U. S. Bankruptcy Laws Took Very Long to Get Off the Ground

The Constitution empowered Congress to “pass uniform laws on the subject of bankruptcies,” which then took more than 100 years to do so.


  • The United State of America started its existence without a national bankruptcy law, and in fact without the ability to have one. The Continental Congress established the United States with its founding constitution consisting of the “Articles of Confederation and Perpetual Union,” drafted in 1776-1777. Not ratified by the 13 states until 1781, the Articles of Confederation did not provide for a nationwide bankruptcy system.
  • The American Revolutionary War ended in 1782, the U.S. Constitution was drafted in 1787 and was ratified by the states in 1789.  It did allow for, yet did not of itself create a national bankruptcy law. It merely empowered Congress to “pass uniform laws on the subject of bankruptcies”.
  • The Constitution may have thus empowered Congress, but Congress did not do a very good job at this for nearly half our nation’s history. Three different times during the 1800s, a federal bankruptcy law was passed in direct reaction to a financial “panic.” But these federal laws were each repealed after the financial crises were over.
  • During the long periods when there was no nationwide law in effect, the states developed a patchwork of bankruptcy and debtor-creditor laws. But these local laws became more and more cumbersome as commerce became ever more interstate.
  • Finally, Congress passed the Bankruptcy Act of 1898. This is the first one that was not quickly repealed, and lasted 80 years.  This law was inspired by commercial creditors, to help in the collection of debts. However, it included the following very important debtor-friendly provisions: most debts became dischargeable, and creditors no longer had to be paid a certain minimum percentage of their debts.
  • This Bankruptcy Act of 1898 was amended many times, significantly in 1938 in reaction to the Great Depression. Among other things that 1938 amendment added the “chapter XIII” wage earners’ plans, the predecessor to today’s Chapter 13s.
  • The 1978 Bankruptcy Reform Act, the result of a decade of study and debate, gave us the Bankruptcy Code. It has been amended every few years since then, most significantly in 2005 with BAPCPA, the so–called Bankruptcy Abuse Prevention and Consumer Protection Act. 
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The Truly Amazing History of Bankruptcy Law

Debtors’ prisons? There’s that and a lot more to the very colorful history of bankruptcy law.

 

American bankruptcy law naturally grew out of the law of England during our colonial history. Pre-Revolutionary War bankruptcy laws were extremely different from current law.

  • The first bankruptcy law in England was enacted more than 450 years ago during the reign of Henry VIII. Debtors were called “offenders” under this first law, in effect seen as perpetrators of a property crime against their creditors. The purpose of this law, and as expanded during the following hundred and fifty years, was not to give relief to debtors. Rather it was to provide to creditors a more effective way to collect against their debtors.
  • Given this purpose, it is not surprising that this first law did not give debtors a discharge—a legal write-off—of their debts. In a bankruptcy the assets of the “offender” were seized, sold, and the proceeds distributed to creditors. And then the creditors could still continue pursuing the “offender” for any remaining balance owed.
  • A bankruptcy proceeding could only be started by creditors, not by debtors.  Creditors accused a debtor of an “act of bankruptcy,” such as physically hiding from creditors, or hiding assets by transferring them to someone else.  The current extremely seldom used “involuntary bankruptcy” is a remnant of this.
  • Strangely, only merchants could file bankruptcy. Why? Credit was seen as immoral, with only merchants being allowed to use credit, for whom it was seen as a necessary evil. As the only ones who had access to credit, only merchants had the capacity to become bankrupt.
  • For the following century and a half through the late 1600s, Parliament made the law even stronger for creditors, allowing bankruptcy “commissioners” to break into the homes of “offenders” to seize their assets, put them into pillories (structures with holes for head and hands used for public shaming), and even cut off their ears.
  • Finally in the early 1700s the discharge of debts was permitted for cooperative debtors, but only if the creditors consented!
  • Yet the law still provided for the death penalty for fraudulent debtors (although it was very seldom used).
  • Cooperative debtors received an allowance from their own assets, the very early beginnings of the current Chapter 13 “adjustment of debts.”

So this was the English bankruptcy law that was largely in effect at the time that the U.S. Constitution was adopted. That gives some perspective on what the framers may have had in mind with the Bankruptcy Clause of the U. S. Constitution. That Clause gave Congress power to “pass uniform laws on the subject of bankruptcies.” Fortunately the language is so open-ended that it gave bankruptcy laws the opportunity to evolve during the last two hundred fifty years into one infinitely both more compassionate and beneficial for the economy.

But this evolution during our national history was extremely rocky, until surprisingly recently. That is the topic of the next blog. 

 

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A Sample Simple Save-Your-Business Chapter 13 Case

A business Chapter 13 case does not have to be complicated. Here’s how it can work.

 

It’s true that if you own a business that usually means you have a more complicated financial picture than someone punching a time clock or getting a regular salary. So usually if does take more time for an attorney to determine whether and how bankruptcy could help you and your business. But saving a business in the right circumstances can be relatively straightforward and extremely effective.

A good way to demonstrate this is by walking through a realistic Chapter 13 “adjustment of debts” case.

Jeremy’s Story

Jeremy, a single 32-year old, started a handyman business when he lost his job a little more than three years ago. He had ten years steady experience before that in construction and maintenance work. A hard worker and self-starter, he’d been itching to run his own business. He’d slowly accumulated the tools and equipment he needed, and had taken some courses at the local community college in small business management. He had decent credit at the time, owing nothing except his modest mortgage that he had never been late on plus about $2,800 spread out on a number of credit cards. Jeremy had always lived in the same area along with most of his extended family, so he had tons of contacts, and had a great reputation as a responsible guy who could fix anything. He had begun to accumulate some money to get him past the start-up of his business, but then his employer ran into financial problems and he was reluctantly laid off. So Jeremy decided to take the risk of starting his business in spite of having very little working capital. He had $8,500 of credit available on his credit cards if he got desperate.

His business started off slowly, partly because he didn’t have the cash to invest in advertising. But he was creative in setting up a website and using social media, and worked very hard building a customer base and a good business reputation. His income crept steadily upwards, but way too slowly. Over the course of the first year Jeremy maxed out his credit cards to keep current on his mortgage, feed himself, and keeps the lights on. But he simply didn’t have enough money to pay any estimated quarterly income taxes to the IRS, falling behind $3,500 to them that year.

Then during the second year of his business, Jeremy managed to keep current on the increased payments on his credit card debts but couldn’t pay them down any. Plus he fell behind another $6,000 in income taxes. Then recently, towards the end of his third year of business, after again failing to pay any estimated quarterly income taxes and falling another $4,500 behind, the IRS required him to start making $400 monthly payments on his $14,000 debt, plus to pay his estimated quarterly payments going forward. As a result he started not being able to keep current on his credit card payments, leading to ratcheted-up interest rates, pushing him over the credit limits and into the vicious cycle of large extra fees piling up. And now he’s missed two payments on his mortgage, putting him $3,000 in arrears.

In spite of all these distractions Jeremy’s business now has reasonably steady income, which continues to increase, slowly but quite consistently. His accumulated debt problems ARE taking a toll on his ability to focus on growing his business. In spite of this he still very much likes his work and being his own boss, and realistically believes he can keep increasing his income, especially as the economy improves. He very much wants to keep his business going.

But his creditors have him in an impossible situation. If he misses a payment, the IRS could levy on his business equipment or even garnish his business customers—requiring them to pay the IRS instead of him and trashing his very hard-won reputation. A couple credit cards creditors are sending their accounts to collection agencies. He not too far behind on his mortgage but still doesn’t see how he could catch up on even just two missed mortgage payments considering his other financial pressures.

The Chapter 13 Solution

If Jeremy met with an experienced business bankruptcy attorney, this is likely what the attorney would tell him that a Chapter 13 case would accomplish:

  • Cancel the $400 monthly payments to the IRS, giving him 5 years to pay that debt, with no additional ongoing interest or penalties during that whole time. This would significantly reduce the amount that he would need to pay each month and overall.
  • Stop all collection efforts by the credit card creditors and any collection agencies. They would only receive any money after Jeremy caught up on the house arrearage and paid off the income taxes, and then only to the extent that Jeremy’s budget would allow.
  • Immediately protect all his business and personal assets—tools and equipment, his business truck and/or personal vehicle, receivables owed by customers for prior work, and his business and personal bank and/or credit union accounts.
  • Enable Jeremy to concentrate on his business by greatly relieving his month-by-month financial burden, as well as save him a lot of money in the long run.
  • At the end of his 3-to-5 year Chapter 13 case, Jeremy will be current on his mortgage, he would owe nothing to the IRS, and he would have paid as much as he could afford on the credit cards, with any remaining amount discharged (legally written off).

 

As a result the business that he loves and in which he has invested so much hope and effort would be thriving and providing him a decent livelihood. 

 

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Some General Guidance about Business Bankruptcy

If your business needs bankruptcy relief, you have to start with basic questions about how your business was set up and its debt amount.

 

The Sole Proprietorship Business

The most straightforward business bankruptcies tend to be those in which the business is a sole proprietorship. Your business is operated through you, not through a separate formal business entity. In other words, you and the business are legally a single entity because you have NOT set up that business as a separate legal entity–a corporation or limited liability company (LLC), or a partnership. You operate it under your own name, or through an assumed business name but not a corporation, LLC, or partnership.

Other Forms of Business

But what if your business is not a simple sole proprietorship, but instead is in one of these separate legal entities, and you are contemplating bankruptcy relief (for either the business, you personally, or both)?

If so, if you have not already done so, you should quickly find and sit down with a competent business bankruptcy attorney.  There are advantages and disadvantages to every form of doing business. But one practical disadvantage of running your business as a corporation/LLC/partnership is that this can make things more complicated in the bankruptcy world. This CAN give you more flexibility—you can file a bankruptcy for yourself without directly filing for the business, and the other way around. But with more flexibility and more options come more complications.

The General Guidance

Beyond these initial points, here are some basic rules for background purposes. They will help you be a bit more prepared when you come to meet with me or another attorney.

1. A corporation, or LLC, or partnership cannot file a Chapter 13 “adjustment of debts.”

Only an “individual” can. This means that you and your sole proprietorship can together file a Chapter 13 case. And if your business is a corporation, LLC, or partnership, you (and your spouse) can file a personal Chapter 13 case to deal with your own liabilities, but that will almost never be adequate for dealing with the business’ own liabilities if you are trying to keep operating that business.

2. Chapter 13s are sometimes mislabeled “wage-earner plans,” but any source of “regular income” is allowed.” The requirement is simply “income sufficiently stable and regular to… make payments under a plan under Chapter 13.” So if your business income—combined with any other income—is even somewhat stable, you would likely qualify under this “regular income” requirement.

3.  But you and your sole proprietorship CAN’T file a Chapter 13 case if your total unsecured debt is $383,175 or more, or if your total secured debt is $1, 149,525 or more. (Note: these were adjusted for inflation as of April 1, 2013 and are valid for the following 3 years.) While these may seem like relatively high maximums, be aware that they include BOTH personal and business debts (since you are personally liable for all the debts of a sole proprietorship). Also the unsecured debt amounts can include less obvious ones such as the portions of your mortgages and other secured debts in excess of the value of the collateral. So a $750,000 debt secured by real estate now worth $550,000 adds $200,000 to the unsecured debt total. Also some debts—especially business ones—can be much higher than you’d expected, such as damages from the terminated lease of business premises, or resulting from business litigation. This can also be pertinent if your business is not a sole proprietorship, because you are likely personally liable for most or all of your corporation’s or LLC’s debts through personal guarantees and otherwise. Either way, add up your potential debts carefully before assuming that you can file a Chapter 13 case.

4. If your debt totals are above one of the above debt limits, you can still file a Chapter 7 “straight bankruptcy” case, but that is very seldom an effective way to keep a business operating. Chapter 7 tends to be a better option for cleaning up after a closed business, whatever its legal form.

5. If your debt totals are above one of the Chapter 13 debt limits and you are trying to save the business, one option is a Chapter 11 “business reorganization.” Also, a business corporation, LLC, or partnership can file a Chapter 11 case to keep the business afloat. The disadvantage of Chapter 11 is that it is a hugely more complicated repayment procedure than Chapter 13, and therefore many times more expensive. This, and the many times higher filing fee, plus significant ongoing court and U.S. Trustee fees, unfortunately makes Chapter 11 a practical solution in only limited small business situations. Bankruptcy courts have tried to address this shortcoming with streamlined “fast-track” Chapter 11s, but they are still often prohibitively expensive.

6. If you do end up filing a personal Chapter 7 case when owing substantial business debt, you may have the advantage of being exempt from qualifying under the “means test” (a test based on your income and allowed expenses) if your business debts are more than half of your total debts.

To repeat, if you are trying to save your financially struggling business, it is crucial to get competent business bankruptcy advice, and to do so just as soon as possible. You have no doubt been working extremely hard trying to keep your business alive. You very likely now need a solid game plan for using the bankruptcy and other laws to your advantage.

 

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Filing a Chapter 7 Case to Save Your Business

A Chapter 13 case is often the preferred way to keep a sole proprietorship business alive. But can a regular Chapter 7 one ever do the same?

 

In my last blog I said that “if you own an ongoing business… which you intend to keep operating, Chapter 7 may be a risky option.” Why? Because Chapter 7 is a “liquidating bankruptcy,” so the bankruptcy trustee could make you surrender any valuable components of your business, thereby jeopardizing the viability of the business. But this deserves further exploration.

Your Assets in a Chapter 7 Bankruptcy

When a Chapter 7 bankruptcy is filed, everything the debtor owns is considered to be part of the bankruptcy “estate.” A bankruptcy trustee oversees this estate. One of his or her primary tasks is to determine whether this estate has any assets worth collecting and distributing to creditors. Often there are no estate assets to collect and distribute because the debtor can protect, or “exempt,” certain categories and amounts of assets. The exempt assets continue to belong to the debtor and can’t be taken by the trustee for distribution to the creditors. The purpose of these “exemptions” is to let people filing bankruptcy keep a minimum amount of assets with which to begin their fresh financial start afterwards. In the vast majority of consumer Chapter 7 cases, the debtor can exempt everything in the estate, leaving nothing for the trustee to collect.  This is called a “no-asset” estate.

Business Assets in a Chapter 7 Case

If you own a sole proprietorship, are all the assets of that business exempt and protected? In other words, is the entire value of the business covered by exemptions, whether approaching the business as a “going concern” or broken up into its distinct assets.

Many very small businesses cannot be sold as an ongoing business because they are operated by and completely reliant for their survival on the services of its one or two owners.  In most such situations the business only has value when broken into its distinct assets.  So the Chapter 7 trustee must consider whether the debtor has exempted all of these business assets to put them out of the trustee’s reach.

The assets of a very small business may include tools and equipment, receivables (money owed by customers for goods or services previously provided), supplies, inventory, and cash on hand or in an account. Sometimes the business may also have some value in a brand name or trademark, a below-market lease, or perhaps in some other unusual asset.  

Whether a business’ assets are exempt depends on the nature and value of those assets, and on the particular exemptions that the law provides for them. For example, a very small business may truly own nothing more than a modest amount of office equipment and supplies, and/or receivables. In these situations the applicable state or federal “tool of trade” or “wildcard” exemptions may protect all the business assets. You need to work conscientiously with your attorney to make certain that all the assets are covered.

So it is possible for a business-owning debtor to have a no-asset Chapter 7 case, potentially allowing the business to pass through the case unscathed.

The Potential Liability Risks of the Business

However, there is an additional issue: will the trustee allow the business to continue to operate during the (usually) three-four months that a no-asset case is open or instead try to force the business to be shut down because of its potential liability risks for the trustee?

How could the Chapter 7 trustee be able to shut down the business? Recall that everything that a debtor owns, including his or her business, becomes part of the bankruptcy estate.  As the technical owner—even if only temporarily—of the business, the trustee becomes potentially liable for damages caused by the business while the Chapter 7 case is open. For example, if a debtor who is a roofing subcontractor drops a load of shingles on someone during the Chapter 7 case, the estate, and thus the trustee, may be liable for the injuries.

The main factors that come into play are whether the business has sufficient liability insurance, and the extent to which the business is of the type prone to generating liabilities. There’s a lot of room for the trustees’ discretion in such matters, so knowing the particular trustee’s inclinations can be very important. That’s one of many reasons why a debtor needs to be represented by an experienced and conscientious attorney who knows all of the trustees on the local Chapter 7 trustee panel and how they deal with this issue.

Conclusion

In many situations it IS risky to file a Chapter 7 case when you want to continue operating a business. You need to be confident that the business assets are exempt from the bankruptcy estate, and that in your situation the trustee will not require the closing of the business to avoid any potential business liability. 

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Bankruptcy: a Tool for Business Success

Bankruptcy doesn’t just clean up after the failure of a business. Bankruptcy can also prevent that failure in the first place.

 

General Motors: 2009 vs. 2013

When General Motors filed bankruptcy in 2009, it was insolvent: it owed about $173 billion and had assets of less than half that, about $82 billion. It was not able to pay its bills when they became due.

Through bankruptcy the business shed a significant amount of its debts, reduced its U.S. plants from 47 to 34 and its U.S. employees from 91,000 to 68,500.  It sold or closed the following vehicle brands: Hummer, Pontiac, Saturn, and Saab. In return for a $50 billion loan from the U.S. government, the nation’s taxpayers became 60.8% owners of G.M.

Now, four years later G.M. is profitable again. By the end of 2013 the government is expected to sell the last of its common stock in the company. According to the Center for Automotive Research, the rescue of the U.S. auto industry—including G.M.—saved 1.14 million jobs at automakers and other companies that rely on them.

If you own and operate a small business, maybe a bankruptcy could save that business, and your job in that business.

Your Business as a Sole Proprietorship

Practically speaking, your business is operated as a sole proprietorship if you did not create a corporation, limited liability (LLC), partnership, or any other kind of formal legal entity when you set up that business. You own and operate your business by yourself for yourself, although the business may have a formal or informal “assumed business name” or “DBA” (“doing business as”).

There are various advantages and disadvantages of operating your business this way. For our immediate purposes what’s important is that you and your business are legally treated as a single economic entity. That’s different than if your business operated as a corporation which would legally own its own assets and owe its own debts, distinct from you and any other shareholder(s). This blog post, and the next few on this broad topic of business bankruptcies, assumes that you operate your business as a sole proprietorship.

Chapter 7

Chapter 7, “straight bankruptcy,” or “liquidating bankruptcy,” allows you to “discharge” (legally write off) your debts in return for liquidation—surrendering your assets to the bankruptcy trustee in order to be sold and the proceeds distributed to your creditors. In most Chapter 7 cases you receive a discharge of your debts even though none of your assets are surrendered and liquidated, because everything you own is protected–“exempt.”

But if you own an ongoing business—again, a sole proprietorship—which you intend to keep operating, Chapter 7 may be a risky option. You and your attorney would need to determine if all your business’ assets would be exempt under the laws applicable to your state. Certain crucial assets of your business—perhaps its accounts receivable, customer list, business name, or favorable premises lease—may not be exempt, and thus subject to being taken by the trustee. Proceed very carefully to avoid having your business effectively shut down in this way.

Chapter 13

The Chapter 13 “adjustment of debts” bankruptcy option is generally better designed than Chapter 7 for ongoing sole proprietorship businesses. It provides much better mechanisms for retaining your personal and business assets. Even business (and personal) assets that are not “exempt” can usually be protected through a Chapter 13 plan.

You and your business get immediate relief from your creditors, usually along with a significant reduction in the amount of debt to be repaid.  So Chapter 13 helps both your immediate cash flow and the long-term prospects for the business. It is also an excellent way to deal with tax debts, often a major issue for struggling businesses. Overall, it allows you to continue operating your business while taking care of a streamlined set of debts.

Next…

In the next few blogs we will focus on some of the most important benefits of filing a business Chapter 13 case.

 

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Chapter 13 Handles Both Older and Newer Income Tax Debts

If you owe a few years of income taxes, Chapter 13 lets you write off those that can be, while giving you time to pay those that must be.

 

Our Example

The last blog post introduced an example of how Chapter 13 can be a particularly good way to handle income tax debts when you owe multiple years of taxes. In that example:

  • Without a bankruptcy, a couple would have to pay about $30,000 to the IRS for back taxes, plus about another $45,000 in medical bills and credit cards, a total of about $75,000. Given their modest income and resulting ability to pay these obligations only very slowly, this couple would almost certainly be subject to many years of collection efforts, lawsuits and garnishments until the obligations were paid off.
  • Under Chapter 13, this same couple would pay only about $18,000—36 months of $500 payments. That’s less than 1/4th of the above $75,000 amount—and substantially less than the taxes alone!. Furthermore, the couple’s monthly payments would be based on their ability to pay. During this payment period their creditors—including the IRS—would be prevented from taking any collection action against them.

How Does Chapter 13 Work to Save So Much on Taxes and Other Debts?

  • Tax debts that are old enough are grouped with the “general unsecured” debts—such as medical bills and credit cards. These are paid usually based on how much money there is left over after paying other more important debts. This means that often these older taxes are paid either nothing or only a few pennies on the dollar.
  • The more recent “priority” taxes DO have to be paid in full in a Chapter 13 case, along with interest accrued until the filing of the case. However: 1) penalties—which can be a significant portion of the debt—are treated like “general unsecured” debts and thus paid little or nothing, and 2) usually interest or penalties stop when the Chapter 13 is filed. These can significantly reduce the total amount that has to be paid.
  • “Priority” taxes—those more recent ones that do have to be paid in full—are all paid before anything is paid to the “general unsecured” debts—the medical bills, credit cards, older income taxes and such. In many cases this means that having these “priority” taxes to pay simply reduces the amount of money which would otherwise have been paid to those “general unsecured” creditors. As a result, in these situations having tax debt does not increase the amount that would have to be paid in a Chapter 13 case, which is after all based on what the debtors can afford. In our example, the couple pays $500 per month because that is what their budget allows. That’s the same amount they would have to pay even if they owed nothing to the IRS! The couple meets their obligations under Chapter 13 by having most of their plan payments go to the IRS recent tax debts, and likely nothing to their other creditors or older IRS debts.
  • The bankruptcy law that stops creditors from trying to collect their debts while a bankruptcy case is active—the “automatic stay”—is as effective stopping the IRS as any other creditor. The IRS can continue to do some very limited and sensible things like demand the filing of a tax return or conduct an audit, but it can’t use the aggressive collection tools that the law otherwise grants to it. Gaining relief from collection pressure from the IRS AND all the rest of the creditors is one of the biggest benefits of Chapter 13.

Deciding Between Chapter 7 and 13 for Income Taxes

If, unlike the example, all of the taxes were old enough to meet the conditions for discharging them under Chapter 7, there would be no need for a Chapter 13 case. On the other hand if more “priority” tax debts had to be paid than in the example, the debtors would have to pay more into their Chapter 13 plan, either through larger monthly payments or for a longer period of time.

There are definitely situations where it is a close call choosing between Chapter 7 or Chapter 13. And sometimes preparing an offer in compromise with the IRS—either instead of or together with a bankruptcy filing—is the best route. To decide which of these is best for you, you need the advice of an experienced bankruptcy attorney to help you make an informed decision and then to execute on it.  

 

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Chapter 13 Handles Tough Income Tax Debts

If you owe recent income taxes, or multiple years of taxes, Chapter 13 can provide huge advantages over Chapter 7, and over other options.

 

This blog post will illustrate this with an example, which will be more fully explained in my next blog.

The Example

Consider a husband and wife with the following scenario:

  • Husband lost his job in 2008, so he started a business, which, after a few promising years in which it generated some income, failed in late 2012.
  • The wife was consistently employed throughout this time, with pay raises only enough to keep up with inflation.
  • They did not have the money to pay the quarterly estimated taxes while husband’s business was in operation, and also could not pay the amount due when they filed their joint tax returns for 2008, 2009, 2010, 2011 and 2012. To simplify the facts, for each of those five years they owe the IRS $4,000 in taxes, $750 in penalties, and $250 in interest. So their total IRS debt for those years is $25,000—including $20,000 in the tax itself, $3,750 in penalties, and $1,250 in interest.
  • Husband found a reliable job six months ago, although earning 20% less than he did at the one he lost before he started his business.  
  • They filed every one of their joint tax returns in mid-April when they were due, and have been making modest payments on their tax balance when they have been able to.
  • They have no debts with collateral—no mortgage, no vehicle loans.
  • They owe $35,000 in medical bills and credit cards.
  • They can currently afford to pay about $500 a month to all of their creditors, which is not nearly enough to pay their regular creditors, and that’s before paying a dime to the IRS.
  • They are in big financial trouble.

Without Any Kind of Bankruptcy

  • If they tried to enter into an installment payment plan with the IRS, they would be required to pay the entire tax obligation, with interest and penalties continuing to accrue until all was paid in full.
  • The IRS monthly payment amount would be imposed likely without regard to the other debts they owe.
  • If the couple failed to make their payments, the IRS would try to collect through garnishments and tax liens.
  • Depending how long paying all these taxes would take, the couple could easily end up paying $30,000 to $35,000 with the additional interest and penalties.
  • This would be in addition to their $35,000 medical and credit card debts, which could easily increase to $45,000 or more when debts went to collections or lawsuits.
  • So the couple would eventually end up being forced to pay at least $75,000 to their creditors.

Under Chapter 13

  • The 2008 and 2009 taxes, interest and penalties would very likely be paid nothing and discharged at the end of the case. Same with the penalties for 2010, 2011, and 2012. That covers $11,500 of the $25,000 present tax debt.
  • The remaining $13,500 of taxes and interest for 2010, 2011, and 2012 would have to be paid as a “priority” debt, although without any additional interest or penalties once the Chapter 13 case is filed.
  • Assuming that their income qualified them for a three-year Chapter 13 plan, this couple would likely be allowed to pay about $500 per month for 36 months, or about $18,000, even though they owe many times that to all their creditors.
  • This would be enough to pay the $13,500 “priority” portion of the taxes and interest, plus the “administrative expenses” (the Chapter 13 trustee fees and your attorney fees).
  • Then after three years of payments, they’d be completely done. The “priority” portion of the IRS debt would have been paid in full, but the older IRS debt and all the penalties would be discharged (written off), likely without being paid anything. So would the credit card and medical debts.

After the three years, under Chapter 13 the couple would have paid a total of around $18,000, instead of eventually paying at least $75,000 without the Chapter 13 case. They’d be done—debt-free—instead of just barely starting to pay their mountain of debt. And they would have not spent the last three years worrying about IRS garnishments and tax liens, lawsuits and harassing phone calls, and the constant lack of money for necessary living expenses.

The next blog post will show how all this works.

 

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The Four Conditions for Writing Off Income Taxes in Bankruptcy

The conditions for writing off income tax debts actually make sense.

 

The last blog introduced the four conditions for discharging (legally writing off) taxes in bankruptcy. Here’s a fuller explanation of them.

The Core Principle Behind the Four Conditions

There is a simple principle behind all four of these conditions: under bankruptcy law taxpayers should be able to write off their tax debts just like the rest of their debts, AFTER the IRS (or other tax authority) has a reasonable length of time to try to collect those taxes.

What’s a reasonable length of time in the eyes of the law? How much of an opportunity do the tax authorities have to collect before you can discharge the tax debt?

The four conditions each measure this amount of time differently, based on the following:

1) when the tax return for the particular income tax was due,

2) when the tax return was actually filed,

3) when the tax was “assessed,” and

4) whether the tax return that was filed was honest and therefore reflected the right amount of tax debt when it was filed.

To discharge an income tax debt, it must meet all four of these conditions.

Here they are in order:

1) Three Years Since Tax Return Due:

All income taxes have a fixed due date for its return to be filed. That date may be delayed by a certain number of months if you asked for an extension, but it’s still a specific point in time. This first condition gives the tax authorities three years from the tax return filing date, or from the extended filing date if you asked for an extension. Note that this is fixed date, not affected by when you actually filed the return nor by what the tax authority did once it received the tax return.

2) Two Years Since Tax Return Actually Filed:

This second condition is different than the first because it is a time period triggered by your own action, your filing of the tax return.

Note that you can file a tax return late and still be able to discharge the debt if at least two years have passed since you filed the return. (Caution: there are some parts of the country where some court opinions have questioned this—be sure to talk with your attorney about the law in your jurisdiction.)

3) 240 Days Since Assessment:

This third condition can be a bit confusing. It very seldom comes into play—most tax debts meet this condition without any problem.

Assessment is the tax authority’s formal determination of your tax liability. It usually happens in a straightforward way, when it receives, processes, and accepts your tax return.

Most of the time an income tax is assessed within a few days or weeks that it is received. So the period of time of 240 days after assessment usually passes long before the above three-years-since-the-return-is-due or two-year-since-tax-return-filed time periods. But the law has to account for the less common situations when the assessment is delayed. These situations can involve a lengthy audit, or litigation, or an “offer-in-compromise” (a taxpayer’s formal offer to settle). In these kinds of situations the three-year and two-year periods may have passed before the official assessment of the tax, and so the tax authority still has 240 days once assessment is made to pursue that tax debt.

4) Fraudulent tax returns and tax evasion:

This last condition effectively means that the above time periods are not triggered at all if you are intentionally dishonest on your tax return or try to avoid paying the tax in some other way. In those situations the tax authority has no opportunity even to begin collecting the tax. So, if you don’t meet this condition, you cannot discharge the tax no matter how old it is.

If your tax debt meets these four hoops, you should be able to discharge that tax in either a Chapter 7 or Chapter 13 bankruptcy.

If You Don’t Meet These Conditions

But what if you owe taxes which do not meet these four conditions, and so can’t be discharged? What if some of your taxes can be discharged by meeting these conditions but some of them don’t? Or what if the IRS or the state tax authority has recorded a tax lien? What if your tax debt arises from your operation of a business? What if you owe not income taxes but some other type of tax? The next few blog posts will get into these questions. 

 

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You Can Write Off Some Income Taxes with a “Straight Bankruptcy”

Chapter 13 can be a great way to deal with tax debts. But you don’t always need it, or its 3-to-5-year payment plan.

 

Chapter 7 vs. 13 for Income Taxes

Thinking that the only way to handle your income tax debts in bankruptcy is through Chapter 13 is a misunderstanding of the law. It’s an angle on the broader error thinking that you can’t write off taxes in a bankruptcy.

Both are understandable mistakes.

It is true that some taxes cannot be discharged (legally written off) in bankruptcy. But some can be.

And it is true that Chapter 13 can be the best way to solve many income tax problems. But that does not necessarily mean it is the best for you. Chapter 7 might be instead.

When Chapter 13 Is Better

Chapter 13 tends to be the better option if you owe a string of income tax debts, and especially if some are relatively recent ones. That’s because in these situations Chapter 13 solves two huge problems in one package.

First, if you owe recent income taxes which cannot be discharged, you get lots of advantages under Chapter 13, including paying less by avoiding most penalties and interest. That can be a huge savings, especially if you can afford only relatively small payments. Indeed the amount you pay each month is based on what you can afford to pay. You can often even hold off on paying anything towards the back taxes while you first pay even more important debts—such as back child support, or home mortgage arrearage.

Second, if you have older back taxes, under Chapter 13 you pay these only to the extent that you can afford to do so after first paying your more recent taxes. Then whatever of these older taxes are not paid during your case are discharged at the end of it.

When Chapter 7 is Better

But you don’t need the Chapter 13 package if all or most of your income tax debts are dischargeable. In that situation, the generally much simpler Chapter 7 could be enough.

So, what makes an income tax debt dischargeable under Chapter 7?

The Conditions for Discharging Income Taxes

Some of the conditions for determining which taxes can be discharged are quite straightforward, but some are more complicated. It’s not as simple as applying a simple formula to any particular tax debt to see if it is dischargeable. Figuring out whether a particular tax debt will be discharged requires the careful judgment of an experienced attorney.

The conditions for discharging income taxes are listed here, and then will be explained in the next blog. As listed, they may well not make perfect sense, so make sure you see the next blog post.

To discharge an income tax debt in a Chapter 7 case, it must meet these conditions:

1) 3 years since tax return due: The tax return for the pertinent tax must have been due more than three years before you file your Chapter 7 case. Also, if you requested any extensions for filing the applicable tax returns, add that extra time to this three-year period.

2) 2 years since tax return actually filed: Regardless when the tax return was due, you must have filed at least two years before your bankruptcy is filed in court.

3) 240 days since “assessment”: The taxing authority must have assessed the tax more than 240 days before the bankruptcy filing.

4) Fraudulent tax returns and tax evasion: You cannot file a “fraudulent return” or “willfully attempt in any manner to evade or defeat such tax.”

These four conditions need clarification, which will be provided in the next blog post.

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