Buy Time to Deal with Multiple Years of Income Tax Debts

 Posted on October 25, 2017 in Income Taxes

What if you have some income tax debt that qualifies for discharge but one (or more) tax year that doesn’t? Does Chapter 7 ever help enough?

Tax Liens under Chapter 7

Last week we showed how Chapter 7 can sometimes permanently prevent an income tax lien from hitting your home. It does that by stopping the recording of the tax lien, and then discharging (writing off) the tax debt.

This works under Chapter 7 “straight bankruptcy” when both:

• that income tax debt meets the conditions for discharge (mostly it’s old enough)
• the IRS/state has not already recorded a tax lien

But what if your tax debt meets these circumstances but you have other reasons to file a Chapter 13 case? (For example, you need to do a “cramdown” on your vehicle loan, catch up on a mortgage or on child/spousal support, or financially don’t qualify for a Chapter 7 case.) In particular what happens if you owe other income taxes that do not qualify for discharge? And what happens if a tax lien has already been recorded before you could stop it with a bankruptcy filing?

We’ll look into these circumstances in the upcoming blog posts. Today we get into what to do if you owe two kinds of income tax—those that qualify for discharge and those that don’t. (For the rules about what taxes can be discharged, see our blog post last month about this.)

When Chapter 7 is Appropriate

Assume that you have an income tax debt for one tax year that meets the conditions for discharge and another one from a later year that does not. To keep things simpler for now, assume that neither has had a tax lien recorded on it. So filing a Chapter 7 case would completely write off the first tax but leave you owing the second one.

That would be okay as long as, after discharging your other debts, you could afford to pay that remaining tax. The IRS and most state tax agencies have monthly payment plans that, under the right circumstances, give you a decent way of paying off a tax debt.

Common sense says that Chapter 7 tends to make more sense in two circumstances:

• The tax(es) being discharged are relatively large
• The tax(es) left owing are relatively small

An Example

Here’s an example of the combination of these two.

Assume that, after making payments of a while you still owe the IRS $10,000 for the 2012 tax year. And now you’ve just submitted your 2016 tax return (after getting an extension) and owe another $2,000. Assume also that your 2012 tax debt qualifies for discharge while the 2016 one does not. You’ve avoided filing bankruptcy so far, but because of new financial problems are now looking into it.

If you now filed a Chapter 7 case the $10,000 older tax debt would be permanently discharged. The newer $2,000 one would not. But especially if the bankruptcy case leaves you otherwise debt-free, paying off that $2,000 may be quite manageable.

Interest and penalties would continue to accrue during the payment period, so you need to consider that. Of course less interest and penalties would accrue if you paid the tax off faster.

The IRS would not likely record a tax lien for such a relatively small amount. But you should ask your bankruptcy lawyer about this, and about the practices of your state tax agencies if applicable.

Other Considerations

But what if you:

• can’t reliably pay anything monthly to the IRS/state because of other debts surviving the Chapter 7 case? (For example, if you’re behind on your home mortgage or vehicle loan or support payments.)
• don’t qualify for Chapter 7 because of your income and expenses?
• need to file a Chapter 13 case for its other benefits? (For example, you can “strip” a second mortgage from your home’s title, “cramdown” your vehicle loan, or delay collection of your student loans.)

In these situations Chapter 13 “adjustment of debts” would likely be the better option. More on that in our next few blog posts.