Most people who close down a failed small business owe income taxes. Chapter 7 and Chapter 13 provide two very different solutions.
Here are the two options:
Chapter 7 “Straight Bankruptcy”
File a Chapter 7 case to discharge (permanently write off) all the other debts that you can, and sometimes some or even all of your income taxes. If you cannot discharge all of your taxes, right after your Chapter 7 is completed you (or your attorney or accountant) would arrange for you either to make monthly payments to pay off those remaining taxes or to enter into a settlement with the taxing authority(ies).
Chapter 13 “Adjustment of Debts”
File a Chapter 13 case to discharge all the other debts that you can, and sometimes some or even all the taxes. If you cannot discharge any of your taxes, you then pay the remaining taxes through your Chapter 13 plan, while under continuous protection against the IRS’s or state’s collection efforts.
The Income Tax Factor in Deciding Between Chapter 7 and 13
In real life, especially after a complicated process like closing a business, often many factors come into play in deciding between Chapter 7 and Chapter 13. But focusing here only on the income taxes you owe, the choice could be summarize with this key question: Would the amount of tax that you would still owe after completing a Chapter 7 case (if any) be small enough so that you could reliably make workable arrangements with the IRS/state to pay off or settle that obligation within a reasonable time?
As just mentioned, in a Chapter 7 case you deal with the IRS/state about any remaining taxes after that Chapter 7 case is completed, when the protection against tax collection efforts against you have expired. In contrast Chapter 13 protects you from such tax collection during the three to five years while you are in the Chapter 13 case.
Being in a Chapter 7 case only makes sense if you don’t need that ongoing protection.
Crucial Information from Your Attorney
To find out whether you need Chapter 13 protection, you need to find out from your attorney the answers to two questions:
1) What tax debts will not be discharged in a Chapter 7 case?
2) What payment or settlement arrangements will you likely be able to make to take care of those remaining taxes?
How reliably your attorney (or anyone else) can predict how a particular taxing authority will allow a tax debt to be paid or settled depends on the circumstances. For example, the IRS has some rather straightforward policies about how long a taxpayer can make monthly payments to pay off income tax obligation in full—and thus how much those monthly payments would have to be—as long as the balance owed is less than a certain amount. In contrast, predicting whether or not the IRS/state will accept a particular “offer-in-compromise” to settle a debt can be much more difficult to predict. Your attorney (or tax accountant) should tell you the likely success of any proposed game plan. However, in order to give you good advice, your attorney (or tax accountant) will need to file a Form 2848 with the IRS in order to get “tax transcripts” for the tax years in question. The tax transcripts will give your attorney a good idea of how much the IRS says you owe.
When in doubt about whether you would be able to pay what the taxing authorities would require after a Chapter 7 case, or in doubt about some other way of resolving the tax debt, you may well be better off under the protections of Chapter 13.
Once you know how much in tax you would still owe after filing a Chapter 7 case, do you have a reasonable and reliable means of paying it off or settling it within a sensible length of time? If so, file a Chapter 7 case. Otherwise, take advantage of the greater protection of Chapter 13. Sometimes, you can do both, but that is the subject of another blog.