Timing Chapter 13 to Discharge Income Taxes

 Posted on August 03, 2020 in Income Taxes

Usually you can discharge income taxes (write them off forever) by waiting long enough to file bankruptcy. Here’s how it works with Chapter 13.

Our blog post of three weeks ago introduced the importance of timing your bankruptcy filing right. We gave a list of 15 examples where timing can make a huge difference. Two weeks we covered the first one, timing bankruptcy to cover as many debts as possible. Last week was about discharging/writing off income taxes, specifically under a Chapter 7 “straight bankruptcy.” This week is about doing so under Chapter 13 “adjustment of debts.”

How to Time a Chapter 13 Filing to Discharge a Tax?

See our last blog post about the timing rules under Chapter 7. That’s because whether you can discharge an income tax is the same under Chapter 7 and 13. Very briefly, you can discharge an income tax as long as you file your Chapter 13 case both:

1. at least 3 years after the tax return for that tax was due, and
2. at least 2 years after that tax return was actually submitted to the IRS or state tax authority.

See Sections 507(a)(8)(A)(i) and 523(a)(1)(B) of the U.S. Bankruptcy Code for these two timing rules.

You and your bankruptcy lawyer will carefully review and apply these rules to see if you can meet them. Your situation may be too urgent to wait long enough. There may be creditor pressures, by the IRS/state tax agency or other unrelated creditors, so you can’t wait. Or there may be other good reasons to file before enough time has passed.

But let’s assume that you find out that you can meet the two timing rules. Also assume that you meet other conditions for discharging the tax. (See last week’s blog post for some other conditions beyond the two timing ones.) You file the Chapter 13 case and the income tax debt qualifies for discharge.

Then what happens? How is the tax dealt with under Chapter 13?

Using Chapter 13 Instead of Chapter 7 to Discharge a Tax

Chapter 7 usually discharges a dischargeable income tax very fast. The moment you file your bankruptcy case the “automatic stay” would protect you from all collection of that tax. Then you would very likely no longer legally owe the tax about 4 months after filing a Chapter 7 case.

Chapter 13 is just as fast at protecting you from tax collection: the “automatic stay” goes immediately into effect. But the discharge of the tax happens only at the end of the case, usually 3 to 5 years later.

Furthermore, often you need to pay some portion of that tax before you can discharge the rest. Not always, but if you have money to spare in your payment plan some will go towards the tax.

Why in the world would you file a Chapter 13 case when it’s so much slower? Why would you when under Chapter 13 you risk paying something on the tax instead of nothing?

Why Discharge Tax through Chapter 13?

The straightforward reason is that Chapter 13 could be much better for you for other reasons. Those other reasons may outweigh the benefit of discharging your dischargeable tax debt quickly and completely.

Chapter 7 and 13 each has tons of potential advantages and disadvantages. Your bankruptcy lawyer’s job is to help you determine whether the other advantages of Chapter 13 outweigh these disadvantages.

What might be some of those advantages?

One example: you may owe some other income tax debt(s) which do not meet the timing conditions for discharge. So these other taxes would not be discharged under either Chapter 7 or 13. In a Chapter 7 case, you’d owe that tax in full immediately upon finishing the case, about 4 months after filing. Interest and penalties would continue accruing. Those tax/interest/penalties may be too large to pay off reasonably through a monthly payment plan with the IRS/state. It may not qualify for an Offer in Compromise or other settlement. Chapter 13 would enable you to pay it more flexibly, usually without accruing interest and penalties. So, you could well save money and avoid significant risks by handling all of your taxes in a Chapter 13 case.

There are many, many other reasons unrelated to income taxes that Chapter 13 could be worthwhile for you. It could potentially prevent a home foreclosure or vehicle repossession, and then give you a workable way to save the home or vehicle. Chapter 13 can often solve child or spousal support problems much better than Chapter 7. There are many other situations where Chapter 13 gives you extraordinary powers over your debts. So those advantages can make this longer procedure very worthwhile overall.

How Does Chapter 13 Discharge an Income Tax?

Assume again that your tax debt qualifies for discharge, timing-wise and by meeting all the legal conditions. So it can get discharged in your Chapter 13 case.

However, Chapter 13 treats a dischargeable tax differently than under Chapter 7. As mentioned above, the discharge happens at the end of the case usually years later. And you may have to pay something on it before then.

What determines how much, if any, you pay on this tax?

Under Chapter 13 a dischargeable income tax debt is treated like the rest of your “general unsecured” debts. Under your payment plan all such debts receive the same percentage of their total amounts. That percentage may be any amount from 0% to 100% of the debt amount, depending on your budget and other factors.

That’s right: it’s theoretically possible that you’d have to pay 100% of your tax and other debts. But that’s highly unlikely. That only happens if you have enough money in your budget that you can reasonably afford to do so. That’s very rare.

More likely your budget is barely enough for living expenses and to pay special higher-priority debts during your case. That could result in your dischargeable tax debt (and all your “general unsecured” debts) receiving 0%—absolutely nothing.

To make better practical sense of this, let’s look at two situations: First, this “0% plan,” and second, where your tax debt does not increase what you pay to your creditors.

The 0% Payment Plan

As just mentioned, in this kind of Chapter 13 case all your available money goes to living expenses plus special debts. Those special debts are either secured or “priority” ones. These could include home mortgages, vehicle loans, nondischargeable taxes, child and spousal support, and such. The law usually requires you to pay them in full before paying anything to the “general unsecured” debts. As a result it’s possible that during your 3-to-5-year payment plan there’s no money at all for your “general unsecured” debts. That means that one of those debts, the dischargeable income tax, also receives nothing. That’s called a 0% Chapter 13 plan. (The percentage means the extent to which you’re paying the general unsecured debts.) These 0%cases are not unusual (although there are regional variations).

If you successfully complete a Chapter 13 case, when you do your bankruptcy judge discharges the entire tax. Under a 0% plan, you didn’t pay any of the tax debt during the case. And then after the discharge you don’t have to pay any of it either, foreever.

Fixed Total Amount Chapter 13 Plans

There are other Chapter 13 payment plans in which your tax debt does not increase the amount you pay. You pay a fixed total amount to your creditors based on the amount you can afford to pay beyond your living expenses.

Often the practical effect of this is that there is some money for your “general unsecured” debts. So it’s not a 0% plan.

But because the amount you pay over the life of the case is a fixed amount, the amount left over for the pool of general unsecured debts, after paying certain secured and priority debts, is a fixed amount as well. That in turn means that all the general unsecured debts have to split up that left over amount. (This is true as long as the total amount of those debts is greater than the amount you can afford to pay. That’s almost always the situation. Otherwise you likely don’t need Chapter 13 help.)

With all the general unsecured debts being paid out of that fixed amount, this means that the total amount of this debt doesn’t matter. If the total debt amount is higher, this just means that you pay each debt a lower percentage.

This means that having a dischargeable tax debt often does not increase the amount you pay.

An Example

Here’s a simple example. Assume that during the life of a 3-year payment plan you expect to have money to pay a total of $3,000 into the pool of general unsecured debts. That’s based on what you can reasonably pay to all your debts, minus what goes to secured and priority debts. Assume also that you have $60,000 in unsecured credit cards and medical debts. This means that the $3,000 you pay would amount to paying 5% of these general unsecured debts. ($3,000 divided by $60,000 equals 5%.)

Now assume that you also have a $10,000 of dischargeable income tax debt. You add this to the $60,000, making a total of $70,000 of general unsecured debts. Now the $3,000 gets divided among the $70,000 in debts, meaning that now you are only paying 4.3% of those debts ($3,000 divided by $70,000 equals 4.3%.)

This situation—where you’re paying a fixed amount to the general unsecured debts—is very common. So it’s common that having a dischargeable tax debt actually does not add anything to the amount you pay. That tax debt just reduces the percentage that all the general unsecured debts receive.