Chapter 7 and Chapter 13--Older Income Taxes

 Posted on November 09, 2015 in Income Taxes

Income tax debts can be written off when meeting certain conditions, mostly by being old enough. Here's what happens in Chapter 7 and 13.

The Choice Simplified

Income tax debt can be discharged—written off in bankruptcy—if it meets certain conditions. If those conditions are met, those income taxes can be discharged in either a Chapter 7 or Chapter 13 case.

So you would usually make your choice between these two options based on other reasons.

There ARE reasons why Chapter 7 would be the better way to go strictly as far as the tax debt is concerned. But practically speaking the choice between these two options should probably not turn on these reasons but rather on other factors in your financial life pushing you towards one option or the other.

One Example

An example of another factor is whether or not you also owe other more recent income tax debts which do NOT qualify for discharge. THIS factor is much more important in choosing between Chapter 7 or 13. Basically, if you owe a lot taxes that do not meet the conditions for discharge, you would owe these taxes after finishing a Chapter 7 case and would have to arrange to pay them. Filing a Chapter 13 case instead protects you from the IRS/state while you pay those taxes over time within a sensible budget incorporating all your other creditors, likely saving you money by stopping any further interest and penalties, and giving you a more favorable way to deal with any tax liens.

So you’d tend to file a Chapter 7 case is you didn’t have any more recent income taxes that couldn’t be discharged, or a small enough amount so that you could enter into a reasonable monthly payment plan with the IRS/state to pay them off within a reasonable time. Otherwise, you would tend to need the extra protections of Chapter 13. You’d be making this decision between the Chapters based on the amount of your taxes that could NOT be discharged rather than on the taxes that could be discharged.

The Reasons for Discharging Taxes Through Chapter 7

But focusing back on the taxes that meet the conditions for discharge, one reason those are better handled under Chapter 7 is that takes care of them quicker. Under Chapter 7 your debts are almost always discharged within 4 months of the filing of your case. If all your owed income taxes meet the conditions for discharge (which we’ll cover in the next section), you will no longer legally owe those taxes that quickly.

In contrast, under Chapter 13 the discharge of debts does not happen until the completion of a 3-to-5-year payment plan. The IRS/state usually cannot take any collection activity against you or your assets during that time as to any of the taxes you owed at the time the case was filed. But instead of being gone quickly, even dischargeable taxes continue to be legally owed for years.

With this delay comes the risk that those otherwise dischargeable income taxes would not be discharged if you don’t successfully complete the Chapter 13 case. The successful completion rate on Chapter 13s is much lower than that of Chapter 7s. A lot can happen in 3 to 5 years. If a Chapter 13 case is not completed, there is no discharge of debts, no discharge of the income taxes. There are possible ways of getting a discharge, such as by converting the case into a Chapter 7 one. But the point is that Chapter 13 comes with greater risk that even taxes that can be discharged wouldn’t be.

A final reason in favor of Chapter 7 is that the quick discharge writes off ALL of the taxes that meet the conditions for discharge. In contrast in a Chapter 13 case you may have to pay a portion of such taxes along with all the rest of your “general unsecured” debts. If you have a “20%” Chapter 13 plan you pay 20% of the pool of “general unsecured” debts.

But this is less of a reason against Chapter 13 than you might think. How much you pay to that pool of “general unsecured” debts turns on a combination of what you can afford to pay to all of your creditors during the period of time you are in the case and how much of that “disposable income” has to be earmarked instead to other more important debts. For example, if you have a mortgage to catch up on, or more recent income taxes that have to be paid, these may use up all or most of your “disposable income” so there is little or even nothing to pay to the dischargeable “general unsecured” debts. Whatever of those debts that aren’t paid are discharged at the end of the Chapter 13 case.

Finally, to the extent you pay a certain amount into that pool of “general unsecured” debts, the income taxes within that pool usually don’t at all increase the amount you’d be paying into it. Usually you are required to pay a certain limited amount into the entire pool. The existence of the dischargeable income taxes usually just takes money away from the other “general unsecured” debts in that pool without affecting how much you need to pay into it.

The Two Main Conditions for Discharging “Older” Income Taxes

We can’t end this blog post without telling you the conditions for discharging an income tax. In most situations those conditions are quite straightforward. Usually meeting those conditions requires just takes filing your tax returns and waiting out a certain amount of time.

The two main conditions for discharging an income tax in bankruptcy are that:

1. more than 3 years must have passed between the due date for the tax return of the tax at issue and the filing date of the bankruptcy case; and

2. more than 2 years must have passed between the date that pertinent tax return was actually submitted to the IRS/state and the filing date of the bankruptcy case.

Summary

Again, if ALL of your income taxes meet these two conditions, those income taxes can be discharged in either a Chapter 7 or Chapter 13 case. All other things being equal we’ve explained why it’s quicker and less risky to discharge those taxes in a Chapter 7 case. But usually other factors have more influence on which Chapter you’d use, such as whether you owe a lot of other more recent, nondischargeable income taxes that need the help of Chapter 13.