If you owe a whole lot of income taxes, especially if you owe for multiple years, bankruptcy can get you tax debt free surprisingly fast.
Bankruptcy Can’t Help with Income Taxes, Right?
Let’s get this fallacy out of the way right away.
Fact: bankruptcy isn’t the solution to every serious income tax debt situation, but it IS the best solution in many such situations.
Filing bankruptcy can hugely help in a combination of ways. But here are the two main ones:
- Chapter 7 “straight bankruptcy” and Chapter 13 “adjustment of debts” can both discharge (legally write off) older income taxes.
- For newer income taxes that you can’t discharge, Chapter 13 protects you and gives you other significant advantages while you pay less than you would otherwise.
Let’s look at these two a step at a time.
Discharging Income Taxes—Under Chapter 7
If you owe a couple years of taxes, you may well be able to completely discharge that tax debt by filing a Chapter 7 case. That’s because those taxes could very well meet the legal requirements for discharge by the time the IRS and/or the state get aggressive about pursuing them, and/or by the time you go to see an attorney about them.
The two main requirements (there are others which are seldom applicable):
- The tax return for the tax at issue was due more than three years before the filing of the Chapter 7 bankruptcy case (after adding any pertinent tax return extension).
- The tax return for the tax at issue was submitted to the IRS or state tax authority more than two years before the filing of the Chapter 7 case.
So, for example, if you owed $10,000 for 2009 income tax, interest and penalties, plus another $12,000 for 2010 tax, interest and penalties, that $22,000 in taxes could be discharged by filing a simple Chapter 7 bankruptcy case any time after April 15, 2014. This assumes that the tax returns for these two years were filed on time on or before the due date of April 15 of the follow year.
This means that you would likely not owe a penny of that $22,000 just three or four months after filing your Chapter 7 case.
Discharging Income Taxes—Under Chapter 13
Under Chapter 13, this $22,000 would be put into the same pot as the rest of your “general unsecured” debts—credit cards, medical bills, other miscellaneous obligations—and only paid to the extent you could afford to do so during the course of the 3-to-5-year case. Often the addition of taxes to your other “general unsecured” debts does not increase the amount you pay—the same amount just gets split up differently among your creditors.
For example, assume that you owed $30,000 in other “general unsecured” debts, and during the course of your Chapter 13 plan you were paying a total of $10,000 towards all of your “general unsecured” debts (that amount being based on your court-approved budget). If you owed no taxes, you would be paying $10,000 of the $30,000, or about 33% of those debts.
But if you owed the $22,000 in taxes, adding that to the other $30,000 in “general unsecured” debts would total $52,000 in that pot. Here you would be paying $10,000 of the $52,000, or about 19% of those debts. Again, the fact that you owe that $22,000 in income taxes did not increase the amount you would pay into your Chapter 13 plan, just how it gets split up.
Paying Non-Dischargeable Income Taxes through Chapter 13
The taxes that do not meet the conditions for discharge can be paid under Chapter 13, with numerous advantages:
- Penalties and interest usually stop being added to the debt as of the date the Chapter 13 case is filed, over time substantially reducing the amount that you would otherwise have to pay.
- The IRS and state tax authorities are forbidden from taking any collection action throughout the course of the case, giving you peace of mind instantly and lasting for years until your case is finished.
- The tax authorities are also prevented from filing tax liens, preserving your assets and preventing those authorities from adding to their leverage.
- You can usually pay other important creditors ahead of or at the same time as the income taxes, such as your vehicle or mortgage payments or arrearage, to preserve that precious collateral, or a child support arrearage because of the importance of getting that caught up.
- Penalties accrued before filing the case are usually treated as “general unsecured” debts and paid only to the extent that you can afford to do so.
- The taxes that cannot be discharged do have to be paid in full, but often that merely reduces dollar for dollar what would otherwise have to be paid to other “general unsecured” creditors.
- If you owe older, dischargeable income taxes as well as newer taxes that cannot be discharged, the existence of the latter taxes often reduces how much, if any, you must pay of the former taxes.
For an example of the last two of these advantages, assume that your budget shows that you can afford to pay $500 per month to your creditors, or a total of $18,000 in a 36-month case. Assume further that you owe $22,000 in the older, dischargeable taxes plus $30,000 in other “general unsecured” debts as in the earlier example, plus another $6,000 for 2011 and $4,000 for 2012 which cannot be discharged.
If you owed NONE of these taxes, the $500 monthly payments totaling $18,000 would all go towards the $30,000 in other “general unsecured” debts, paying 60% of those debts (disregarding, for the sake of simplicity, trustee and attorney fees throughout these examples).
If you owed only that $30,000 in “general unsecured” debts plus the $22,000 in older, dischargeable taxes, that total of $52,000 would be paid about 35% ($18,000 divided by $52,000).
If you owed the $10,000 in newer taxes that could not be discharged ($6,000 + $4,000), that would be first paid in full, leaving only $8,000 to be divided among the $52,000 in total “general unsecured” debts, or paying them only about 15%.
Note that in all three of these scenarios, the amount you’d be paying would be the same, $500 per month for 36 months. The fact that you have taxes, either the older, dischargeable ones or the newer, nondischargeable ones, DOES NOT increase the amount you pay, it just reduces what gets paid on the older taxes and/or on the other “general unsecured” debts.
CAUTION: Under other facts, some of these advantages may not so significant, or may not even apply. Always, but especially with taxes, you need to have a competent and conscientious attorney review your own unique situation and advise you accordingly.