The federal tax code and the Bankruptcy Code are two very complicated documents. So you can expect that when you bring these two codes together, the interplay can get extremely complicated. This post will touch on the treatment of tax claims (federal, state, and local) in a Chapter 13 bankruptcy case.
We note first that tax claims are going to be handled differently depending on what type of bankruptcy someone is on. Each chapter (Chapter 7, 13, and 11) has its own separate and specific way to treat tax debts. So, it is very important to begin with this observation. Taxes might get treated one way in a Chapter 13 case, but in another way if a debtor files a Chapter 7 or Chapter 11 case.
When a Chapter 13 case is filed, the creditors are notified of the filing. Tax authorities have a certain period of time in which to file a proof of claim in the case. The proof of claim will show a breakdown of the tax debt. It may be classified as priority unsecured debt, priority secured debt, or non-priority unsecured debt. In other words, the taxes are broken down into different parts. Very often, the priority portion of the tax debt is small, and the non-priority unsecured portion (interest and penalties) is large.
In the Chapter 13 plan, it is a requirement that the debtor pay the priority portion of the tax claims in full, just like any domestic support obligation. However, the nonpriority unsecured portion of the tax claim is included along with all the other general unsecured creditors (credit cards, medical bills, deficiencies, etc.). And this pool of creditors often gets very little in a Chapter 13 case.
In other words, a debtor who has significant tax debt can end up wiping out a portion of his tax debt by doing a Chapter 13 case. He or she can end up paying back only a small portion of the total tax debt. This is a significant advantage. In fact, it is not often appreciated that bankruptcy is one of the most powerful and underappreciated tax management tools out there. You have more leverage and power than you realize.
Section 523(a)(1) of the Bankruptcy Code provides that the following types of debts of not dischargeable:
- Taxes that are accorded as priority taxes under 11 U.S.C. Section 507(a)(8)
- Taxes with respect to which a return has not been filed
- Taxes with respect to which a return was filed within 2 years of the bankruptcy filing date
- Taxes with respect to which the debtor filed a fraudulent return, or willfully attempted to evade or defeat.
If even one of the categories above applies, then the tax would not be dischargeable. Even if the tax happens to be nondischargeable, there are significant advantages to dealing with it through a Chapter 13 or Chapter 11 plan: the tax would be broken down into priority, secured, or general unsecured components, and these different categories would be treated differently. Often the general unsecured portion gets little or nothing. This can get very complicated. In a Chapter 13 case, there will typically be a situation where some of the debt is classified as priority (and is paid through the plan) and some of it is general unsecured (and it is treated the same as all the other general unsecured debt, like the credit cards, medical bills, etc.) In most cases, the general unsecured portions of tax debts in Chapter 13 cases receive little or nothing. The nondischargeability provisions of Section 523(a)(1) and 523(a)(7) are self-exectuting, meaning that it is not necessary for the state or federal income tax authority to file an objection or a request to determine the dischargeability of the debt, or even to participate in the debtor’s case by showing up in court. (A proof of claim would still have to be filed, of course, for the creditor to be paid).
It is important to mention here how critical it is for a debtor to file a tax return in a timely fashion, even if the tax cannot be paid. Delaying or ignoring this responsibility is one of the major problems encountered in this area. A clear way of summarizing the what we have discussed here is the following. These types of taxes will be treated as general unsecured claims in a Chapter 13 bankruptcy case:
- The debt is for income taxes. Payroll taxes, witholding taxes, excise taxes, and other types of taxes do not qualify.
- The return was due at least three years ago. The return should have been due (including all valid extensions) at least three years before you filed for bankruptcy.
- The return was filed at least two years ago. You must have filed the tax return at least two years before filing for bankruptcy. This is one of the reasons why it is so important just to get the return filed, even if the tax cannot be paid.
- The taxes were assessed at least 240 days ago. The taxing authority must have assessed (recorded you as owning the tax) the tax against you at least 240 days before you filed for bankruptcy.
- There was no fraud or willful evasion of taxes. This requirement is self-explanatory.
Again, to emphasize a critically important point, even if a tax does not meet all of the above requirements and is not dischargeable, there are huge advantages to paying it back in a Chapter 13 case: no liens, no garnishments, some of the tax (general unsecured portion) may be wiped out, and peace of mind from knowing that it is being taken care of. Filing a Chapter 13 case is an underappreciated tax management tool, in fact. Experience has shown that the so-called “offers in compromise” that the IRS theoretically offers are only extremely rarely granted. For the vast majority of people with serious tax issues, a bankruptcy presents a much better alternative.
Please keep in mind that the rules regarding taxes and Chapter 13 are very complicated. This article touches on some major themes, but it is critical to consult with us if you have tax issues or questions. Every case is different, and there may be additional complications when people ask for extensions, have missed returns, offers in compromise, etc. It is very important to speak with an attorney at the earliest opportunity, as the tax authorities are unaware of the legal rights you may have. Very often, there will be multiple ways to solve your problem that will need detailed planning and explanation to achieve.
Read More: Tax Debts In A Chapter 7 Case In Kansas City