The issue of unpaid taxes turns the government into an insidious creature that prevents a taxpayer from getting on with his or her life. Income tax debt comes with penalties as well as accruing interest, the possibility of tax liens and wage garnishments, plus untold years of headaches.
Thankfully, Chapter 13 bankruptcy may offer relief from tax debt collections. It’s almost comical, how the government (U.S. Bankruptcy Court) can help save you from the government (Internal Revenue Service and state taxing authorities).
Here’s how it works.
Overview of Chapter 13 Bankruptcy
Chapter 13 is a personal reorganization. In Chapter 13 bankruptcy the taxpayer-debtor is responsible for proposing a repayment plan. Once the Plan is approved by the court, it is binding on all creditors. That means creditors (including the taxing authorities) don’t get the opportunity to object once the court formally approves the Plan.
Under Chapter 13 bankruptcy, the proposed plan provides for repayment of all or a portion of debts. The amount paid is based on means testing, which dictates the length of the payment plan as well as the amount of money to be paid each month.
The Test For Getting A Chapter 13 Plan Approved
In order for a Chapter 13 Plan to be approved by the court, it must meet certain tests:
- The Plan must give creditors at least what they would have gotten had the case been filed as a Chapter 7 liquidation bankruptcy;
- The Chapter 13 Plan must provide for payment in full of priority claims, including priority taxes;
- The debtor must devote all projected disposable income, as stated on the means test, for either 36 or 60 months (depending on whether income is above or below median for a household of your size).
It’s important to remember that taxing authorities are required to accept the Plan if it meets statutory requirements and is approved by the court.
Chapter 13 Bankruptcy Impact On Personal Income Tax Debts
Chapter 13 bankruptcy provides significant relief from personal income tax debts. A Chapter 13 Plan allows the taxpayer to:
- discharge (wipe out) tax penalties;
- eliminate tax liens or reduce liens to the present value of your assets; and
- impose an interest free repayment plan for recent taxes.
Is The Tax A Priority Debt?
Priority tax debts must be paid in full in a Chapter 13 bankruptcy; if the tax debt is not considered to be a priority tax debt then it need not be paid in full over the 36-60 month Plan period.
Timing is an important issue in determining whether a personal tax debt is considered a priority tax debt for bankruptcy purposes. To be considered a non-priority tax debt, the following rules apply:
- Your tax returns must have been due three years or more before the petition was filed;
- Your tax returns have to have been filed more than two years before the petition;
- The tax you owe must have been assessed against you by the government for at least 240 days before the case is filed;
- Your tax returns must have been truthful and not fraudulent; and,
- You must not have been intentionally attempting to evade or defeat the tax when you failed to pay.
Using Chapter 13 Bankruptcy To Stop Interest And Penalties
Interest on all unsecured claims in bankruptcy stops running upon the filing of the case. Unsecured priority taxes are paid, then, without interest accruing or continued penalties after the filing of the Chapter 13 bankruptcy.
The Pitfall Of Unfiled Tax Returns
Non-priority taxes, unpaid interest and tax penalties are discharged at the completion of the Chapter 13 Plan. Priority taxes are paid in full through the Chapter 13 Plan.
In the event that the taxpayer has a tax debt that is more than three years old, however, it will not be discharged as a non-priority tax debt if the return has not been on file for at least two full years. Nor is that debt paid as a priority tax debt unless the debt was assessed within 240 days of the filing.
How About Tax Liens?
Often, the taxing authority will place a lien on property in order to secure payment of the tax debt. In Chapter 13 bankruptcy, we value that lien as the value of the equity in property owned as of the date on which the case is filed.
If there’s no equity in property as of the date of filing, the lien is valued at $0.
The Chapter 13 Plan will need to provide for payment in full of the value of the lien, and at the completion of the case you will be able to obtain a release of the lien.
Why Tax Professionals Should Consider Chapter 13 Bankruptcy For Their Clients
Chapter 13 bankruptcy is the great unsung hero of tax professionals. Rather than haggling with the taxing authority and entering into lengthy negotiations, the taxpayer is able to make monthly payments without further interest or penalties.
Old tax debts can be paid pennies on the dollar rather than requiring payment in full. Tax liens are paid based on the value of property as of the date of filing rather than escalating with every day the debt goes unpaid.
At the end of the Chapter 13 bankruptcy, tax liabilities are gone forever. The taxpayer is free to go about his or her life without fearing the taxing authorities.
Finally, the discharge of tax debt, penalties and interest in Chapter 13 bankruptcy do not trigger cancellation of debt income. This along can save the taxpayer thousands of dollars in additional liabilities going forward.
Are you a tax professional or taxpayer with past due tax debts? If so, give me a call or drop me a line to talk.