Chapter 7 “straight bankruptcy” can give some relief with income tax debt, but Chapter 13 can give so much more.
The last blog post showed how Chapter 7 can help you with your income tax debt, mostly by writing off older tax debts and most of your other debts so that you can financially concentrate on paying off your more recent taxes. A Chapter 7 case can discharge (write off forever) some tax debts, but only those in which at least three years have passed since that tax’s returns were due, AND you meet some other conditions. So if you owe a lot of taxes, and especially if you owe a number of years of taxes, Chapter 7 will often not give enough help. So what more can Chapter 13 “adjustment of debts” do?
Chapter 13 Rule of Thumb about Income Taxes
The rule of thumb about when you should seriously consider filing a Chapter 13 case is quite simple:
File a Chapter 13 case if Chapter 7 does not gain you enough cash flow to enable you to get caught up on your back and current taxes through manageable monthly payments to be made over a reasonable period of time. Otherwise file a Chapter 13 case, because you will need the extra protection provided only under Chapter 13.
What extra protection?
Short-Term Chapter 7 Protection
In a Chapter 7 case you are protected from the collection efforts of the IRS and state taxing authorities as soon as you file the case, but that protection ends in almost all cases about three or four months later. So if you have more recent income tax debts that are not discharged because they don’t meet the necessary conditions, you’ll have to arrange for and then make payments to the IRS/state while you’re not under any protection from their collection pressures.
That may not be a serious problem 1) if you address with the situation very proactively by contacting the IRS/state quickly, 2) if you can comfortably afford to pay the monthly payment that the IRS/state will require, 3) if you know that you will be able to pay that amount consistently until it’s paid off, and 4) if you do in fact succeed in paying perfectly until you pay it off.
But those conditions are difficult to meet for many people, especially those who owe a lot of taxes that can’t be discharged.
Chapter 13 Protection
In contrast to the short-term protection under Chapter 7, under Chapter 13 that protection from tax collections efforts continues throughout the whole 3-to-5-year length of the case. That’s protection you’ll need if you can only afford payments smaller than what the IRS/state wants, and/or you need more flexibly than the IRS/state would allow.
Under Chapter 13 you are generally allowed to pay other even more important creditors ahead of the IRS/state—such as mortgage arrearage, vehicle payments, and back child support. Plus you will generally not have to pay additional penalties and interest on the taxes, and may not have to pay all or most of the previous penalties. If the IRS/state has recorded a tax lien, you will have the opportunity to pay off that lien, usually under very favorable conditions, without the IRS/state being able to enforce that lien.
Chapter 13 even often allows you to adjust your monthly plan payments in advance based on anticipated seasonal adjustments in your income and expenses, and even change those payments mid-stream as your circumstances change.
You do need to act responsibly and proactively throughout the process, or you could lose this protection from the IRS/state, as well as from your other creditors.
Furthermore, if you can’t fulfill the terms of your proposed, negotiated, and court-approved Chapter 13 payment plan, so as a result you don’t finish your Chapter 13 case successfully, you will not get a discharge of ANY of your debts.
However, if your plan was put together sensibly and you comply with its terms, you would end your Chapter 13 case owing no taxes. And, other than long-term obligations you want to retain like your home mortgage, you would also be debt-free.