by an individual primarily for a personal, family, or household purpose.”

The focus is on the purpose for which you incurred the debt in the first place. If you made a credit purchase or took out the loan exclusively, or even mostly, for your business, then it may well not a “consumer debt.” That is a factual question that must be decided separately for each one of your debts.

“Primarily Consumer Debts”?

The Bankruptcy Code does not make this crystal clear, but generally if the total amount of consumer debt is less than the total amount of non-consumer debts, your debts are not “primarily consumer debts.” And then you do not have to mess with the “means test.”

Seemingly Consumer Debts May Not Be

Small business owner often financed the start-up and ongoing operation of their businesses with what would otherwise appear to be consumer credit—credit cards, home equity lines of credit and such. Given their purpose, these may qualify as non-consumer debts in calculating whether you have “primarily consumer debts.” This is definitely something to discuss with your attorney to consider how the local judges are interpreting this issue.

Unexpectedly High Business Debts Can Help

Sometimes business owners have business debts larger than they thought they had, which could push their non-consumer debt higher than their consumer debt. For example, if you had to break a commercial lease when you closed your business, the unpaid lease payments projected out over the intended term of the broken lease could be huge. Or your business closure may have left you with other hidden debts, such as obligations to business partners or unresolved litigation, with tremendous damages owed. The silver lining to these larger-than-expected business debts is that they may allow you to skip the “means test” and other grounds for dismissal or conversion to Chapter 13, allowing you to discharge all your debts through a Chapter 7 case when you could not have otherwise.

 

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Getting Just Enough Help for Your Home through Chapter 7

When does filing a Chapter 7 “straight bankruptcy” case help you enough so that you don’t need a 3-to-5-year Chapter 13 case?

If you are behind on your mortgage payments but want to keep your home, you have likely heard that a Chapter 13 “payment plan” is what you need. And that IS a powerful package, with an impressive set of tools to deal with a wide variety of home-related problems—everything from the mortgages themselves to property taxes, income tax liens, and judgment liens.

But what if you need to discharge other debts to get a fresh financial start, and have managed to fall only a couple of months behind on your mortgage? Or what if you are not keeping the house, but just need a little more time to find another place to live?

Then you may well not need a Chapter 13 case, and can maybe avoid the disadvantages it comes with—mostly, that it takes so much longer and generally costs lots more than Chapter 7. This extra time and cost can be well worthwhile when you need the great advantages of Chapter 13, but let’s look at ways that Chapter 7 can do enough for your home:

In a Chapter 7 case:

1. The “automatic stay”—the bankruptcy provision that stops virtually all actions by creditors against you or your property—applies to Chapter 7 just as it does to Chapter 13. So the filing of a Chapter 7 case STOPS a foreclosure in its tracks, just as quickly as a Chapter 13 filing. But if you are just trying to buy time to save money for a rental, the tough question is HOW LONG that break in the mortgage company’s foreclosure efforts will last, and how much extra time it’ll buy you. An aggressive creditor could quickly ask the court for “relief from the stay”—permission to resume the foreclosure process—thus potentially getting you only a few extra weeks. Or on the other extreme, a mortgage creditor could just do nothing for the 3 months or so until your Chapter 7 case runs its course and the “automatic stay” expires with the completion of your case. So, Chapter 7 often does not come with much predictability about how much time you’d gain. On the other hand, your bankruptcy attorney may well have experience in how fast certain mortgage lenders tend to ask for “relief from stay” under facts similar to yours.

2. Chapter 7 stops—at least briefly—not only mortgage foreclosures, but also prevents other potential liens from being placed against your house, including the IRS’s tax liens and judgment liens. But why would the few weeks or months that Chapter 7 gains make any difference with these kinds of creditors? In the right set of facts, it can make many thousands of dollars of difference.

• A timely filing of a Chapter 7 case can prevent you from having to pay a debt that would otherwise have become a lien against your house. For example, let’s say you have an older IRS debt that meets the necessary conditions for discharge, and you also have a little equity in your home but not more than your homestead exemption allows. If you waited until after the IRS recorded a tax lien for that debt against your house, that lien would continue being attached to your house even if you filed a bankruptcy and would eventually have to be paid. However, if your Chapter 7 filing happened before the IRS recorded a tax lien, the “automatic stay” would prevent that tax lien from being filed, the tax debt would be discharged forever, and your home’s equity would be preserved.

• Or if instead let’s say you have a debt that is NOT going to be discharged in bankruptcy—say a more recent tax debt—but you also had some assets that you were going to have to surrender to the Chapter 7 trustee, what we call an “asset case.” If again you filed the bankruptcy case before the recording of the tax lien, your Chapter 7 trustee could well pay those taxes as a “priority” debt in front of any of your other debts, potentially leaving you with no tax debt at the completion of your case.

3. Chapter 7 allows you to concentrate on your house payments by getting rid of your other debts. If you’ve managed to keep current on those mortgage payments, but don’t know how long you will be able to do so, the relief you get from discharging your other debts greatly improves your odds of staying current on your home long term. Or if you have missed only a few mortgage payments, AND can reliably make future ones, PLUS enough to catch up on your arrearage within year or less, then Chapter 7 would like very likely do enough for you. Most mortgage creditors will let you enter into an agreement –often called a “forbearance agreement”—to catch up the missed payments by paying a sufficient specific amount extra each month until you’re caught up, again, as long as that period of catch-up time is relatively short. Otherwise, you may well need a Chapter 13.

 

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Reasons to Do a Short Sale? Maybe Not

Besides avoiding a foreclosure and its hit on your credit record, you may have other sensible reasons for looking into a short sale of your home. Let’s consider those other reasons.

In my last blog I showed how a short sale may be harder to pull off than expected, and how they can be dangerous if you do not get advice from knowledgeable professionals looking out for your interests. Simply put, you should not assume that any particular solution is the right one without knowing all your options. And that means asking whether the reasons you are pursuing one option might or might not actually be better served through a different option.

So here are some sensible reasons to consider doing a short sale:

1. You can’t afford the house anymore and so believe you have no choice but to get out.

If your income has been cut or the mortgage payments have gone up so that you cannot keep up those payments, and yet you can’t sell your house in the normal fashion because it’s worth less than the mortgage balances, then a short sale may be a good way to escape the house and its debt.

But maybe you have important reasons to stay in your home. Your family may benefit from staying for deep personal reasons—such as not leaving your kids’ school district or maintaining family stability. If you leave this home it may be a long time before you would have the financial means to buy again. So there may be ways to lower the cost of keeping your home. A mortgage modification may now be more available than in the last few years because of the recent large mortgage fraud settlement with the major banks, and other improved programs. A Chapter 13 case in bankruptcy court may enable you to eliminate or drastically reduce a second mortgage balance, and either eliminate, reduce, or delay payments on other liens on the house. And either a Chapter 7 or 13 could reduce or eliminate other debts so that you could better afford to pay the home obligations.

2. You’ve heard that bankruptcy does not allow “cram downs” of mortgages on your home. So you see no way out of your second mortgage other than getting them at least a partial payment through a short sale in return for writing off the rest of that debt.

You’ve been doing your homework if you understand that mortgages secured only by your primary residence cannot be “crammed down,” reduced in bankruptcy to the value of that residence, unlike lots of other kids of secured debts.

But there’s a big exception, one that keeps getting bigger as home values continue to decline in many areas. If your home is worth less than the balance of your first mortgage, so that there is no equity at all in your home for the second mortgage, then through a Chapter 13 case you can “strip” this lien off your home. That means that your second mortgage debt can be paid very little—sometimes even nothing—during your 3-to-5 year Chapter 13 case, and then written off completely. This not only saves you from paying the 2nd mortgage payment from then on, it reduces your debt on your home forever, making hanging onto your home economically more sensible. If this second mortgage strip applies to your situation, then you will pay less each month for a home with less debt on it.

3. You may be induced to do a short sale not just because of your voluntary mortgage debts on your home, but because of various other usually involuntary ones which have attached to your home’s title, like one or more tax, judgment, support, utility, or construction liens.

You may have found out that your title is saddled with other obligations, and in fact you may well be under a great deal of pressure to pay one or more of these obligations. The IRS and support enforcement agencies can be especially aggressive. So you would understandably feel that you have no choice but to sell your home to get that aggressive creditor paid. And since you have no equity in your home, you can only sell it on a short sale. But the problem is that the more lienholders you have, the more challenging a short sale becomes. And even if it does succeed, the troublesome lienholder may agree to sign off for less than the balance, leaving you still being pursued by it.

I can’t cover here how a Chapter 7 or Chapter 13 case would deal with each of these kinds of lienholders. That’s a many-blog discussion, and would depend on each person’s circumstances. But often you would have options that would give you more control over your home and over your financial life than would happen in a short sale. Considering what is at your stake, it certainly makes sense to consult an attorney who is ethically bound to explain all the options in terms of your own goals and best interests.

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Study Shows Chapter 7 Debtors Represented by an Attorney Are “Almost Ten Times More Likely to Receive a Discharge” of their Debts

My own professional experience about the dangers of filing bankruptcy without an attorney is validated by carefully analyzed data.

In my work as a bankruptcy attorney, I spend a fair amount of my time attending Chapter 7 “341 hearings” with my clients. That’s the usually straightforward 10-minute or so meeting with the bankruptcy trustee that everyone filing bankruptcy gets to go through a month or so after their case is filed. As I wait for my clients’ turn and listen to other hearings, I see the bad things that happen there to people who file bankruptcy without an attorney. I won’t go through a litany of horror stories here, but let me just say I’ve seen countless examples proving how dangerous it is to file a Chapter 7 bankruptcy without an attorney. Besides, I know how complicated bankruptcy laws and procedures are because that’s what I deal with day in and day out. Yet, I’ve always wondered: in actual fact, beyond my own professional knowledge and experience, how much more dangerous is it going without an attorney?

This question is addressed, among many others about the current state of bankruptcy, by a book that was published just a few weeks ago, Broke: How Debt Bankrupts the Middle Class. A compilation of articles by respected scholars, one of the chapters focuses on “pro se” filers (those without attorneys). The author of this chapter, Asst. Professor Angela K. Littwin of the University of Texas School of Law, analyzed data from the Consumer Bankruptcy Project, “the leading [ongoing] national study of consumer bankruptcy for nearly 30 years.” She concluded “that pro se filers were significantly more likely to have their cases dismissed than their represented counterparts.”

I haven’t yet gotten my hands on that book for the statistical details there, but in another closely related study from last year, Prof. Littwin concluded that “17.6 percent of unrepresented debtors had their cases dismissed or converted” to Chapter 13, [while] only 1.9 percent of debtors with lawyers met this fate.”  Even after controlling for other factors such as “education, race and ethnicity, income, age, homeownership, prior bankruptcy, whether the debtor had any nonminimal unencumbered assets at the time of the filing,” “represented debtors were almost ten times more likely to receive a discharge than their pro se counterparts.”

In her carefully understated and scholarly appropriate way, Prof. Littwin concluded that “there may always be additional unobservable factors for which I cannot control… [b]ut this analysis suggests that filing pro se dramatically escalates the chance that a Chapter 7 bankruptcy will not provide a person with debt relief.”

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Special Protection for Your Co-Signers Under Chapter 13

Chapter 7 protects you and your assets with the automatic stay. Chapter 13 goes a big step further by also protecting your co-signers and their assets.

The first three chapters of the Bankruptcy Code—chapters 1, 3, and 5—include code sections that tend to apply to all of the bankruptcy options. In contrast, the code sections within chapters 7 and 13 apply only to cases filed under those chapters. Because the automatic stay—your protection from collection by creditors that kicks in as soon as your bankruptcy case is filed—applies to all bankruptcy cases, it is found in one of the earlier chapters of the code. It’s in chapter 3, section 362.

But the very first section of chapter 13—section 1301—also deals with the automatic stay, and adds another layer of protection that only applies to cases filed under Chapter 13.

The core of section 1301 states that once a Chapter 13 case is filed, “a creditor may not act, or commence or continue any civil action, to collect all or any part of a consumer debt of the debtor from any other individual that is liable on such debt with the debtor.”

This means that a creditor on a consumer debt, who is already stopped by the general automatic stay provisions of section 362 from doing anything to collect a debt directly from the debtor, is also stopped from collecting on the same debt from anybody else who is co-signed or otherwise also obligated to pay that debt.

If you think about it, that’s rather powerful. You are given the ability to protect somebody—often somebody your really care about—who is not filing bankruptcy and so is not even directly in front of the court. The person being protected may not even know that you are protecting them from the creditor.

This “co-debtor” protection does have some important conditions and limits:

1. It applies only to “consumer debts” (those “incurred by an individual primarily for a personal, family, or household purpose”).

2. For purposes of this code section, income tax debts are not considered “consumer debts.” So spouses on jointly filed tax returns or business associates with whom you share a tax liability are NOT protected.

3. This protection does not extend to those who “became liable on… such debt in the ordinary course of such individual’s business.”

4. Creditors can ask for and get permission to pursue the otherwise protected co-debtor to the extent that:

(a)  the co-debtor received the benefit of the loan or whatever “consideration” was provided by the creditor (instead of the person filing the bankruptcy), or

(b)  the Chapter 13 plan “proposes not to pay such claim.”

5. This co-debtor stay evaporates as soon as the Chapter 13 case is completed, or if it’s dismissed (such as for failure to make the plan payments), or converted into a Chapter 7 case.

Choosing between Chapter 7 and 13 often involves weighing a series of considerations. If you want to insulate a co-signer or someone liable on a debt with you from any adverse consequences of your bankruptcy case, that is one consideration that will likely push you in the Chapter 13 direction because of the co-debtor stay.

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Are You Eligible for Chapter 7? Chapter 13?

Eligibility can turn on 1) who is filing the bankruptcy, 2) the kinds and amounts of debts, 3) the amount of income, and 4) the amount of expenses.

1) Who is filing the bankruptcy:

If you are a human being (or a human being and his or her spouse), you can file either a Chapter 7 or 13 case.

If you are a part owner of a partnership or corporation, that partnership or corporation cannot file a Chapter 13 case. But it can file a Chapter 7 one. And it can do so whether or not you also file one individually.

2) The kinds and amounts of debts:

If you have “primarily consumer debts” (more than 50% by dollar amount), then you have to pass the “means test” to be allowed to be in a Chapter 7 case. (More about that below.)

Chapter 7 has no restriction on the amount of debt allowed. In contrast, Chapter 13 is restricted to cases with a maximum of $360,475 in unsecured debts and $1,081,400 in secured debts.

3) Amount of income:

The “means test” in Chapter 7 is quickly satisfied if your income is no more than the published “median income” for your family size and state.

Chapter 13 requires “regular income,” which is defined in somewhat circular fashion to be income “sufficiently stable and regular” to enable you to “make payments under a [Chapter 13] plan.” Also, if the income is less than the “median income” applicable to your family size and state, then the plan will generally last three years; if the income is at the applicable “median income” amount or more, the plan will last five years.

4) The amount of expenses:

In Chapter 7, if you are not below “median income,” then you enter into a largely mathematical test involving your expenses to see if you pass the “means test” and are eligible for filing a Chapter 7 case.

In Chapter 13, a similar calculation largely determines the amount you must pay monthly into your plan to satisfy the requirements of Chapter 13.

 

Choosing between Chapter 7 and 13 can often be very simple and obvious. But there are at least a dozen major differences among them, ones that you may well not be aware of. So when you come in to see me or another attorney, be clear about your goals but also open-minded about how to reach them. You may well have tools available that you were not aware of.

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Pre-Bankruptcy Tax Strategies

Get the maximum benefit from your bankruptcy against your taxes by following these sophisticated strategies.

Pre-bankruptcy planning to position a debtor in the best way for discharging or for otherwise favorably dealing with tax debts is one of the more complicated tasks handled by a bankruptcy attorney. Do NOT attempt these strategies, including the five mentioned here, without an attorney, indeed frankly without an attorney who focuses his or her law practice on bankruptcy. Elsewhere in this website I make clear that you cannot take anything in this website, including what I write in these blogs, as legal advice. That’s especially true in this very sophisticated area. Also, I could write a chapter in a book on each of these five strategies, so all I’m doing here is introducing you to them, to begin the discussion when you come in to see me.

1st:  Wait out the appropriate legal periods before the filing of your bankruptcy case.

As you may know from elsewhere in these blogs, most (but not all) forms of income tax become dischargeable after the passing of specific periods of time. Much of pre-bankruptcy tax strategy turns on figuring out precisely when each of your tax liabilities will become dischargeable, and then either waiting to file bankruptcy until all those liabilities are dischargeable, or, when under serious time pressure to file, at least when the maximum amount will be discharged as is possible under the circumstances.

2nd:  File past-due returns to start the clock running on those as soon as possible.

If you know you owe taxes for prior years and don’t have the money to pay them, your gut feeling may well be to avoid filing those tax returns in an attempt to “fly under the radar” as long as you can. But irrespective of any other rules, you cannot discharge a tax debt until two years after the pertinent tax return has been filed. Get good advice about how to deal with the IRS or other taxing authority during those two years so that you take appropriate steps to protect yourself and your assets. You deserve a rational basis for getting beyond your understandable fears about this.

3rd:  Try to stay in compliance with the new tax year(s) while you wait to file your bankruptcy case, by designating tax payments to the more recent tax years instead of older ones.

Because recent tax year tax liabilities cannot be discharged in a Chapter 7 case and must be paid in full as a priority debt in a Chapter 13 case, you want to try to stay current on your most recent tax debts. It’s also usually a necessary step in keeping the IRS and its ilk from taking aggressive action against you, thus allowing you to wait longer and discharge more taxes. With the IRS in particular you can and should explicitly designate which tax account any particular tax payments are to be applied to achieve this purpose.

4th:  Avoid tax fraud and evasion, and whenever possible, withholding taxes.

Simply put, you can’t ever discharge any taxes related to fraud, fraudulent tax returns, or tax evasion, so avoid these kinds of illegal behavior. If you have any doubt, talk to a knowledgeable tax accountant or attorney. Unpaid tax withholdings also cannot be discharged, so either try to avoid them from accruing, focus your resources on paying them off, or just recognize that they will either have to be paid after your Chapter 7 case or as a priority debt during your Chapter 13 case.

5th:  Be aware of tax liens.

Tax lien claims have to be paid in full in Chapter 13, with interest, and can survive a Chapter 7 discharge. So try to avoid having the taxing authority record a tax lien against you—admittedly sometimes easier said than done. Or if that is not possible, at least refrain from building up equity in possessions or real estate. That equity, although often exempt from the clutches of the bankruptcy trustee and most creditors, is still subject to a tax lien. So any built up equity just increases what you will have to pay to the taxing authority on debt you might otherwise been able to discharge completely.

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The Benefits of a “Short Tax Year Election” in an Asset Chapter 7 Case

Your Chapter 7 trustee can use your unneeded assets to pay current-year income taxes if you split the calendar tax year into two: the pre-bankruptcy and post-bankruptcy “short years.”

I’m closing this series on taxes and bankruptcy with three blogs on some relatively sophisticated topics. The tools I discuss do not apply to most cases. But when they do, they can save you a lot of amount of money, and better meet your goals. This first one is a good example.

Let’s first set the scene. If you have substantial income tax liabilities, especially if they are spread over a number of years, Chapter 13 is often the best tool for dealing with them. But a Chapter 13 takes three to five years. Sometimes a Chapter 7 case accomplishes enough so that it’s the better option. If your taxes are old enough and you meet a series of conditions (see my last blog about this), a Chapter 7 case could discharge (legally write off) most or all of your tax debts. But even if Chapter 7 would leave you with a significant nondischargeable tax debt, it might still make more sense as long as you could anticipate a reliable and manageable arrangement for satisfying that one last debt outside of bankruptcy. Getting in and out of bankruptcy in a matter of months instead of up to five years may be worth a lot to you.

The short year election could help just enough to make Chapter 7 a feasible option, and therefore the preferred option. That’s  because it can enable more of your nondischargeable taxes to be paid by the Chapter 7 trustee, leaving you owing less taxes at the completion of your bankruptcy case.

As I said in the first sentence of this blog, the short year election allows you to split your tax year into two tax portions, each of which is treated as its own tax year. The first “short year” covers from January 1 of that year to the day immediately before the filing of your Chapter 7 case, and the other “short year” is the rest of the year—from the date of filing your case until December 31.  

How can this possibly help? Two ways.

1. It allows any taxes you may owe for the short year before filing the Chapter 7 case to be a “priority” debt in your case, so that it can be paid from assets collected by the Chapter 7 trustee. This turns debt that would have been treated as incurred after the filing of the case, and thus wholly your obligation, into one that may be paid in whole or in part by the trustee. This can reduce or eliminate the current year tax debt, leaving you with either less or none to pay after your bankruptcy case is over.

2. It allows you to apply any loss carry forwards or credit carry forwards from the prior tax year to the income earned during that same pre-bankruptcy short year. The loss carry forwards reduce the tax for that short year, thus reducing any your potential tax debt owed after your case is finished. The credit carry forwards increase the tax for that short year, but that gives the trustee the opportunity to pay it if there are estate assets with which to do so. Each in their own way can increase the possibility that you will have less or no taxes to pay after your case is over.

The context that this works best in is a closed business or some other situation where the debtors have non-exempt assets that they do not mind surrendering to the trustee in return for a discharge of most of or all of the debts. Imagine a spouse who had been trying to run a business, and then had to close it down. The other spouse has a relatively high salary or other income but stopped paying withholdings or quarterly estimated taxes at the beginning of the year because of the lack of income from the other spouse closing down the business. By three-fourths of the way through the year, a substantial amount of tax liability could accrue. They may not be able to simply wait until after the end of the year because of pressure from creditors. The short year election allows the tax debt accrued through three-fourths of the year to be potentially paid by the trustee by liquidating the no longer needed business assets. The trustee may also have funds from other sources, such as preferential payments from a creditor or two.

So, through the benefit of the short year election, in the right circumstances the trustee could pay thousands of dollars of your nondischargeable tax debt by liquidating assets that you no longer need, instead of having this same money just going to your other creditors. And to the extent that the trustee would be getting some of that money through forced reimbursement of creditor’s preference payments, some of your taxes would be indirectly paid by those creditors. Not often that you can get somebody else to pay your taxes.

As I said at the beginning, the short year election is a tool which applies only limited cases, but when it does it can be extremely helpful.

 

NOTE: This election is available ONLY in asset Chapter 7 cases–not Chapter 13s or no-asset Chapter 7s.

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