If you owe taxes on more than one tax year, Chapter 7 may discharge the older year(s) so can make low monthly payments on the rest.
Stopping the IRS and State Tax Authority Collections through Bankruptcy
If you owe income taxes and you are either currently being subjected to tax collection activities, or fear that you will be in the near future, you should consider the benefits of bankruptcy. The “automatic stay” imposed at the moment of the filing of your bankruptcy against all of your creditors—including the IRS and state tax creditors—will stop virtually all collection activities by the IRS and state tax authorities. Once your case is filed they cannot begin, and if they have, they must stop:
- sending you tax billing notices, or contacting you by phone or otherwise to collect the taxes you owe
- garnishing your paycheck or any of your sources of income, including contacting third parties who owe you money
- levying (seizing) anything—your home, vehicle, other possessions
- recording a tax lien on anything
- beginning any civil lawsuit or administrative proceeding against you for the purpose of collecting a tax you owe
By stopping or preventing these aggressive modes of tax collection, bankruptcy can be a powerful tool in your favor.
A 3-to-5-Year Chapter 13 Case May Not Be Necessary
If you owe taxes, you may have heard that Chapter 13 “adjustment of debts” is a particularly good way to go. This is often true, particularly if your tax debt is particularly large or spans a number of tax years. In the latter case Chapter 13 is particularly adept at dealing BOTH with older taxes that would be discharged (legally written off) under a Chapter 7 “straight bankruptcy” and with newer taxes that would not be discharged under Chapter 7.
But Chapter 13 has a number of disadvantages, so the decision between it and Chapter 7 should be made very carefully. It takes 3 to 5 years instead of the mere 3 to 4 months that the usual Chapter 7 takes. Usually you can’t really start rebuilding your credit for that much longer. And your financial life is tied up in various ways while you are in a Chapter 13 case, requiring you to potentially pay more to your creditors if you make more money during those years. Or if your finances worsen your case could be dismissed resulting in not discharging any of your debts (although there are usually alternatives to prevent that). Also, Chapter 13 usually costs 3 to 4 times as much in attorney fees, plus there is a trustee fee of usually around 5 to 10 percent of what you pay to your creditors through your payment plan.
So as a general rule of thumb, IF you can solve your debt problems—and your tax debt problems in particular—through the usually much quicker, cheaper, cleaner Chapter 7 process, you should do so.
When Chapter 7 Is Enough
You may not need all the ammunition that Chapter 13 can provide you in attacking your tax debts. If you find out that after filing a Chapter 7 case you would likely owe nothing but a relatively low amount of income taxes (plus maybe a manageable vehicle and/or mortgage payment), you could likely arrange to make reasonable monthly payments on that tax debt directly to the IRS or the state after completing your Chapter 7 case. You would have to pay ongoing interest and penalties—which usually stop accruing under Chapter 13, but those could easily be less than all the tangible and intangible costs of Chapter 13.
What is a “relatively low amount” of non-discharged income taxes that would justify a Chapter 7 filing? That truly depends on your circumstances. Practically speaking, it’s whatever amount that the tax authority will allow you to pay off in reasonable installment payments. This depends both on the reliability of your future income and expenses AND on the practices of the tax authority in determining the installment payment amounts.
If Your Income and Expenses Are Currently Steady But Unreliable in the Future
Chapter 13 is generally more flexible about future changes in your circumstances than the IRS or state tax authorities would be. You have the protection of the “automatic stay” throughout your case—as long as you fulfill what you are required to do, including initiating adjustments in your case as your circumstances change. So if your future income stream is unreliable, it may make sense to have the added protection of the bankruptcy process.
Calculating Your Likely Post-Chapter 7 Tax Installment Payment Amount
Assuming that you believe you could make payments to the IRS or state reliably after completing a Chapter 7 case, take the following two steps to determine how much you would have to pay per month. First, your bankruptcy attorney would make a careful assessment of the amount of tax debts that would survive a Chapter 7 case. Second, based on that and on your anticipated post-Chapter 7 budget, either that attorney or an appropriate tax accountant or tax attorney would make an estimate of the monthly payment amount the IRS and/or the state would likely be willing to accept on that tax debt.
There is more to life than taxes. That is, you may well have other reasons to file a Chapter 13 case than just your tax debts. You may be saving a home from foreclosure, stopping collections for child support arrearage, or reducing vehicle loan payments—all of which can be done much better under Chapter 13 than Chapter 7. So even if Chapter 7 would otherwise leave you in a decent position for paying off any remaining, these other reasons for being in Chapter 13 may well trump that.
The Bottom Line
If the reason you are considering Chapter 13 is your tax debts, particularly tax debts that won’t get discharged under Chapter 7, Chapter 13 may not be necessary if whatever taxes that would survive Chapter 7 could be paid off through reasonable monthly payments. The extra ongoing interest and penalties for paying by direct installment payments could be more than offset by all the costs and delays of Chapter 13.