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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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