Use Chapter 7 to stop paying an unaffordable income tax payment plan when the tax owed is dischargeable. Use Chapter 13 when it’s not.
Tax Agreement Payments Too High
We laid out the problem last week. You’d entered into a monthly payment plan with the IRS or your state because you couldn’t pay what you owed. But now you don’t have the money to make the payments. Or you’re in a payment plan but will owe more income taxes soon, putting you then in violation of your payment agreement.
If you violate your tax agreement the IRS/state could then take aggressive collection action against you. Or you might be able to add an upcoming new income tax owed into your current tax payment agreement. But the increased monthly payment may well push you over the financial edge. But even if you think you could afford it, you’d be going backwards instead of making progress.
Chapter 7 Makes Sense When Your Tax Owed Can Be Discharged
If all, or most, of the income tax debt in your present monthly payment plan is dischargeable, Chapter 7 likely makes sense. You’d discharge (forever write off) all or most of the taxes you owe. You’d either owe no taxes or owe a small enough amount to be able to handle it with a new smaller payment plan.
But if you can’t discharge all your income taxes, or enough, through Chapter 7, Chapter 13 “adjustment of debts” is likely the better tool.
Chapter 13 Plan
A Chapter 13 payment plan wraps all or most of your debts into a single monthly payment. This payment includes any tax debts. This single Chapter 13 monthly plan payment is based on your actual budget. Some debts—such as taxes, and secured debts such as a home mortgage and vehicle loan—get prioritized. Usually you pay less on your other debts, often not much, sometimes nothing.
Dealing with income tax debts with Chapter 13 gives you the following advantages over Chapter 7:
- Income taxes that don’t qualify for discharge do need to be paid in full, but on a very flexible schedule. You and your bankruptcy lawyer create a new plan incorporating all of your debts. This plan focuses your resources on your most important debts, including nondischargeable income taxes.
- Usually you don’t pay ongoing interest and penalties. This saves you potentially lots of money. That’s particularly true if tax interest rates will rise in the near future along with other interest rates.
- Other even more important debts—such as child/spousal support, or unpaid mortgage or home mortgage payments—can often be paid ahead of income tax debts.
- The budget you enter into earmarks enough money to withhold from your paycheck or pay quarterly for the current year’s taxes. This enables you to break out of the endless cycle of being behind on your income taxes.
- Chapter 13 handles income tax liens much better than Chapter 7. If there’s no equity supporting the lien, you can often get rid of the lien without paying anything for it. If the lien is partially secured, you will likely pay less to get rid of it than otherwise. Chapter 13 takes away much of the leverage of tax liens from the tax authorities.
- You are protected throughout your entire 3-5-year Chapter 13 payment plan from tax collection. Bankruptcy stops all tax collection, including the recording of tax liens. In Chapter 7 this protection lasts only 3-4 months. Then you’re on your own dealing with any remaining tax debts. With Chapter 13 the protection lasts until the end of your Chapter 13 case. At that point you should owe absolutely no tax debt.
Filing bankruptcy allows you to unilaterally break your monthly payment agreement with the IRS and/or state. With Chapter 7 you may be able to discharge all or most of your tax debts. Or, discharging all or most of your other debts may make it possible to stay in your tax payment plan, if that’s your only significant debt. However, if Chapter 7 doesn’t help you enough, Chapter 13 gives you many other significant advantages (some listed above). Talk with an experienced local bankruptcy lawyer to figure out which is better for you.