Here’s an example of a Chapter 13 payment plan to pay income tax, showing how you pay what you can afford and avoid some interest, penalties.
Today we put the facts of last week’s blog post into a Chapter 13 plan, showing how it actually works. You’ll see how Chapter 13 saves you money and avoids stress as you pay off your priority income taxes.
The Example: The Tax, Interest, and Penalties
Assume you owe $10,000 to the IRS for income taxes from the 2016 tax year. That’s for the tax alone without the penalties and interest. Plus you owe interest of $1,200 (currently 5% annually), $2,000 for a failure-to-file penalty (which the IRS assesses at 5% per month of being late), and $1,650 for a failure-to-pay penalty (calculated at 0.5% per month). So including the current interest of $1,200 and a total of $3,650 in penalties this $10,000 tax has turned into a total debt to the IRS of $14,850. And the interest and failure-to-pay penalty just keep on accruing.
As we showed two weeks ago, this relatively recent $10,000 income tax itself can’t be discharged (written off) in bankruptcy. You’d have to figure out a way to pay it after completing a Chapter 7 “straight bankruptcy” case. In a Chapter 13 case you pay that amount through your court-approved payment plan.
The Tax and Interest vs. the Penalties
In either a Chapter 7 or Chapter 13 case the $1,200 in accrued interest has to be paid in full as well. The interest continues accruing nonstop during and after a Chapter 7 case. The difference is that interest effectively stops accruing under Chapter 13. You don’t have to pay any interest beyond the case filing date as long as you successfully complete your case.
The situation is usually the same with any penalties that accrue beyond the bankruptcy case filing date. Under Chapter 7 the penalties continue to accrue, during the case and after it’s completed. Penalties keep getting added on until the tax is paid in full. But under Chapter 13 the penalties generally stop accruing. This is true as long as the IRS did not record a lien on this specific tax before you filed the Chapter 13 case. (Prior-recorded tax liens create a number of complications that we don’t get into here.)
So, in a Chapter 7 case (or outside of bankruptcy altogether) you’d have to pay the full $14,850 of tax/interest/penalties. Plus the interest and penalties would continue to accrue until you finished paying off the entire debt. If you’d pay it off slowly in an extended monthly payment plan, the additional interest and penalties would be substantial. Conceivably you could end up paying around $20,000 for the $10,000 tax.
In contrast, in a Chapter 13 case you may only pay the $10,000 tax plus prior-accrued $1,200 of interest. Assuming no tax lien and a successfully completed 0% Chapter 13 case, you’d be paying about $11,200 instead of as much as $20,000. (In a 0% case there’s no money for the general unsecured debts.)
The Chapter 13 Plan
To keep this explanation as straightforward as possible, assume you owe this IRS tax debt and only other simple debts. That is, all your other debts are “general unsecured” ones. They are not secured—such as a vehicle loan, home mortgage, and a debt with any other collateral. They are not special, priority debts like unpaid child support or other recent tax debts. Chapter 13 is actually often very good at handling multiple secured and priority debts. In fact it’s often the very best tool if your situation is complicated with such other tough debts. But for the sake of this example we focus on how Chapter 13 handles this single income tax debt.
So assume you have a lot of medical bills, credit cards, and/or other general unsecured debts—say $90,000 total. Your prior accrued income tax penalties of $3,650 are also general unsecured debts, so now the total is $93,650. This plus the 2016 tax-plus-interest amount of $11,200 means you have just under $105,000 in debt. Here’s how a Chapter 13 plan with these debts could look like.
You and your bankruptcy lawyer would put together your monthly budget. Let’s say that after subtracting you and family’s reasonable living expenses from your monthly income, you’d have $385 per month left in “disposable income.” That would not even come close to paying monthly payments on your $105,000 or so of debt.
The Great Result Here
But this $385 amount would be enough—just enough—to pay off your IRS debt in full in just 3 years. $385 for 36 months is enough to pay off the $10,000 base tax, plus the $1,200 in already accrued interest. It would also pay a relatively modest amount of Chapter 13 trustee’s fees (generally a set percentage of whatever you pay into your payment plan) and your own attorney’s fees (whatever you didn’t pay before filing your case). The law usually allows (indeed requires) these “administrative costs” to get paid before the general unsecured debts receive anything.
So in this example $385 per month for 36 months would pay off the $11,200 priority portion of your tax debt. ($10,000 + $1,200.) But beyond that there would not be any money for the general unsecured debts. This means there would be nothing for the $3,850 in prior accrued tax penalties.
As a result all of your “disposable income” during the 3 years of the plan would go just to pay the tax and prior interest. (Plus the mandatory “administrative costs.”) Then after the 36th month of payments, your Chapter 13 plan would be finished. At that point all of your general unsecured debts would be legally discharged. This includes the $3,850 in prior tax penalties. In addition, the IRS would then wipe off its books any penalties and interest that would have accrued since the date of your Chapter 13 filing.
After only paying the $10,000 tax plus $1,200 in prior interest, you’d owe the IRS nothing. You’d also be free and clear of all the rest of your debts. After paying only as much as your budget allowed for 3 years, you’d have a completely fresh financial start.