If you owe a lot of income taxes, you may have wondered whether bankruptcy can help you deal with this special kind of debt. There’s a good chance that you have misconceptions about whether and how it might help. Hopefully this list will help clear things up.
1. BANKRUPTCY CAN WRITE OFF (“DISCHARGE”) INCOME TAX DEBTS
Contrary to some misinformation, bankruptcy will permanently discharge an income tax debt as long as that tax meets a few conditions. Some of those conditions—such as the one involving tax fraud—don’t even apply to most people. The two main conditions that will apply simply relate to filing bankruptcy after waiting a certain amount of time after the pertinent tax return was due (3 years) and after the tax return was actually filed (2 years). Most of the time as long as those two timing conditions are met, the income tax is gone, no different that if it was a credit card debt or a medical bill.
2. EITHER CHAPTER 7 OR CHAPTER 13 WILL STOP A TAX GARNISHMENT OR LEVY
Similarly, the IRS and the California Franchise Tax Board (FTB) must comply with the “automatic stay” just like any other creditor or collector on a credit card or medical bill. The “automatic stay” is the provision in bankruptcy law which makes illegal for a creditor to take any further collection action against you or your assets from the moment your bankruptcy is filed. So a taxing authority must stop any ongoing garnishment or enforcement process, and can’t begin one it had not yet started.
There are some modest and sensible exceptions that apply only to taxing authorities, who can send you a demand to file a tax return and can do an audit to determine your tax debt amount—but once that amount is known cannot do anything to collect on that amount.
That protection against tax collection generally lasts as long as the bankruptcy case lasts, generally about 3 to 4 months in a Chapter 7 case and about 3 to 5 years in a Chapter 13 one.
3. INCOME TAXES THAT DON’T QUALIFY FOR DISCHARGE CAN BE PAID ON VERY FLEXIBLE TERMS UNDER CHAPTER 13
Instead of being stuck with the payment requirements that the IRS and FTB impose on you if you deal directly with them, under Chapter 13 you pay a single monthly payment to the pool of ALL of your creditors (although you might pay certain special debts directly, like a home mortgage or vehicle loan). The amount of that single Chapter 13 plan monthly payment is determined primarily by how much you can afford to pay. And those income taxes that you have to pay are paid out of that single monthly payment.
Such taxes are “priority” debts, meaning they have to be paid in full before you can finish your Chapter 13 case. But other “priority” debts (such as child support arrears), and especially secured debts (such as a home mortgage or vehicle loan) can be paid simultaneously or often even ahead of the taxes. And if your circumstances change so that the payments to the IRS/FTB have to change, those taxing authorities don’t have much grounds to complain as long as you go through the appropriate procedures to adjust your plan payments consistent with your changed finances. This kind of payment flexibility can make dealing with your tax debts much more peaceful and manageable.
4. THE “AUTOMATIC STAY” PROTECTS YOU FROM THE IRS/STATE THROUGHOUT THE 3-TO-5 YEARS OF A CHAPTER 13 CASE
Chapter 13 forces the IRS/FTB to be patient because the “automatic stay” prevents most collection action against you and everything you own from the beginning to the end of a 3-to-5-year case.
The “priority” tax debts, those (usually newer taxes) that could not be discharged in a Chapter 7 case, as stated above do have to be paid in full, but can essentially be paid any time during that multi-year period. The other tax debts, those that could not be discharged in a Chapter 7 case, are treated like other “general unsecured” debts, and so only have to be paid if and to the extent there is any money available in your budget to do so within that same period of time. As to these (usually older) taxes, as long as you follow the appropriate procedures there is not much that the IRS/FTB can do other than wait to see whether and how much they will get paid.
5. TAX LIENS CAN BE RELEASED EITHER WITHOUT PAYMENT OR WITH LESS MONEY THROUGH CHAPTER 13
Outside of Chapter 13, recorded tax liens give the IRS/FTB a great amount of leverage and power over you and the assets they attach to, like your home, vehicle, business equipment, etc. But Chapter 13 in particular provides a very good procedure to get a tax lien released either without payment at all or after paying no more than the fair value of the lien.
The way this works is that you and your attorney propose, through the terms of your Chapter 13 plan, the dollar value of the asset(s) to which the tax lien is attached. Then the taxing authority has the burden of objecting and coming up with its own amount that it thinks the lien is worth. But as long as you are fair in your proposal, the taxing authorities do not tend to object. And even if they do, there’s a bankruptcy judge already on the case ready to force a speedy and just resolution of the amount to be paid. So the IRS/FTB can’t hold your assets for ransom, forcing you to pay more to get them to release the lien.
For example, if a tax lien was recorded against your home but you have no equity in it, you can get a bankruptcy court determination that the tax lien attaches to nothing and is thus worthless. That way you get the lien released without paying anything to do so. Or if the lien does attach to something you own but it’s not worth much, you won’t have to pay much to get the lien released.
6. IF YOU WOULD OWE SOME TAXES AFTER FILING A CHAPTER 7 CASE IT MAY STILL BE THE BEST OPTION IF YOU CAN AFFORD THE MONTHLY PAYMENTS TO PAY OFF THOSE TAXES
The IRS in particular has a quite user-friendly and time-generous payment program for past due taxes—as long as you qualify for it based on how much you owe and some other conditions. If the taxes you owe that can’t be discharged are relatively small, or at least small enough so that you can genuinely afford to pay the required monthly payment that the IRS/FTB would require, you should seriously consider filing a Chapter 7 case instead of a Chapter 13 one. It’s usually a much simpler procedure, and takes a few months instead of a few years. It can definitely make sense to quickly get rid of all of your other debts—maybe including some of your older tax debts—so that you owe nothing except an affordable tax debt then paid directly to the IRS/FTB, instead of filing a Chapter 13 case.
But keep in mind that just because you could afford the monthly tax payment does not necessarily mean that’s the best way to go. If the payments are stretched out over a long period the tax interest and penalties could add up to a large amount—and interest and penalties do not usually accrue in a Chapter 13 case (as long as you finish it successfully). Also, if you anticipate needing future payment flexibility—because of concerns about your future income and expenses—you may benefit from the often greater ability to adjust for income and expense changes in a Chapter 13 compared to dealing directly with the tax authorities.
7. IF A CHAPTER 7 CASE WOULD LEAVE YOU OWING MORE TAXES THAN YOU COULD AFFORD TO PAY DIRECTLY, CHAPTER 13 MAY HANDLE THOSE TAXES BETTER
The crucial question is whether the tax debt that would survive a Chapter 7 case would be affordable or not, and would pay the tax within a reasonable time. Your attorney will tell you which of your taxes would not get discharged and thus would have to be paid. And your attorney—or the IRS/FTB itself—can tell you whether you would qualify for and what your monthly payment would be on an installment plan. By carefully looking at your after-bankruptcy budget you should be able to tell how comfortably you would be able to make the monthly tax payment, and how long you would have to make those payments.
If you wouldn’t be able to afford the monthly tax payments after completing a Chapter 7 case, and/or if some of the advantages of Chapter 13 in this list apply to you (or any of the many other advantages beyond taxes), look closely at Chapter 13. The rough rule of thumb is to file a Chapter 7 case if you don’t need the advantages of Chapter 13, and file a Chapter 13 case if you do.
8. SET YOURSELF UP FOR A TAX SETTLEMENT OR UNCOLLECTABLE STATUS BY DISCHARGING YOUR OTHER DEBTS AND MAYBE PART OF YOUR TAXES THROUGH CHAPTER 7
So what if you have a significant amount of tax debt that won’t get discharged in a Chapter 7 bankruptcy, way more than you can afford to pay in monthly payments directly to the IRS/FTB once your Chapter 7 case is finished, but you also aren’t a good candidate for a Chapter 13 payment plan? You might be able to file a Chapter 7 case and then negotiate a settlement of that remaining tax debt for significantly less than you owe. And in the right circumstances the IRS and FTB do accept the reality that you simply don’t have the ability, now or in the foreseeable future, to pay the taxes you owe. So you may be put into a temporary or permanent uncollectible status.
It’s crucial for you to get highly experienced advice about this, because predicting whether an IRS Offer in Compromise or settlement with the California Franchise Tax Board will get approved can often be a delicate judgment call. Same with predicting whether you would get assigned to uncollectable status. These require an attorney or accountant well-versed in this specific kind of work.
9. KEEP OPERATING YOUR BUSINESS PROTECTED FROM THE IRS/STATE WHILE YOU CATCH UP ON LATE EMPLOYEE WITHHOLDING AND OTHER TAXES
If you now have or in the past had an employee and are behind on employee withholding taxes, the IRS/FTB tend to very aggressive about the collection of these taxes. They are called “trust fund taxes” because employers are supposed to take these funds out of an employee’s wages and hold them “in trust” for the taxing authorities and transfer them regularly to them.
Unlike income taxes, withholding taxes can never be discharged in bankruptcy. But, just like more recent income taxes that also can’t be discharged, withholding taxes CAN be paid over time in a Chapter 13 “adjustment of debts” payment plan, during which time you and your sole proprietorship business are continuously protected from the IRS/FTB by the “automatic stay.”
Be aware that the “automatic stay” only simultaneously protects your business and business assets as well as your personal ones under Chapter 13 if you operate your business as a sole proprietorship, not a corporation, limited liability company, or such. That’s because generally the protection of the “automatic stay” only extends to the person or entity filing the bankruptcy case. A business run under your own name or merely under an assumed business name is not a separate legal person from you, as would be a business operated as a corporation/limited liability company. So your personal Chapter 13 filing enables you to pay both your personal and business tax liabilities while under bankruptcy court protection of both you and your business.
10. DISCHARGE MORE TAX DEBT THROUGH WISE PRE-BANKRUPTCY PLANNING
The nature of the conditions which must be met in order to discharge (write off) an income tax debt means that you can usually discharge more of your taxes by correctly timing your bankruptcy filing. So waiting to file bankruptcy until more of or all of your taxes can be discharged is often worthwhile.
But in the real world waiting long enough can be very delicate. First, there’s the reality that other creditors put pressure on you to file bankruptcy sooner—whether you are paying creditors to keep them happy or because they are forcing payment by suing and garnishing your paychecks and such. The money going to other creditors before filing—which would be avoided by filing earlier—has to be weighed against the benefit of discharging more tax debts.
Second, you have to have a very carefully thought out and researched game plan before proceeding with it. You don’t want to go through the risks and costs of delaying filing bankruptcy only to find out that you could not discharge a tax that you were expecting to. As you wait to file you will likely be under pressure from other creditors, as well as likely from the IRS and/or the FTB, and you may need the help of an attorney to avoid being forced to file earlier than you’d planned. And finally, you may well also need to reassess your game plan as your circumstances evolve.
To state expressly what should be obvious, this kind of maneuvering to take advantage of the bankruptcy laws requires ongoing competent legal advice.
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Orange County and Riverside bankruptcy attorney Norma Duenas has represented more than 3,000 individuals and couples in filing for Chapter 7 and Chapter 13 bankruptcy. Her focus is on ensuring that clients understand how bankruptcy works and whether it is the right option for their unique financial circumstances.
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