Including New Income Tax Debts in Chapter 13

 Posted on November 14, 2016 in Income Taxes

File your Chapter 13 “adjustment of debts” case at the right time to include all possible tax debts. Then budget right to prevent new ones.

Drastic Solutions for a Drastic Situation

Our last blog post was about what we called drastic solutions to a drastic change in circumstances. The changed circumstance was if a large new debt arises during your 3-to-5-year Chapter 13 case. Post-petition debts are those that arise after you file your case.

You can’t include post-petition debts within your Chapter 13 payment plan. You can’t discharge (write off) those debts. You can’t usually include them among the debts you are paying within your Chapter 13 plan.

New, post-petition debts during a Chapter 13 case can be a big problem because you’re in the middle of solving all your prior financial problems when you’re hit with a big new one. If the new debt is large enough, you can’t finish the Chapter 13 case that was resolving your old debts. So the drastic solutions involve throwing out the Chapter 13 case. Then you use a Chapter 7 case, or a new Chapter 13 one, to deal with both the prior debts and the new one.

But if you can, you want to avoid these solutions. They are drastic because they can be a real pain. You’ve put a lot of time, effort, and money at setting up a solution for your whole financial situation. Then you’ve put even more into making that solution work for many months and maybe even for a couple years. Then you have to start over when the new debt(s) hit you.

Avoiding the Drastic Situation with Income Taxes

If the new debt(s) come from a vehicle accident or a medical emergency, you can’t do much to avoid them. But you have some greater control over certain kinds of debts—upcoming income taxes, for example.

Once you are in the middle of a Chapter 13 case you and your bankruptcy lawyer can put your payment plan and your budget together to prevent future income tax debt. And you can file your Chapter 13 case at the right time so that all your income taxes are included.

Preventing Post-Petition Income Tax Debt

If you owe income taxes, there’s a good chance it’s because you didn’t have enough taxes withheld from your income. Or if you’re self-employed or operate a business, you didn’t pay enough in quarterly estimated taxes. Especially if you owe for more than one year, you’ve probably have some entrenched bad habits along these lines.

Simply put, a carefully thought out Chapter 13 budget and payment plan will cure those bad habits. And they should do so relatively painlessly.

You likely didn’t withhold enough or pay enough in estimated taxes because you didn’t have the money to do so. It was going to pay debts, including maybe some older taxes. Chapter 13 usually drastically reduces the amount you pay each month towards your debts. That allows you to immediately increase the amount withheld for taxes on your paycheck. Or it frees up money for the quarterly estimated tax payments. So when it’s time to file your income tax returns from now on, you will not owe any new taxes.

So you won’t have any post-petition tax debt that could jeopardize your ongoing Chapter 13 case. And you’ll finally be out of the vicious income tax debt cycle.

Timing of Chapter 13 Filing to Include Upcoming Tax Debt

But that solution doesn’t work so well if you’re filing your Chapter 13 case well into the current tax year. By that time you may well have underwithheld, or underpaid estimated taxes, for most of the year. So if you file a Chapter 13 case now you could be setting it up for failure. When you do your tax returns a few months later you find out that you owe more taxes. But all your income would already be budgeted for expenses and your Chapter 13 plan payment, dealing with your past taxes and other debts. So you’d have no means to pay the new post-petition tax.

Often the best solution to this problem is to wait to file the Chapter 13 case until after the end of the tax year (after December 31 for those using the usual calendar tax year). That tax is considered legally owed as of then and would be included in your case. Prepare your tax returns right after filing so that you know how much you owe. Then this tax debt is incorporated into your Chapter 13 payment plan.

If you can’t wait until the start of the new year, consider the possibility of filing a partial-year tax return. You may be able to submit a tax return covering the time up until your Chapter 13 filing. That would include the taxes you owe up until that point, and that tax debt would be included in your case. Then you file another partial-year tax return after the end of the year covering the second part of the year. Since you’ve corrected the budgeting problem in your Chapter 13 case, you shouldn’t owe any more taxes.

Or If You Can’t Make the Tax a Post-Petition Debt...

Finally, if neither of these works for you, another possibility is to just file a Chapter 13 whenever you need to. With the help of a tax professional carefully calculate your current year tax debt amount as of that point. Then have your bankruptcy lawyer make room in your budget for installment payments on that tax when it becomes due later during your Chapter 13 case.