Good Reason to Delay Filing Bankruptcy until Now: Pay Less Income Taxes in Your Chapter 13 Case

If you owe income taxes, with the right timing you may be able to pay less taxes and pay no more into your Chapter 13 case.

Our last blog post showed how smart timing in filing a Chapter 7 “straight bankruptcy” can result in the discharge—the legal write-off—of certain tax debts. But what if you need to file a Chapter 13 “adjustment of debts” instead? What benefits come from smart timing?

Income Taxes Under Chapter 7 vs. Chapter 13

In many situations Chapter 13 is a much better tool for handling income tax debts.

Chapter 7 can help in only two limited ways—1) by discharging older income taxes that meet a set of conditions; or 2) by discharging all or most of your other debts, so that you can afford to enter into an affordable payment plan to pay the taxes that can’t be discharged.

So Chapter 7 tends to be your best option either if all your income taxes can be discharged, or it those that can’t are small enough that they can be easily handled in a reasonable payment plan.

But what if you owe tax debts spanning a number of tax years, some of which meet the conditions for discharge and some of which don’t? Chapter 13 is particularly helpful in those situations.

Chapter 13 Handling Taxes That Can’t Be Discharged

You would use a Chapter 13 case to deal with income taxes that could not be discharged in a Chapter 7 case in three scenarios:

1. If the amount of such tax would be too large to pay directly to the IRS and/or state tax authority through a monthly payment plan.
2. If you need the much greater flexibility and other advantages of paying the tax through Chapter 13.
3. If you need to be in Chapter 13 for some other purpose—such as catching up on a home mortgage or back child support, doing a “cramdown” on your vehicle loan, or stripping a second mortgage—and need to handle your tax debts within the same Chapter 13 package.

Whichever of these reasons apply to you, paying nondischargeable income taxes through Chapter 13 has the following advantages:

1. Usually you pay no ongoing interest and penalties.
2. You pay the tax debt based on your own budget not the IRS’ or state’s payment requirements.
3. You can often pay other even higher priority debts ahead of the taxes—such as child and spousal support arrearage, mortgage or vehicle loan payments or arrearage.
4. If you have a tax lien recorded against your home and/or other assets, you protect them simply by paying a modest interest rate.
5. You are protected from ongoing collection efforts by the IRS and the state against you and your assets, including preventing the recording of future tax liens

But How Does Chapter 13 Handle Debts that Would Be Discharged Under Chapter 7?

That’s great to see how well Chapter 13 deals with newer taxes that can’t be discharged, but doesn’t that come at the cost of dealing not as well with older taxes that would simply get discharged in a Chapter 7 case? What if you have both kinds of taxes? Don’t the advantages of using Chapter 13 for your newer nondischargeable taxes get outweighed by the disadvantage of having to pay for part of your older taxes?

It’s true that under Chapter 13 those older income taxes that you could simply discharge and not pay a dime to under Chapter 7 are treated as “general unsecured” debts along with your credit card and medical debts and such. And those “general unsecured” debts must be paid as much as you are able to during the 3-to-5-year Chapter 13 case.

But because of how this all works in practice, most of the time you pay nothing more than you would otherwise as a result of those older dischargeable taxes.

First, in many situations, and in jurisdictions where this is allowed, you pay nothing to your “general unsecured” creditors because all the available money you have during the 3-to-5-year period is going to newer, nondischargeable taxes and to other debts that must be paid—such as vehicle loans and home mortgages, support arrears. This is referred to as a “zero percent” Chapter 13 plan—the “general unsecured” debts are paid nothing. Having more “general unsecured” debts with the addition of the dischargeable taxes has no effect on how much you must pay because 0 percent of the larger amount is still $0.

Second, in many other situations you do pay the “general unsecured” debts to some extent, but the amount you pay to ALL of such debts is fixed. So the increase in the amount in the pool of those debts (with the addition of the dischargeable taxes) does not change how much you have to pay. It just changes the mix of what debts are being paid out of the fixed amount you are paying, shifting some of what you are paying to the taxes and away from the other “general unsecured” debts.

So What Does Waiting Until a Tax Becomes Dischargeable Accomplish Under Chapter 13?

The effect is that a tax that otherwise would have to be paid in full (although without additional interest and penalties, and with all the other Chapter 13 advantages listed above), becomes treated like every other “general unsecured” debt, often paid nothing (in a “zero percent plan”) or resulting in paying no more into your Chapter 13 plan than if you did not owe that tax at all.

These positive results do not always happen. In rare cases you must pay all your creditors in full—including otherwise dischargeable older tax debts—or must pay your “general unsecured” creditors a relatively high percentage of what you owe them. Your attorney will analyze what kind of income tax debts you have and what practical impact any otherwise dischargeable taxes would have on your Chapter 13 case.

The primary point here is that if you owe both income taxes that could be discharged under Chapter 7 and those that couldn’t, Chapter 13 often lets you “have your cake and eat it, too”: it gives you great advantages in how you pay those newer taxes that you must pay, without needing to pay anything more as a result of owing the older taxes.