Chapter 13 Conquers Both Older and Newer Income Taxes

If you owe a number of years of income tax debt, Chapter 13 allows you to favor those taxes that have to be favored, while dumping the taxes that can be dumped.

In my last blog I gave an example showing how Chapter 13 can be an extremely good way to handle income tax debts particularly when you owe multiple years of taxes. In that hypothetical case, without a bankruptcy a couple would have had to pay about $30,000 to the IRS for back taxes, plus about another $45,000 in medical bills and credit cards, a total of $75,000. And paying this huge sum of money on their income would have taken them many, many years of pressure and uncertainty. In huge contrast, in a Chapter 13 case this same couple would only need to pay about $17,500, less than 1/4^th the amount. And they would be allowed to do so through pre-arranged affordable monthly payments, for three years, all the while not having to worry about aggressive actions by any of their creditors, including the IRS.

How does Chapter 13 pull this off?

1) Tax debts that are old enough are lumped in with the lowest priority “general unsecured” creditors—like medical bills and credit cards—and so in many cases do not need to be paid anything unless there is enough “disposable income” to do so. This means that often those taxes are paid either nothing—as in the example—or  only a few pennies on the dollar.

2) The more recent “priority” taxes DO have to be paid in full in a Chapter 13 case, along with interest accrued until the filing of the case, but a) penalties—which can be a large part of the debt—are treated like “general unsecured” debts rather than “priority” ones, and 2) usually interest or penalties stop when the Chapter 13 is filed. These can significantly reduce the amount of tax that has to be paid.

3) “Priority” taxes are paid in a Chapter 13 case before and instead of “general unsecured” debts. This often means that having these taxes to pay simply reduces the amount of money which would otherwise have gone to those “general unsecured” creditors. So sometimes, amazingly, having tax debt does not increase the amount paid in a Chapter 13 case. In our example, the couple paid about $500 per month for three years, which is the same amount they would have paid even if they did not owe a dime to the IRS! They met their obligations under Chapter 13 by paying the IRS instead of their other creditors.

4) The bankruptcy law that stops creditors from trying to collect their debts while a bankruptcy case is active—the “automatic stay”—is just as binding on the IRS as on any other creditor. The IRS can continue to do some very limited and sensible things like demand the filing of a tax return or conduct an audit, but it can’t use the aggressive collection tools that the law otherwise grants to it. Gaining relief from collection pressure from the IRS AND all the rest of the creditors is one of the biggest benefits of Chapter 13.

I confess that I put this example together in a way that would showcase the advantages of Chapter 13 in dealing with income tax debts. If the facts were different, the advantages could easily be less. If, for instance, more of the taxes were “priority” debts that had to be paid, the debtors would have to pay more, either through larger monthly payments or for a longer period of time. There are definitely situations where it is a close call choosing between Chapter 7 or Chapter 13, or possibly even not filing bankruptcy at all but doing an offer in compromise with the IRS. To decide what is best for you, you need the independent advice of an experienced bankruptcy attorney, who is ethically and legally bound to look out for your best interests. Regardless whether your tax debts and other circumstances point strongly in one direction or it’s a closer call, you need a professional qualified both to help you make an informed decision and then to execute on it.

Chapter 13 Tames Your Income Tax Monster

A “straight” Chapter 7 can write off some income taxes. But if you owe recent taxes, or multiple years of taxes, Chapter 13 is usually a much better way to go. It often provides tremendous advantages over both Chapter 7 and dealing with the IRS on your own.

I’ll illustrate this with an example, and then explain it in my next blog.

Let’s say a husband and wife owe $35,000 in a combination of medical bills and credit cards, requiring monthly payments of $800. After the husband lost his long-time job back in 2006, he followed his dream of starting a business, which was starting to make progress when it got hammered in the Great Recession. He closed it in 2010 and found a reliable job a number of months later, although one where he earns 30% less than he did at the one lost years earlier. His business had generated some income, but barely enough for the couple to meet their bare essentials. So there was no money to pay the quarterly estimated taxes, and they had no money to pay the amount due when they filed their joint tax returns for 2006, 2007, 2008, 2009 and 2010. They expect to come out even for the 2011 tax year because of tax withholdings from their wages. To try to simplify the facts, assume they owe the IRS $4,000 in taxes, $750 in penalties, and $250 in interest for each of those five years. So their total IRS debt for those years is $25,000—including $20,000 in the original taxes, $3,750 in penalties, and $1,250 in interest. The wife has had consistent employment throughout this time, with pay raises only enough to keep up with inflation. They filed each of the tax returns in mid-April when they were due, and have been making modest payments when they have been able to, but those have not even been keeping up with the penalties and interest. Assume they have no secured debts—no mortgage or vehicle loans. They can realistically afford to pay about $500 a month to all of their creditors, not nearly enough to pay their regular creditors much less the IRS. They are clearly in trouble.

Outside of bankruptcy, the IRS would likely require payment in full of the entire tax obligation, with interest and sometimes penalties continuing to accrue until everything was paid in full. Their payments would be imposed without regard to the other debts they owe. And if the couple failed to make their payments, the IRS would likely try to collect through garnishments and tax liens. Depending how long repayment would take, the couple could easily end up paying $30,000 or more with additional interest and penalties. This would be in addition to their $35,000 medical and credit card debts, which could easily increase to $45,000 or more, especially if these other debts went to collections or lawsuits. That’s likely because the couple would be paying all available money to the IRS. So likely the couple would eventually end up paying at least $75,000 to their creditors.

In a Chapter 13 case, the 2006 and 2007 taxes, interest and penalties would very likely be paid nothing and discharged at the end of the case. So would the penalties for 2008, 2009, and 2010. That takes care of $11,500 of the $25,000 present tax debt. The remaining $13,500 of taxes and interest for 2008, 2009, and 2010 would have to be paid as a “priority” debt, although without any additional interest or penalties once the Chapter 13 case is filed. Adding in some “administrative expenses” (the Chapter 13 trustee and our attorney fees), and assuming that their income qualified them for a three-year Chapter 13 plan, this couple would likely be allowed to pay about $500 per month. in spite of how much they owe to all of their creditors. Then after three years, they’d be done. The “priority” portion of the IRS debt would have been paid in full, but the older IRS debt and all the penalties would be discharged likely without any payment. So would the credit card and medical debts. After the three years, the couple would have paid a total of around $17,500 (including the “administrative expenses”), instead of about $75,000 without the Chapter 13. They’d be done instead of barely starting to pay their mountain of debt. And they would have not spent the last three years worrying about IRS garnishments and tax liens, lawsuits and harassing phone calls, and the constant lack of money for necessities.

As I said, in my next blog I’ll explain how all this works.

Writing Off Income Taxes with a “Straight Bankruptcy”

You don’t always need to file a Chapter 13 case—with its 3-to-5-year payment plan–to deal with income tax debts. Thinking that you do is a myth, alongside the broader myth that “you can’t write off taxes in a bankruptcy.” Both have a kernel of truth, which is why they persist. It’s true: some taxes cannot be discharged (legally written off) in bankruptcy. But some can. And it’s true: Chapter 13 is often an excellent way to solve tax problems. But that does not necessarily mean it is the best for you. Instead Chapter 7 might be.

Chapter 13 tends to be the better tool if you owe a string of income tax debts including relatively recent ones. Why? Because in this situation Chapter 13 gives you the best of both worlds. First, if you owe recent income taxes which cannot be discharged, you get lots of advantages under Chapter 13, including paying less by avoiding most penalties and interest. That can be a huge savings, especially if you can afford only relatively small payments. Second, if you have older back taxes, these are also wrapped into the Chapter 13 plan, often without you paying any more into your plan, then they are discharged at the end of your case.

But you DON’T NEED the best of both worlds if all or most of your income tax debts are dischargeable. Then Chapter 7, the straightforward “straight” bankruptcy is enough.

So, WHAT are the conditions for a specific income tax debt to be discharged in Chapter 7? How are you going to know if Chapter 7 will discharge all or most of your taxes so that it is the right option for you?

Some of the conditions for discharge of taxes are quite straightforward. Some are more complicated. And as you’ll see, some are even purposely vague. So unfortunately it’s not as simple as plugging a particular tax debt into a clear formula to see if it is dischargeable. Determining whether a particular tax debt will be discharged requires the careful judgment of an experienced attorney.

I’ll just list these conditions for discharging income taxes here, and then explain them in my next blog. Don’t be surprised if they sound confusing in this list. It’s true: anything having to do with taxes tends to be complicated!

To discharge an income tax debt in a Chapter 7 bankruptcy case, it must meet these conditions:

1) Three years since tax return due: The applicable tax return must have been due more than three years before you file your Chapter 7 case. And if you requested any extensions for filing the applicable tax returns, you have to add that extra time to this three-year period.

2) Two years since tax return actually filed: Regardless when the tax return was due, you must have filed at least two years before your bankruptcy is filed in court.

3) 240 days since assessment: The taxing authority must have assessed the tax more than 240 days before the bankruptcy filing.

4) Fraudulent tax returns and tax evasion: You cannot have filed a “fraudulent return” or “willfully attempted in any manner to evade or defeat such tax.”

You can see that these are begging for some clarification. For that please come back to read my next blog. Or else call to set up a consultation with me. If you have substantial tax debts, you should definitely get some thorough personal advice. Know your options so you can make an informed choice, about bankruptcy and otherwise.

– Patrick J. Conway, attorney. http://www.patrickconwaylaw.com

Chapter 13 Plans Can Change

Change Your Plans
Its possible to change the terms of your chapter 13 plan. Payment terms can, with court approval, change even after the plan is confirmed. For example, if you have a permanent change to your income, the court can approve a lower payment. There are limits to the changes possible. The plan must complete within five years, for example. Call me if you are experiencing problems with your plan payments.

Strip Down Vehicle Debt

Its possible to reduce the debt on your vehicle by filing a bankruptcy case. This benefits vehicle owners who owe more than their car is worth. Both chapter 7 and chapter 13 allow for reducing the vehicle loan.

In chapter 7, you can reduce the debt if you qualify for a redemption loan. The new creditor pays the vehicle’s fair market value to your lender. The remaing debt is discharge by the bankruptcy court.

In chapter 13, you may propose a plan that pays the fair market value provided the loan is at least 2.5 years old. The payment for the vehicle is included in the monthly payment you make on all your debts.

Debt Consolidation Is Not The Way To Go

Debt consolidation companies advertise that they can negotiate with your creditors for lower payments and interest rates. They claim they can help you repay your debt quickly and improve your credit score immediately. If this sounds too good to be true, that’s because it is. Problems with debt consolidation include:
1. It is an unregulated industry under investigation by the federal and state authorities
2. These companies are not forced to deliver what they promise
3. People using these services can pay thousands of dollars in fees before any money goes to creditors.

Debt consolidation scams abound. I see many people who are being sued even though current on their debt plan payments. Take my advice. Chapter 13 is a much better alternative to debt consolidation.

Change Your Chapter 13 Plan

A client told me recently that her employer reduced her hours. She expects to earn $500 per month less that her previous income. Fortunately, chapter 13 provides flexibility in situations like hers. In many cases, its possible to change the payment amount. The law requires a showing of a substantial change in circumstances. She should have no trouble in meeting this requirement.

We can’t always change the amount of a chapter 13 plan payment. For example, plans must pay out in a maximum of five years. If the proposed payment change is too great, then the court does not approve it. But if you have a change, don’t hesitate to call to see if we can’t change the plan payment.

How To Avoid A Deadly Trap

Credit cards are so useful and convenient. At least until you suffer a loss of income. Or unexpected medical expense. Or divorce. Or any other problem that impacts your ability to make monthly payments. Then credit cards become a trap. Think you can talk to the credit card company about lowering payments? Don’t count on it. My clients tell me that they get nowhere when they ask for a break. Miss three payments and watch your interest rate climb to 30%. Good luck trying to catch up payments after that.

You could get lucky and have a way to pay off the card. You could borrow against your home, but that is getting hard to do. You may have a retirement account you could tap into. If you can get together a lump sum payment, your creditor may settle for 50 cents on the dollar.

Other alternatives include debt consolidation companies and bankruptcy. Be careful with debt consolidation. I hear many horror stories from clients about them. It’s an unregulated industry. Many companies are being sued for false promises and fraud.

Chapter 13 bankruptcy lets you adjust payments on your debts based on an amount you can afford. You get the payment amount approved by a court trustee. You don’t need your creditors to agree.

If you are in default on your payments, your credit score has already taken a hit. Bankruptcy can stop the downward slide and help you to rebuild it. It’s a way to avoid the deadly credit card trap.

Home Values Keep Falling

Local property values fell by eight percent compared with last year’s values. This from a new report by the Hamilton County Auditor. Values declined in nearly every county neighborhood. Other reports show that home sales and prices continue to fall across the Greater Cincinnati and Northern Kentucky region. Forty-five percent of all sales in March were lenders selling properties recently in foreclosure or a short sale.

All this is bad news from people trapped with a house payment that can no longer afford. Declining values make it more difficult to borrow or sell their homes.

Bankruptcy can help in a couple of ways. Chapter 13 gives people a way to catch up missed house payments. It some cases it allows the home owner to eliminate a second mortgage. Chapter 7 protects the owner from the mortgage debt if the owner wants to give up the house.

Garnishments Can Be Recovered

In some cases debtors can sue to recover garnishments taken within 90 days of the bankruptcy filing. The catch is that the debtor must be able to claim the garnished funds exempt.

Ohio residents can exempt a maximum of $1,500. Kentucky residents can exempt much more, almost $10,000. Kentucky residents can claim federal exemptions. Ohio residents must claim Ohio exemptions in most cases.