Tax Season: File Chapter 7 Bankruptcy and Then Settle Your Income Tax Debt

Wasson and ThornhillIncome Taxes

What if you can’t write off all the income taxes you owe with a Chapter 7 case but can’t afford to pay those taxes in a Chapter 13 one?

 

Chapter 7 vs. Chapter 13?

If you owe an overwhelming amount of back income taxes, a common way of looking at your options is to ask whether all or most of those taxes meet the conditions for writing them off (“discharging” them) in a Chapter 7 “straight bankruptcy” case. Those conditions for discharge mostly involve how old the taxes owed are, and how long since the applicable tax returns were filed. If all or most of the taxes you owe CAN be discharged under Chapter 7, then file a Chapter 7 case. Otherwise file a Chapter 13 “adjustment of debts” case, in which you would have up to 5 years to pay the taxes that would not be discharged under Chapter 7.

But What If Neither of These Options Would Work?

First, what if a Chapter 7 case would leave a lot of income taxes not discharged, because the taxes you owe don’t meet the conditions for discharge?

If so, you may be able to wait until all or most of your tax debts meet those conditions, and file a Chapter 7 case only when they do. But that can take several years and you often can’t wait because of pressure by other creditors, or by the IRS or state themselves.

Or you may be able, immediately after your Chapter 7 case is finished, to make monthly payment arrangements with the IRS/state for paying off those nondischargeable taxes. (See the most recent blog post which discussed this option.) But this option only works if the discharge of your other debts in the bankruptcy case would ease your cash flow enough so that after its completion you could realistically afford to make consistent monthly tax payments. And those payments have to be at an amount that the IRS/state would accept and that would pay the remaining tax off within a reasonable period of time (so as to avoid accruing excessive interest and penalty charges).

Second, what if the usual other option—Chapter 13—does not solve the problem either?

Chapter 13 does provide many advantages for taking care of nondischargeable taxes, but in certain situations it may not do it well enough. Chapter 13 requires you to have reasonably consistent income—you may not. There are debt limits which you may exceed. Chapter 13 requires payment in full of all “priority” debts—including nondischargeable income taxes—during the life of the case, a maximum of 5 years. You may simply not have enough disposable income to pay into a Chapter 13 plan to be able to do that. Your tax debt may just be too much compared to what you can afford, especially if you have other mandatory obligations to pay—such as child or spousal support arrearage, a vehicle “cramdown,” or a mortgage arrearage. Even with up to 5 years to pay, there just may not be enough money.

What Then?

If you don’t foresee having enough spare cash flow after discharging your other debts through Chapter 7 to pay off any remaining taxes through monthly payments, and if you don’t anticipate being able to do so through Chapter 13, what then?. At that point your best option may be to file a Chapter 7 case, but then instead of entering into a monthly payment plan to pay off the remaining tax debt, make a formal offer with the IRS and/or the state to settle the remaining tax, usually for substantially less than you owe them.

How Do You Know Whether a Tax Settlement Offer Will Be Accepted?

You don’t for sure. There is more discretion involved on the part of the IRS/state with settlement offers than with, say, the monthly payment amount on an installment plan.

The basic settlement standard with the IRS (for example) is that “the amount offered represents the most we can expect to collect within a reasonable period of time.” Determining what that means in your situation, and so whether a particular offer will succeed, are delicate judgment calls for which you need the guidance of an experienced attorney or other tax professional. Ask your bankruptcy attorney whether he or she regularly negotiates IRS Offers in Compromise and/or tax settlements with the state. If not, get him or her to give you a referral to a tax attorney or accountant who does.

Conclusion

You are fortunate if you can discharge all or most of your tax debts through Chapter 7. Or if you can reasonably pay any nondischargeable tax debts through either a direct monthly payment plan or through Chapter 13. Most people who have relatively recent income tax debts which can’t be discharged resolve their situation one of these two ways. But if you don’t anticipate having the monthly cash flow for either of these, look into filing a Chapter 7 to take care of all your other debts and then try to settle the taxes with a much-reduced amount.