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Chapter 13 Tames Your Income Tax Monster

A “straight” Chapter 7 can write off some income taxes. But if you owe recent taxes, or multiple years of taxes, Chapter 13 is usually a much better way to go. It often provides tremendous advantages over both Chapter 7 and dealing with the IRS on your own.

I’ll illustrate this with an example, and then explain it in my next blog.

Let’s say a husband and wife owe $35,000 in a combination of medical bills and credit cards, requiring monthly payments of $800. After the husband lost his long-time job back in 2006, he followed his dream of starting a business, which was starting to make progress when it got hammered in the Great Recession. He closed it in 2010 and found a reliable job a number of months later, although one where he earns 30% less than he did at the one lost years earlier. His business had generated some income, but barely enough for the couple to meet their bare essentials. So there was no money to pay the quarterly estimated taxes, and they had no money to pay the amount due when they filed their joint tax returns for 2006, 2007, 2008, 2009 and 2010. They expect to come out even for the 2011 tax year because of tax withholdings from their wages. To try to simplify the facts, assume they owe the IRS $4,000 in taxes, $750 in penalties, and $250 in interest for each of those five years. So their total IRS debt for those years is $25,000—including $20,000 in the original taxes, $3,750 in penalties, and $1,250 in interest. The wife has had consistent employment throughout this time, with pay raises only enough to keep up with inflation. They filed each of the tax returns in mid-April when they were due, and have been making modest payments when they have been able to, but those have not even been keeping up with the penalties and interest. Assume they have no secured debts—no mortgage or vehicle loans. They can realistically afford to pay about $500 a month to all of their creditors, not enough to pay their regular creditors much less the IRS.

Outside of bankruptcy, the IRS would likely require payment in full of the entire tax obligation, with interest and sometimes penalties continuing to accrue until everything was paid in full. Their payments would be imposed without regard to the other debts they owe. And if the couple failed to make their payments, the IRS would likely try to collect through garnishments and tax liens. Depending how long repayment would take, the couple could easily end up paying $30,000 or more with 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, especially if these other debts went to collections or lawsuits. That’s likely because the couple would be paying all available money to the IRS. So likely the couple would eventually end up paying at least $75,000 to their creditors.  

In a Chapter 13 case, the 2006 and 2007 taxes, interest and penalties would very likely be paid nothing and discharged at the end of the case. So would the penalties for 2008, 2009, and 2010. That takes care of $11,500 of the $25,000 present tax debt. The remaining $13,500 of taxes and interest for 2008, 2009, and 2010 would have to be paid as a “priority” debt, although without any additional interest or penalties once the Chapter 13 case is filed. Adding in some “administrative expenses” (the Chapter 13 trustee and our attorney fees), and 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 to ALL of their creditors—credit cards and medical, AND the IRS. Then after three years, they’d be 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 likely without any payment. So would the credit card and medical debts. After the three years, the couple would have paid a total of around $17,500 (including the “administrative expenses”), instead of about $75,000 without the Chapter 13. They’d be done instead of 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 necessities.

As I said, in my next blog I’ll explain how all this works.

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Four Hoops to Jump Through to Write Off Income Taxes in Bankruptcy

The conditions you have to meet to write off an income tax debt actually make sense. And understanding those conditions is a lot easier if you understand the sense behind them.

In my last blog I introduced the four conditions for discharging taxes in a Chapter 7 “straight bankruptcy,” and said I’d explain them in this blog today.

This is made easier by the fact that there is a single principle behind all four of these conditions: bankruptcy law believes that taxpayers who pretty much follow the tax laws should be able to write off their tax debts just like the rest of their other debts, after first giving the IRS (or other tax authority) a sensible amount of time to collect the taxes.

How long is this sensible amount of time? How much of an opportunity do the tax authorities have to collect before you can discharge the tax debt? Each of the four conditions measures this amount of time differently, based on 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. You must meet all four of these conditions, all four of these measures of time.

Taking them one at a time:

1) Three years since tax return due: Every income tax debt has a fixed point in time when its return had to be filed. That date is extended by a certain number of months if you asked for an extension, but it’s still a fixed point in time, one that can be easily ascertained. So this first condition gives the tax authorities three years to collect, three years from a fixed point not affected by your actions (the timing of filing the return) or their actions (audits, legal disputes).

2) Two years since tax return actually filed: In contrast, this is a time period triggered by your own action. Notice above when I stated the overall principle at work here, I said you must “pretty much” follow the tax law. Thus you can file a tax return late and still be able to discharge the debt if at least two years has passed since you filed the return.

3) 240 days since assessment: Assessment is the tax authority’s formal determination of your tax liability, usually by its review and acceptance of your tax return. Normally an income tax is assessed within a few weeks that it is received, so the 240 days since assessment usually passes way before the above three-year or two-year time periods. But the law has to account for the less common situations when assessment is delayed. So, when a tax is subject to a lengthy audit or litigation, or an “offer-in-compromise” (a taxpayer’s formal offer to settle), and the three-year and two-year periods have passed, the tax authority still has 240 days after assessment to chase that tax debt.

4) Fraudulent tax returns and tax evasion: This last condition essentially says that none of the above time periods are triggered at all if you are intentionally dishonest on your tax return or try to avoid paying the tax in some other way. If you are cheating on your taxes then the tax authority has no opportunity to collect the debt, so you cannot discharge the debt, no matter how old the tax is.

If your tax debt can jump through these four hoops, you should be able to discharge that tax in a Chapter 7 bankruptcy.

But what if you owe taxes which do not meet these four conditions? What if some of your taxes do but others do not? Or what if the IRS has recorded a tax lien? Or if a lot of the taxes came from operating a business, or are not income taxes but some other kind? I’ll tell you about these situations in my next blogs.

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Writing Off Income Taxes with a “Straight Bankruptcy”

You don’t always need to file a Chapter 13 case—with its 3-to-5-year payment plan–to deal with income tax debts. Thinking that you do is a myth, alongside the broader myth that “you can’t write off taxes in a bankruptcy.” Both have a kernel of truth, which is why they persist. It’s true: some taxes cannot be discharged (legally written off) in bankruptcy. But some can. And it’s true: Chapter 13 is often an excellent way to solve tax problems. But that does not necessarily mean it is the best for you. Instead Chapter 7 might be.

Chapter 13 tends to be the better tool if you owe a string of income tax debts including relatively recent ones. Why? Because in this situation Chapter 13 gives you the best of both worlds. 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. Second, if you have older back taxes, these are also wrapped into the Chapter 13 plan, often without you paying any more into your plan, then they are discharged at the end of your case.

But you DON’T NEED the best of both worlds if all or most of your income tax debts are dischargeable. Then Chapter 7, the straightforward “straight” bankruptcy is enough.

So, WHAT ARE the conditions for a specific income tax debt to be discharged in Chapter 7? How are you going to know if Chapter 7 will discharge all or most of your taxes so that it is the right option for you?

Some of the conditions for discharge of taxes are quite straightforward. Some are more complicated. And as you’ll see, some are even purposely vague. So unfortunately it’s not as simple as plugging a particular tax debt into a clear formula to see if it is dischargeable. Determining whether a particular tax debt will be discharged requires the careful judgment of an experienced attorney.

I’ll just list these conditions for discharging income taxes here, and then explain them in my next blog. Don’t be surprised if they sound confusing in this list. It’s true: anything having to do with taxes tends to be complicated!

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

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

2) Two 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 have filed a “fraudulent return” or “willfully attempted in any manner to evade or defeat such tax.”

You can see that these are begging for some clarification. For that please come back to read my next blog. Or else call to set up a consultation with me. If you have substantial tax debts, you should definitely get some thorough personal advice. Know your options so you can make an informed choice, about bankruptcy and otherwise.

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Taxes and Bankruptcy–Debunking a Hardy Myth

No wonder people think “bankruptcy can’t help me with my tax debt.” Even attorneys sometimes perpetuate the myth.

A few days ago I saw a video of a bankruptcy attorney being interviewed in what amounted to be an infomercial. He was asked by the interviewer whether there were some debts that can’t be “touched” in a bankruptcy:

Attorney: “Absolutely. Things like child support, alimony, uh, tax debts, student loans. Those generally aren’t dischargeable.”

Interviewer:  “So the government’s gonna help you eliminate some of the debt in a bankruptcy. But not the debt to them.”

Attorney: “Not theirs, of course!”

Lumping tax debts in with child support and alimony—which indeed cannot be legally written off, or discharged—is just plain wrong. For him to say that tax debts “generally aren’t dischargeable” while including it with other debts that are never dischargeable, or in the case of student loans very rarely dischargeable, is at best very confusing.

And no question, the merger of taxes and bankruptcy can be confusing, because each of these are rather complicated areas of law. Misinformation doesn’t help.

In my next few blogs, you’ll get some solid answers about what taxes can be discharged and what can’t. The fact is that bankruptcy can discharge taxes of many types and in many situations. Sometimes ALL of a taxpayer’s taxes can be discharged, or most of them. But there ARE significant limitations, which I will explain carefully.

But right now maybe the most important thing to understand is that even as to the particular taxes that may not be discharged, a bankruptcy still usually provides huge advantages in dealing with those taxes. So besides the possibility that you will be able to discharge some or all of your taxes, bankruptcy can also:

1. Keep the taxing authorities from garnishing your wages and bank accounts, and “levying on” (seizing) your personal and business assets.

2. Stop them from gaining greater leverage against you, through tax liens and piling on greater penalties and interest.

3. Avoid forcing you to pay them monthly payments based on totally unreasonable policies (such as giving no consideration to most of your other legal obligations), all the while penalties and interest continue to accrue.

Overall, bankruptcy gives you leverage against the IRS, or state or local taxing authority that you cannot get any other way. It gives you a lot more control over a very powerful class of creditors. And your tax problems are resolved as part of your whole financial package, so you don’t find yourself working hard to deal with your taxes while worrying about being blindsided by other creditors.

I’ll explain all this in my next blogs. Call me in the meantime if you can’t wait, or you know you shouldn’t wait. There is no kind of debt that needs more careful personal attention and advice than tax debts.

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Some Student Loan Borrowers Get Some Relief

Starting in 2012, about 1.6 million student loan borrowers will be able to make smaller monthly payments, and make less of these payments before the remaining balances are forgiven. On October 26, President Obama announced these improvements to the Income-Based Repayment Plan.

The changes are simple.

1. Monthly payments:  Under the Income-Based Repayment Plan, payments are capped “at an amount intended to be affordable based on your income and family size.” The payment amount has been 15% of your disposable income. It is now going down to 10% of disposable income. (Click on the above link for more details on how to determine your disposable income and payment amount.)

2. Repayment term:  The current 25-year repayment period is being shortened to 20 years.

Although 20 years is still a very long time, if your income is low enough the monthly payments can be very low, or even $0, meaning that you may not have to pay very much during those 20 years.

Unfortunately, this new improved Income-Based Repayment Plan only applies to people who 1) graduate in 2012 or later, 2) took out their first student loan no earlier than 2008, and 3) will be taking out at least one new federal student loan during 2012 or later. It’s clearly designed for current and future student loan borrowers.

But even if you don’t qualify for the 10%/20-year improved version, the older 15%/25-year Plan can also be very helpful—saving you money right away in your monthly budget, and also potentially saving a lot of money in your lifetime budget.

However, there ARE other limitations: none of this, including the Income-Based Repayment Plan, applies to private student loans. You need to contact your private lender to find out your options. And even if you do have a federal student loan, you cannot be in default on the loan to qualify for this Plan. To find out what type of student loans you have and their default status, go to the National Student Loan Data System for this and related information.

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Avoid the “Presumption of Fraud” for Using Credit Cards during the Holidays

Paying for the holidays with credit cards, even at a relatively modest amount, can mean that you will have to pay back those purchases if you file a bankruptcy. That could happen even if at the time you made those purchases you fully intended to repay that credit—in other words, even if you weren’t planning to file a bankruptcy.

The Bankruptcy Code contains some very specific rules about the consequences of using credit to buy “luxury goods or services” during the months before filing a bankruptcy.

If you use a credit card—or any other type of consumer credit—to buy at least $500 of consumer “luxury goods or services” through any single creditor within the 90 days before filing bankruptcy, there is a “presumption” that the debt incurred this way is nondischargeable—that it can’t be legally written off.

Don’t be fooled by the word “luxury” in that rule. That means anything not “reasonably necessary.” Arguably anything not used for survival in not “reasonably necessary.” So even modest Christmas and holiday gifts could be considered “luxuries” for this purpose.

Similar rules apply to the use of cash advances, except that the trigger dollar amount is $750 per creditor, and the period of time is within 70 days before filing bankruptcy, with the same “presumption” that the debt would not be dischargeable.

You may be thinking that these rules only create presumptions, which can be defeated. So that you can still discharge these kinds of debts by showing that you in fact you had every intention of paying them at the time you used the credit. Yes, that true, in theory but not likely in practice. First, coming up with that kind of evidence—proving your intent at some point of time in the past– is usually not easy. And second, and more important, the high cost to bring that kind of evidence to court usually makes trying to do so not worthwhile. Usually the amount of attorney fees it costs you to fight the issue is more than the amount being fought about.

What all this means that if during the holidays you use a credit card or other consumer credit exceeding these dollar limits, and then file bankruptcy within the applicable 70-day and 90-day periods, most likely you will still have to pay for whatever credit was incurred during those periods. You can avoid these presumptions by waiting to file the bankruptcy until after those periods of time have expired, but that’s not always possible. At best you’ll delay getting your bankruptcy filed, and so will delay the eventual resolution of your financial problems. And even if you wait, the creditor can still try to show your bad intention. Avoid all this by not using your credit cards and/or lines of credit whenever there is a sensible chance that you’ll have to file a bankruptcy in the near future.

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Pre-Holiday Warning about Credit Card Use for Gift-Giving

Especially if you’re thinking about filing bankruptcy, resist the urge to rack up a big credit card bill for Christmas and other holiday gifts.  Otherwise you may find your hands tied about what debts you can write off in bankruptcy or even when you can file your case. But before getting to these legal reasons, there are some more basic ones.

When money is tight, your anxiety about paying for gifts and for special meals clouds the holidays. If you have room on your credit cards, and very little disposable income, the temptation to use the credit cards is just about irresistible. We live in a rather materialistic culture, so when we express our love and affection through gifts we tend to let their price carry too much meaning. We feel that an expensive gift shows how close we are to someone. We also let the gifts we give, and their price, define us and our own worth. We’re no good if you can’t give our loved ones nice gifts. That’s especially true with our spouse or that someone special, and with our kids. If we can’t give our sweetheart something really special, if we don’t fill under the Christmas tree for our kids, then we feel like we are not a very good spouse, friend, or parent. We don’t want to disappoint them, and have them be disappointed in us.

This feeling may be especially intense if there is tension in the marriage, or within the household, often the case when there are intense financial pressures. It can be a vicious cycle.

In our hearts we know that the price of gift is not a true measure of the extent of our love, and certainly that gifts don’t buy love. To help you follow your wiser impulses, here are three suggestions.

First, give gifts appropriate to your financial circumstances, no matter how modest those gifts may be.  That is the only responsible way, and in fact shows your love—especially to family members—a lot more than if you gave gifts you could not afford.

Second, put the energy that you would put into fretting about how to pay for a relatively expensive gift instead into creatively thinking about an appropriately priced perfect gift. Come up with something that reflects the connection between the two of you, one that the person will enjoy but also shows that you really put your heart into it.  

Third, whenever possible communicate honestly with your loved ones about your financial constraints. This has to be done the right way, preserving your own dignity, and appropriate for the relationship—different for extended family, spouse, your children. Instead of being negative, it can be a constructive conversation about priorities, honesty, and what love is really all about.

I know, this is lots easier said than done.

To help motivate you, in my next blog I’ll give you some legal reasons why piling holiday charges onto your credit cards can tie your hands in ways you don’t expect.

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Avoiding Judgments that Can Really Hurt You, and Hurt Your Bankruptcy

Many judgments against you don’t matter once you file a bankruptcy. But certain ones are very dangerous. How can you tell the difference?

Letting a creditor get a judgment against you after it has sued you can sometimes result in that debt not being written off (“discharged”) in a later bankruptcy case. Or that debt may instead become much more difficult to discharge, even if eventually it is. But in the meantime it can turn an otherwise straightforward case into one much more complicated. 

So how can certain judgments make a debt not dischargeable? Because of a basic principle of law which says that once one court has decided an issue, another court must respect that decision. The theory is that litigants should only get to use court resources once to resolve a dispute. Once a court decides an issue, it’s been decided (except for the limited exception of appeals to a higher court).

But as I said, most judgments by creditors are NOT a problem in bankruptcy. That’s because most creditor lawsuits are about only one thing: whether the debt is legally owed. A judgment that establishes nothing more than that can generally be discharged in a subsequent bankruptcy.

The judgments that are dangerous are more complicated. They arise in lawsuits in which the creditor is alleging that the person owing the debt incurred it in some fraudulent or inappropriate way. If the judgment clearly establishes that’s what happened, then the bankruptcy court later has to accept that decision. If the wording of the lawsuit and judgment shows that the behavior was of the kind that the bankruptcy laws say results in the debt not being discharged, then without further litigation the bankruptcy court would rule the same way.

These cases can get complicated because often it’s not clear precisely what the previous lawsuit decided, or whether what was decided meshes closely enough with the dischargeablility rules of bankruptcy. There’s also the question whether the matter was “actually litigated” if the person against whom the judgment was entered did not appear to defend the lawsuit or did not have an attorney.  In other words you may or may not be able to get your day in bankruptcy court depending on whether in the eyes of the law you really already had your day in the prior court.

This risk of losing your chance to defend your case in bankruptcy court can be avoided by not waiting until after a judgment has been entered against you to see a bankruptcy attorney. That is especially true if the allegations against you involve any bad behavior other than not repaying the debt. As a general rule, if you get sued by any creditor you should see an attorney, even if you don’t plan on fighting the lawsuit and hiring an attorney for that purpose. That allows you to find out if the lawsuit could lead to a judgment making the debt not be dischargeable in a bankruptcy. And if so, you would then still have to option of filing the bankruptcy to prevent such a harmful judgment from being entered, instead of being stuck with it once you file a bankruptcy later.

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Preserve Your Ability to File Bankruptcy at the Time You Want

Sometimes the timing of your bankruptcy filing hardly matters, but other times it’s huge.  The three examples in this blog should convince you that you want to avoid being rushed to file your case because a creditor sued you earlier and is now garnishing your wages. Instead you want to preserve the ability to file bankruptcy at a time that is tactically the best for you.

1. Choosing between Chapter 7 and 13:  Being able to file a Chapter 7 generally requires you to pass the “means test.” This test largely turns on a very special definition of “income.” For many people, their “income” under that definition can change every month, sometime by quite a lot. This means that you may not qualify to file a Chapter 7 case one month but then do so the next month. Being able to delay filing your case means being able to file when you will pass the “means test,” or at least more likely would do so, and therefore not be forced to file a Chapter 13 case. This means usually finishing your case in three or four months instead of three to five years, and almost always saving many thousands of dollars.

2. Discharging—writing off—debts:  Getting certain debts discharged is harder if those debts were incurred within a certain amount of time before the filing of your bankruptcy case. So being able to delay the filing of your bankruptcy case makes it less likely the creditor on one of these debts would challenge your ability to discharge that debt. Or if such a creditor would still raise such a challenge, defeating it would be easier.  The amount at stake is the amount of that debt, plus often the creditor’s costs and attorney fees, and your own attorney’s fees.  Avoid or reduce the risk of continuing to owe that after your bankruptcy is over by avoiding getting creditor judgments against you.

3. Choosing property exemptions:  The possessions you are allowed to keep in a bankruptcy depend on which state’s exemption laws apply to your case. If you moved to your present state of residence within two years before your bankruptcy is filed, you will not be able to use that state’s exemptions but rather your former state’s. Especially if you are getting close to the two-year mark, having flexibility about when to file would allow you to pick whichever state’s exemptions were better for you. Otherwise, you may either lose an asset in a Chapter 7 case, have to pay the trustee to be able to keep it, or else even be compelled to file a Chapter 13 case to keep it.

You may sensibly ask: if you do get sued, what are you supposed to do to avoid getting a judgment against you, so that you’re not later rushed into filling bankruptcy at an unfavorable time?  The answer: see a bankruptcy attorney as soon as you get sued to figure out how to deal with that law suit and with your entire financial circumstances. The earlier you get advice, the more options you will have.

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Get a “Fresh Start” in Bankruptcy for Your Assets, Not Just Your Debts

Bankruptcy helps both sides of your balance sheet. Getting a financial fresh start means not just getting relieved of your debts, but also protecting your essential assets. You can preserve this crucial benefit of bankruptcy by not selling, using up, or borrowing against your protected assets BEFORE the filing of your bankruptcy case.

It is much more difficult to get your financial footing if you have nothing to stand on—if you don’t have at least basic housing, household goods, clothing, transportation, and, where appropriate, tools of trade, unemployment or disability benefits, and retirement savings.  

Bankruptcy usually protects most or all of your assets. On the one hand, Chapter 7 protects all “exempt” assets, so that a very high percentage of people who file under Chapter 7 lose nothing. And if you have assets which are worth more than the applicable exemptions, Chapter 13 usually protects those additional or higher-value assets as well.

But bankruptcy cannot protect what you’ve already squandered. It saddens me when just about every day new clients tell me how in the months or year or two before coming in to file bankruptcy they depleted their assets in a desperate attempt at avoiding bankruptcy. Most of the time, the assets they sold, spent, or borrowed against would have been completely protected had they filed bankruptcy while they still had them.

I recognize that it’s easy being a Monday morning quarterback—to say, after a client comes in needing to file bankruptcy, that they should not have used up assets in an effort to avoid filing. After all there undoubtedly are some people who were able avoid bankruptcy by selling their assets, and I don’t see them because they don’t need my services.

But I challenge you—if you are considering spending, selling, or borrowing against any of your assets, do you know whether that asset is one which would be protected in bankruptcy?

What concerns me are decisions with serious long-term consequences made without any legal advice about the alternatives. If a person in her 50s cashes in a substantial amount of a 401(k) retirement plan to pay creditors who would be written off, that can significantly harm the quality of her retirement lifetime.  Or if a husband and wife sell a free-and-clear vehicle that’s in good condition on the assumption that they’ll lose it once they file bankruptcy, only to be left with a single older vehicle that cannot reliably get them to work, that decision would lead to anything but a fresh start.

For a bunch of reasons, people tend to get legal advice when at the absolute end of their rope, well after these kinds of dangerous decisions have been made.  Let me help you avoid that. You have the capacity to get a better fresh start by getting the necessary advice on time in order to to preserve your assets.

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