Chapter 13 is the most frequent bankruptcy used by people with tax debts. It is a debt payment plan, with a monthly payment to a court-appointed trustee. Chapter 13 bankruptcy repayment plans are for a minimum of three years and a maximum of five years. Here are six tax tips about Chapter 13:
1. Debts, including some taxes, may not have to be paid in full, in the discretion of the bankruptcy judge. The debts are referred to as "crammed down." To be discounted, taxes must be (a) income taxes; with (b) the returns due more than three years before filing and (c) taxes were assessed by the IRS at least 240 days ago.
2. To be crammed down, the IRS must not have recorded a lien (or there is no property for that lien to attach to). Example. The IRS has recorded a $50,000 tax lien against the debtor who files Chapter 13. Debtor owns $10,000 worth of household goods and furniture, and a car worth $5,000. So, the taxes are secured for $15,000, which may be paid at a discount, if the judge is convinced this is all Debtor has the ability to pay on a monthly basis.
3. If a tax return was due less than three years ago, or the taxes were assessed less than 240 days ago, or the taxes are not income taxes (such as for payroll), they are "priority" taxes. Priority taxes must be paid off in full through the plan. Nevertheless, Chapter 13 stops interest and penalties the moment it is filed.
By contrast, under an IRS Installment Agreement (IA), interest and penalties continue to run. So, paying $1,000 per month under an IA for $60,000 tax bill, leaves a balance of at least $30,000 after five years. The same payment in a Chapter 13 plan pays off the tax debt in full! In effect, Chapter 13 forces a repayment plan on the IRS. The IRS cannot get anything more than the bankruptcy judge approves.
The IRS cannot restart collection activities -- seizures of property or wages -- as long as a Chapter 13 plan is underway. This is a way to get around an unreasonable Revenue Officer who won't agree to a fair IA. In most Chapter 13 plans, the monthly amount paid to the IRS is less than the rejected IA proposal.
4. Tax penalties may be greatly reduced by the court. Even fraud penalties, never dischargeable in Chapter 7, might be cut down in Chapter 13.
5. Unfiled income taxes may be paid a fraction on the dollar. Though actual filing of tax returns more than two years ago is a requirement to discharge taxes in a Chapter 7, there is no "2- Year Rule" in Chapter 13.
6. Tax Liens are extinguished once the Chapter 13 plan has been completed.
To qualify for Chapter 13, the debtor must have a steady stream of income. It need not be wages -- Social Security, pension payments, and receipts of an independent contractor all qualify. Unsecured debts --credit cards, doctor bills, student loans, and taxes that have not been recorded as a lien-- cannot exceed $360,000. Secured debts--mortgages, car loans, or taxes for which a lien was recorded--cannot exceed $1,050,000..
The re-payment plan is submitted to the bankruptcy judge. A hearing is set for your creditors to come and object to your plan. The IRS rarely ever objects. The judge may make adjustments to the plan, before approving it. Then monthly payments are made to the court- appointed trustee, who in turn, pays the IRS and other creditors.
Combining Bankruptcy Chapters: "Chapter 20 & Chapter 26"
The law allows a tax debtor to file under more than one chapter in bankruptcy. Why would someone do that? Suppose the debtor file Chapter 7 to wipe out all their qualifying dischargeable taxes. When Chapter 7 is completed, some non-dischargeable taxes remain. The debtor could simply file Chapter 13 for a repayment plan to deal with the balance. Bankruptcy gurus tab this strategy: "Chapter 20" (7 + 13). This also stops interest and penalties.
Likewise, a "Chapter 26" may be a way to spread paying a tax debt over a longer period-- perhaps up to ten years. This means filing one Chapter 13 and completing it, and then filing a second Chapter 13 for remaining debts. If timed right, this can be accomplished before the IRS starts up collection again.
Dropping Out of a Chapter 13: If debtors fail to make all payments under a Chapter 13, interest and penalties on taxes are revived retroactively, as if they had never been in a Chapter 13. This can be quite a sum! While revived penalties can be paid at a discount in a subsequent Chapter 13, the old interest charges remain.
State Income Taxes and Bankruptcy
Generally, the rules are the same for state income taxes as they are for federal ones. The bankruptcy code only talks about "taxes" meeting the 3-year rule, 2-year rule, etc. However, there are three traps for the unwary:
1. Some states send out preliminary notices of state tax deficiencies. For example, the final date of assessment can be 60 days or more after the proposed additional assessment. This extends the waiting time to discharge a state income taxes to 300 days So, 60 days are added to the 240 day federal rule for qualifying state taxes for bankruptcy.
2. Some states require filing an Amended Return after an IRS audit assessment. The 3-Year Rule qualification for bankruptcy is measured from when this Amended Return was due, and the 2-Year Rule from when it was filed.
3. Most state sales taxes are not dischargeable in Chapter 7. In Chapter 13, they are treated as priority taxes to be paid in full.
Final Word to the Wise:
The bankruptcy courts are filled with folks who filed cases too early--and so didn't meet the various strict time rules. For instance, if the debtors file tax returns that were filed two years and 11 months before filing Chapter 7. Or, if taxes were assessed 239 days ago, they will be barred from filing a new Chapter 7 for six more years. It is not as bad with a Chapter 13 as you can simply drop out and refile after the waiting periods have run. But, in addition to the period spent in a prior bankruptcy, there is an additional six months waiting period.