Income taxes that can and can’t be discharged and recorded tax liens…. Here are straightforward examples of how Chapter 13 can help with income tax debts.
Getting rid of income tax debt in bankruptcy is complicated, and you will need advice specific to your situation. It is best to be prepared to consult with an attorney by having the information you need handy – what years you owe for, how much you owe, and when the returns were filed / when it was determined that you owed. This blog focuses specifically on how Chapter 13 can help with income tax debts.
Personal Income Taxes that CAN’T Be “Discharged”
An income tax debt can be discharged—legally written off in bankruptcy—if it meets certain conditions. The two main conditions are time-based—1) more than 3 years must have passed since the tax return for the tax was DUE (including any extensions), AND 2) more than 2 years must have passed since the tax return was FILED with the IRS/state. (There are a couple other conditions, but they seldom apply.)
If these conditions are met and you file a Chapter 7 “straight bankruptcy” case, the tax debt is simply discharged—written off—no different than a credit card or medical bill. But if the conditions are not met, the tax debt continues to be owed in spite of the bankruptcy filing. If you owe a lot of relatively recent income taxes—those that would not be discharged in a Chapter 7 case—that would often be a good reason to consider filing a Chapter 13 case. That’s because under Chapter 13 you are protected from the IRS/state while you pay off the tax debt, based on your own budget, and usually without any ongoing interest and penalties. Sometimes, even if someone qualifies for Chapter 7, we put people in this situation in Chapter 13 because it gives them more financial relief.
Ken owes $5,000 personal income taxes for the 2010 tax year, $7,500 for 2011, $8,500 for 2012, and $4,000 for 2013, and $2,500 for 2014, a total of $22,500. He filed his tax returns for 2011 and 2012 one year ago, for 2013 on October 15, 2014, and will file for 2014 early in 2015. Ken also owes an overwhelming amount of other debts.
Because all the tax returns for his tax debts were filed less than 2 years ago, none would be discharged if he filed a Chapter 7 case. So Ken instead files a Chapter 13 case, enabling him to pay those taxes over 5 years while being protected from all collection activity by the IRS/state. He would pay the taxes based on his budget, including being allowed to pay certain other creditors ahead of the taxes (such as mortgage or child support arrearage). No more interest or penalties would be added during that time, reducing how much he’d have to pay to finish it off. The payments to the IRS/state could be changed to reflect future changes in his income and expenses.
Personal Income Taxes that CAN Be “Discharged”
If you owe an income tax that meets the conditions for discharge, a Chapter 7 case would usually discharge that tax altogether and would be the sensible option. But often a person who owes a tax that can be discharged also owes other (usually more recent) income taxes that can’t be discharged and so would be better handled through a Chapter 13 case. Or that person has other reasons to be filing Chapter 13, such as “stripping” a second mortgage on a home or a “cramdown” on a vehicle loan.
Chapter 13 usually handles dischargeable income taxes in a manageable way. Essentially, you only have to the extent, if at all, as your budget allows within the time you are in the Chapter 13 case. Then at the end of the case the unpaid portion is discharged.
In the above example with Ken, let’s say that in addition to the taxes referred to there, he also owed $6,000 for the 2009 tax year, for which he had filed the tax returns on time, on April 15, 2010. That tax is dischargeable since more than 3 years had passed since the tax return was due (April 15, 2010, or October 15, 2010 with an extension) and more than 2 years had passed since the tax return was in fact filed. The $6,000 is dischargeable.
Ken had decided to do a Chapter 13 case to deal with the more recent $22,500 in income taxes owed referred to above. Assume that for him to pay off that amount—even without any additional interest and penalties—would exhaust all of Ken’s disposable income over 5 years, leaving nothing available to pay towards the $6,000 owed for 2009 (and for the rest of his “general unsecured” debts). So, if everything went as expected Ken would pay nothing of that $6,000, and then would get a discharge of that entire amount at the end of his Chapter 13 case.
Personal Income Tax with a Recorded Tax Lien
A recorded tax lien turns an unsecured tax debt into a secured one, secured by whatever the particular tax lien covered, usually either all your real estate or all your personal property (everything other than real estate) – sometimes both.
If a tax lien is recorded on a tax debt that COULD otherwise be discharged in bankruptcy, and the tax lien attaches to whatever equity and/or value you have in the assets to which the lien attaches. That could turn a tax on which you’d not have to pay anything into one that you may have to pay in full, depending on the value of whatever the lien attaches to. Chapter 13 is a good way to take care of that portion of the debt covered by the tax lien because it provides a convenient, efficient and relatively favorable forum within which to value and pay it.
Continuing with our example above of Ken, let’s say that the IRS had recently recorded a tax lien on his home for the 2009 otherwise dischargeable income tax of $6,000, and that he had equity of only $1,000 in that home after any prior mortgage(s)/liens. If Ken filed a Chapter 7 case the IRS could apply the leverage of its tax lien on his home to require Ken to pay all or most of the $6,000 tax debt before it would release the lien.
In contrast, in a Chapter 13 plan Ken would propose to pay $1,000 (plus interest at the IRS’ relatively low current rate of 3%) over the life of the 5-year plan. If the IRS did not object and establish that there was more equity in his home than Ken said there was, that is what would happen. At the end of the case, the remaining 2009 tax debt would be forever discharged and the lien would be released.
If a tax lien is recorded on a tax debt that COULD NOT be discharged in bankruptcy, then that portion of the tax would simply be paid interest (with the IRS, again currently at the rate of 3%).
Back to our example:
Assume that the IRS had recorded a tax lien also on the 2010 tax, after the 2009 one. The 2010 tax could not be discharged but rather Ken had to pay in a Chapter 13 case, although usually without any ongoing interest and penalties. Because the 2009 tax lien exhausted the final $1,000 equity in his home, Ken’s Chapter 13 plan would show that there was no remaining equity in his home for this 2010 tax lien, and so he would propose to pay NO interest on the tax. As long as the IRS did not object and establish that there was indeed some equity in the home covered by the tax lien, Ken would pay no interest, and the tax debt would be paid as if there was no tax lien. Then at the end of his Chapter 13 case the IRS would release its tax lien on his home.
Yes, it’s a little complicated. You’ll want to talk to your attorney.