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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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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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Writing Off Income Taxes Forever through Bankruptcy

What income taxes can a Chapter 7 bankruptcy completely write off?

My last blog ended saying how Chapter 13 lets you pay off certain income taxes much more conveniently because you’re protected from the tax collector and can usually avoid paying substantial amounts of interest and penalties. But that’s for taxes you can’t write off. What exactly does it take to write off a tax completely?

It takes meeting four main conditions.

But before I list and describe these, I have to emphasize that this whole area—dealing with tax debts in bankruptcy—is a very complex one. I present the information in these blogs to you because the more you know the better. But part of being informed is knowing when you definitely need an attorney’s help. So, part of my job is to make very clear when you are in a particularly difficult area, when you truly need the help of someone who spends his or her professional life thoroughly understanding the complex rules, and constantly applying them in the real world. This is clearly one of those areas.

And now on to those four main conditions for writing off income taxes.  

1. Have three years passed since the tax return was due?

This one is pretty straightforward, because every income tax debt has a due date for the filing of its tax return. The important twist here: if you requested an extension of time—usually from April 15 to October 15—the three-year period does not begin until the extended due date.  

2. Have two years passed since the applicable tax return was actually filed?

It does not matter how ancient the tax if at least two years have not passed since the return was in fact filed. And a “substitute for return”—the common procedure in which the IRS in effect prepares a tax return on your behalf based on the (usually incomplete) information it has available—that doesn’t count as a filed return for this purpose.  

3. Have 240 days passed since assessment of the tax?

In most situations an income tax is assessed within a few weeks after you file it. Assessment is the tax authority’s formal determination of your tax liability, usually through its review and acceptance of your tax return. But sometimes the amount of tax is in dispute because of a tax audit or litigation about the amount. By the time the accurate tax amount is finally assessed, the above three-year or two-year time periods may have passed, but that tax cannot be written off unless that bankruptcy case is filed more than 240 days after the assessment. This 240-day period is also put on hold while a taxpayer’s “offer in compromise” is pending. Just like it sounds, that’s an offer to the IRS to settle the tax for less money or for specific payment terms.

4. Have you filed a fraudulent tax return or intentionally attempted to evade the tax?

Even if all the required time periods have passed, if you were dishonest on your tax return—such as not including some of your income or claiming invalid deductions–or tried to avoid paying a tax in some other way, that tax will not be written off in bankruptcy.

This discussion should give you a good idea whether any or all of your income tax debts can be written off in a bankruptcy. And in some cases applying these four conditions will give you the accurate answer. But there are some other considerations that can come into play. What if the IRS recorded a tax lien against your home and on your personal possessions?  How would a prior bankruptcy affect these timing rules? What about your appeal of a tax? What’s considered an honest mistake on a tax return instead of an intentional tax evasion? When can the taxing authority add a 30-day “tack-on” to the 240-day rule?

Bankruptcy can certainly write off income taxes under the right circumstances, but you need to have an experienced attorney review your personal situation to see if you truly meet those circumstances.

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Income Tax Refunds in Chapter 7 Bankruptcy

Can you keep your tax refund if you file a Chapter 7 case? It’s mostly a matter of timing.

 

Here are the bullet points:

  • Everything you own at the time your Chapter 7 bankruptcy case is filed becomes your “bankruptcy estate.” Usually, most or all of that “estate” stays in your possession and you get to keep because it’s “exempt,” or protected.
  • That “estate” includes not only your tangible, physical possessions, but also intangible ones—assets you own that you can’t physically touch—such as money owed and not yet paid to you.
  • Depending on the timing, a tax refund can be an intangible asset that becomes part of your bankruptcy estate. Then whether you can keep it or not depends on whether it is exempt.
  • Because an income tax refund usually consists of the overpayment of payroll withholdings, the full amount of that refund has accrued by the time of your last payroll withholding of that tax year. So even though nobody knows the amount of your refund until your tax return is prepared a few weeks or months later, for bankruptcy purposes it is all yours as of the very beginning of the next year.
  • So if you file a Chapter 7 case after the beginning of the following year and before you have received your tax refund, it is part of your bankruptcy estate and the trustee can keep it if it is not exempt, or can keep as much of it as it not exempt. That’s also true if you have received the refund and not done anything with it.
  • You can avoid this by filing your tax return and receiving and appropriately spending the refund before your Chapter 7 case is filed. DO NOT do this without very specific advice from your attorney. The bankruptcy system is very interested in what money you receive and precisely how you spend it before filing bankruptcy, and you can very easily get into trouble if this is not all done very carefully.
  • If the bankruptcy is filed so that the refund is an asset of the bankruptcy estate, whether or not it is exempt depends on how large it is and how much of an exemption is allowed in your state. In some cases, using all or part of an exemption for the tax refund may reduce the availability of the exemption for other assets.
  • Some states have specific exemptions applicable to certain parts of the tax refund, or laws that exclude them from the bankruptcy estate altogether, particularly regarding the Child Tax Credit or the Earned Income Tax Credit. These likely do not exist in a majority of the states, but it’s worth checking.  
  • Even if the refund, or a portion of it, is not exempt, the Chapter 7 trustee may still NOT claim it if he or she determines the amount is not enough to open an “asset case.” That is, the amount of refund to be collected is so small that the benefit of distributing it to the creditors is outweighed by the administrative cost involved. You might hear a phrase similar to the amount being “insufficient for a meaningful distribution to the creditors.” This threshold amount can vary from one court to another, indeed from one trustee to another, so be sure to discuss this with your attorney. But note that if the trustee is collecting any other assets, then most likely he or she will want every dollar of tax refunds that are not exempt.
  • There is a risk that you will not be able to claim an exemption if you don’t list the tax refund to which the exemption applies. So be sure to always list any tax refund to which you may be entitled.
  • Although I’m focusing on this issue now because we are in tax season, the same principles apply year-round. Frankly, it can be a little harder to wrap your brain around this as applied to, say, filing a bankruptcy in the middle of the year. As of July 1, you’ve had a half-year of tax withholdings deducted from your paychecks and forwarded by your employer to the taxing authorities. So, assuming the same amounts were withheld throughout the year, if you end up getting a substantial refund the following spring, for bankruptcy purposes about half of that had accrued by mid-year. So a bankruptcy filed on July 1, needs to take that into account. Some Chapter 7 trustees don’t push this issue much until the last quarter of the year, when that much more of the refunds have accrued. But regardless, tell your attorney about income tax refunds anticipated the following year, particularly if you have a history of relatively large tax refunds.

 

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Taxes in a Closed-Business Bankruptcy Case

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.  

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“Asset” and “No Asset” Closed-Business Chapter 7 Cases

When the sole proprietor of a just-closed business files a personal Chapter 7 bankruptcy case, the trustee may or may not have assets to liquidate and distribute to the creditors. If NOT, the case will more likely be finished faster. But if the trustee DOES collect some assets, the extra time may be worth it for the former business owner.  

If you’ve closed down your business and as a result are now personally liable on large debts that you cannot pay, you may well be wondering whether bankruptcy is your best option. Assuming that you qualify for a Chapter 7 “straight bankruptcy,” one important issue to consider is whether your case would likely be an “asset” or “no asset” one.  An “asset case” is one in which the Chapter 7 trustee collects assets from you to sell, and then distribute their proceeds to your creditors. A “no asset case” is one in which the trustee does not collect any assets from you because your assets are either protected by “exemptions” or are not worth the trustee’s efforts and expense to collect.

Generally a “no asset case” is simpler and quicker than an “asset case,” although not necessarily better. It’s simpler because it avoids the entire liquidation and distribution process. A simple “no asset case” can be completed about three months after it is filed (assuming other kinds of complication do not arise).  In contrast, it takes at least a number of additional months for a trustee to take possession of an asset, sell it in a fair and open manner with notice to all interested parties, give creditors the opportunity to file claims on the sale proceeds, object to any inappropriate claims, and then distribute the funds to the creditors.  Some assets—especially intangible ones such as a debtor’s disputed claims against a third party—can take several years for the trustee to negotiate and/or litigate in order to convert it into cash, with the bankruptcy case kept open throughout this time.

In spite of this seeming disadvantage, an “asset case” can be better for a former business owner in certain circumstances.

First, a business owner may decide to close down a business and file a bankruptcy quickly afterwards to hand over to the trustee the headaches of collecting and liquidating the remaining assets and paying the creditors in a fair and legally appropriate way. After fighting for a long time to try to save a business, the owner may well be emotionally spent and in no position to try to negotiate work-out terms with all the creditors. There is unlikely sufficient money available to pay an attorney to do this. And if there are relatively few assets compared to the amount of debts—the usual situation—it’s likely that after all that effort the former owner will still owe an impossible amount of debt.

And second, that former business owner may want his or her assets to go through the Chapter 7 liquidation process if the debts that the trustee will likely pay first are ones that the former business owner especially wants to be paid. The trustee pays creditors according to a legal list of priorities. Without going here into the details of that long priorities list, at the top of the list are child and spousal support arrearages. Also high on the list are certain employee wage, commission, and benefits claims, as well as certain tax claims. He or she may well feel a special responsibility to take care of the ex-spouse and children, former employees, and taxes. And the fact that he or she would likely continue being personally liable on these obligations after the bankruptcy is over undoubtedly adds some motivation.

A “no asset” personal Chapter 7 case can be a relatively quick and efficient way for a former sole proprietor to put the closed business legally into the past. While an “asset” case can take somewhat longer, it can help pay some of the special creditors you want to be paid anyway.

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