Bankruptcy is often the last resort for anyone, but there can be benefits. For example, one of the benefits of filing Chapter 13 is that you can spread out tax debt over the term of the Chapter 13 plan. Instead of having your wages garnished or your bank accounts seized by the IRS, you can enter a payment plan that does not have the high interest and ongoing penalties that an IRS installment plan would cost.
Let’s take a closer look at how taxes are handled in Chapter 13.
Income Tax Debt in Chapter 13 – Priority Tax Debt vs. Nonpriority Tax Debt
Most income tax debt is considered a priority debt.
Priority debts must be paid in full through your Chapter 13 plan. Even though you must pay the priority tax debt in full through the Chapter 13 plan, you have three to five years to pay off tax debts. Another benefit of filing Chapter 13 for income tax debt is that the interest stops accruing on the tax debt paid through the Chapter 13 plan. It may also stop penalties from accruing on the tax debt.
Also, nonpriority income tax debt may be discharged through your Chapter 13 bankruptcy for less than you owe the IRS. When you file a Chapter 13 bankruptcy, the Internal Revenue Service must divide your income tax debts into priority debt and non-priority debt.
As discussed above, priority tax debt must be paid in full through your Chapter 13 plan. However, nonpriority tax debt is treated as a general unsecured creditor.
General unsecured creditors receive a percentage of their debts through the Chapter 13 plan. When you complete your Chapter 13 case, the remaining amount owed to general unsecured creditors is discharged. A bankruptcy discharge means you do not have a legal obligation to repay the debt, and the creditor cannot resume collection efforts for the discharged debt.
The percentage of general unsecured debts you must pay is based on several factors, including your disposable income, assets, and recent financial transactions. The percentage is between one and 100. Therefore, depending on your situation, you could get rid of nonpriority tax debt for as little as 1 cent on the dollar.
What are the criteria for tax debt to be considered nonpriority?
To determine if income tax debt is classified as priority debt or nonpriority debt, the IRS applies the 3-2-240 Rule.
The 3-2-240 Rule states:
- Three Years – The income tax debt must have become due at least three years before the Chapter 13 bankruptcy filing. Most income tax debts are due on April 15 of the following year. However, with recent extensions due to COVID-19, individuals filing Chapter 13 in a few years will need to be careful when calculating the three-year rule.
- Two Years – The income tax returns that resulted in the tax debt must have been filed at least two years before you filed for Chapter 13 bankruptcy relief. You could have filed the income tax returns late, but the filing date must be at least two years before the Chapter 13 filing date.
- 240 Days – The tax debt must have been charged by the Internal Revenue Service at least 240 days before you filed your Chapter 13 bankruptcy petition. In many cases, the tax was assessed on the date the IRS accepted the tax return or within a few days after.
If you meet all of the above three requirements, the income tax debt should be dischargeable. The tax debt is included as a nonpriority debt (general unsecured debt) and receives the same percentage of payment as your other unsecured debts.
For example, if you owe $10,000 in nonpriority debts and your payment to unsecured creditors is 10 percent, you would pay $1,000 toward the nonpriority income tax debt. When you complete your Chapter 13 case, the remaining $9,000 in nonpriority tax debt is discharged.
It is important to note that you can only discharge nonpriority income tax debt if you did not willfully try to evade the tax debt or file fraudulent returns.
Tax Liens – Secured Tax Debts
If the IRS or other taxing authority has filed a tax lien, the tax debt is secured. The secured tax debt would need to be paid in full through the Chapter 13 plan to release the lien on your assets. However, secured tax debt would be limited to the value of the IRS lien on the property. Any debt above the value of the lien would become unsecured debt or priority tax debt, depending on whether it meets the requirements of the 3-2-240 Rule.
For example, the IRS files a tax lien against you for $50,000 in back taxes. However, your net equity in all your assets covered by the lien is only $10,000. The secured portion of the IRS lien that must be paid in full is $10,000. The remaining $40,000 becomes priority tax debt or general unsecured debt, depending on the outcome of the 3-2-240 Rule.
Other Types of Tax Debts
There are special rules for handling other types of tax debts in Chapter 13. Some tax debts may not be eligible for a discharge or may need to be paid in full regardless of when the tax debt became due.
- Employee Payroll Taxes are not eligible for a bankruptcy discharge. Employers cannot discharge the payroll taxes they failed to withhold or withheld, but did not pay.
- Employer Payroll Taxes can be dischargeable in bankruptcy. These taxes are the employer’s portion of payroll tax.
- Sales Taxes collected from customers but not paid to the government are not dischargeable in bankruptcy.
- Tax Penalties on nondischargeable tax debt cannot be discharged.
- Property Taxes payable within one year of the bankruptcy filing.
- Tax Refunds that a person received by mistake are not dischargeable.
There may be other taxes that you cannot discharge in bankruptcy. A bankruptcy lawyer can review your tax debts to determine how a Chapter 13 bankruptcy filing can benefit you.
Filing Chapter 13 Bankruptcy to Get Rid of Tax Debts
For some individuals, filing bankruptcy to get rid of tax debts is the most affordable way to handle tax debts. They may pay less through a Chapter 13 bankruptcy plan than if they entered an IRS Installment Plan or made an Offer in Compromise.
Tax debts are a complicated issue in bankruptcy cases. You must be careful to follow the bankruptcy rules for tax debt to ensure that you are eligible to discharge as much tax debt as allowed by law. Also, you need to ensure that you include all tax debts in your Chapter 13 plan. If you do not include the tax debt in your bankruptcy case, the debt survives the bankruptcy filing.
Understand Your Options to Eliminate Tax Debt
You probably have lots of questions about debt relief. At Ascend, we assist individuals who need help with a debt problem find the debt relief option that works best for them.
We can help you locate a bankruptcy attorney near you that provides free consultations. The first step in determining if filing bankruptcy is right for you is to talk to a bankruptcy lawyer.
We have tools and information that we provide free of charge on our website. You can use our free Chapter 13 bankruptcy calculator to estimate your Chapter 13 plan payment. You may want to try our free Chapter 7 bankruptcy calculator to see if you qualify to file under Chapter 7. Our free Debt Relief comparison calculator is also available if you want to compare various debt relief options.
We encourage you to reach out to Ascend to speak with a representative free of charge. Call us at (833) 272-3631 or contact us online for more information about our free services.