Solving Tax Problems Using Chapter 13 Bankruptcy

As discussed in one of our previous blog posts, Chapter 13 Bankruptcy can be a very powerful tool to solve a fairly wide variety of financial problems.  One of the more common uses of Chapter 13 is to solve tax problems – some taxes can be discharged in bankruptcy, and those that cannot can be paid as part of a Chapter 13 case without interference from the taxing authorities.  Under federal law, tax collection efforts must stop once the taxpayer files a Chapter 13 Bankruptcy as the “automatic stay” prevents the continuation of such collection efforts.

In Chapter 13 Bankruptcy, the taxpayer makes monthly payments to the Chapter 13 Trustee over a maximum five-year time period.  The amount of the payment depends primarily on the type of debts involved, the taxpayer’s current income and expenses, and the taxpayer’s assets.

State and federal taxes are generally separated into two different categories – “priority” and “non-priority”.  Priority taxes are generally those taxes which are not dischargeable; non-priority taxes are generally those taxes which are dischargeable.  In any event, priority debts must be paid in full as part of the Chapter 13 case from the payments made to the Trustee by the taxpayer.  If there is money left over in the case after priority taxes are paid, non-priority taxes may receive some percentage of what is owed (pro rata with other general unsecured creditors).

Aside from stopping collection efforts by the taxing authorities, Chapter 13 has the advantage of stopping further interest and penalties on the tax debt once the case is filed.  That being said, I would like to offer some cautions and warnings about using Chapter 13 to address tax problems:

✔    The taxpayer must have sufficient income to be able to cover regular monthly living expenses, and make a payment to the Chapter 13 Trustee, depending on how large the tax debt is.  Without sufficient income, the Bankruptcy Court will not confirm a Chapter 13 case.

✔    Anyone filing for Chapter 13 Bankruptcy must normally turn over tax refunds to the Chapter 13 Trustee for at least the first three years of the Plan, and is prohibited by Court order from incurring any new credit during the case without the approval of the Trustee.

✔    Depending on the situation, if income increases at some point during the case, it is likely that monthly payments to the Chapter 13 Trustee will increase.

✔    It is vitally important that the taxpayer not incur any further tax debt once the Chapter 13 case is filed.  If traditionally employed, it is essential that the taxpayer adjust payroll withholdings to ensure that no taxes are owed at the end of the year.  If self-employed, the taxpayer must be sure to set aside sufficient money each quarter to pay estimated taxes so that no additional money is owing when it is time to file the tax return.  If a significant amount of taxes is in fact owed at the end of the year, the taxpayer is subject to having the case dismissed, which returns the taxpayer to the moment immediately prior to the filing of the Chapter 13 case.

✔    If the case is dismissed for any reason, the interest and penalties which were stayed will be retroactively added to the taxpayer’s debt.  This will obviously make a bad situation worse, so it is essential that the taxpayer complete the case to minimize tax liability.

While Chapter 13 does offer some powerful advantages, it also comes with some drawbacks.  Each taxpayer must make an individual assessment to determine whether or not a Chapter 13 filing makes sense, both from an economic, and personal, standpoint.

This post is intended to be purely informational in nature, and cannot be considered legal advice.  If you have questions related to the use of Chapter 13 to solve tax problems, please call our office at (503) 545-1061 (Oregon cases) or (360) 836-4238 (Washington cases) to schedule a free initial consultation.