Looming income tax debt can be daunting and create financial stress.  What are your best options to resolve the debt and would filing bankruptcy help?  Here is the breakdown of how tax debt is handled in the two main types of consumer bankruptcy.

Chapter 13 bankruptcy  is a debt repayment plan.  While it is still possible to discharge or eliminate a portion of debt through a Chapter 13 plan, the focus is repayment of debt with court protection from creditors.  This includes State of Michigan Income tax debt as well as IRS tax obligations.

The key to how the debt is handled is based on:

• The age of the tax debt
• The amount of time that has passed since the tax returns have been filed, including whether the tax returns were filed late.

Under a Chapter 13 plan, any tax debts associated with tax returns that are due within 3 years of the filing date are paid back as a priority debt.  This means the base liability must be paid back at 100%.  The penalties are put into a separate category of debt and are not required to be paid in full and can be discharged.  In Chapter 13 the repayment is structured to pay the priority debt prior to any unsecured debt obligations (credit card bills, medical bills, etc.).

If the tax debt is over 3 years old, the return has been filed for at least 2 years, and the tax has been assessed for at least 240 days, the debt is considered unsecured and is treated just like credit cards, medical bills, personal loans, etc.  This means that you are only required to pay back what your budget allows during the course of the 36 – 60 month repayment process and the balance of the income tax debt is legally eliminated or discharged at the completion of the program.

In the event the taxing authority has a lien on your property the value of the property may impact the taxing authorities’ rights in the bankruptcy and a Chapter 13 bankruptcy will ultimately have the effect of eliminating those liens.

In short, Chapter 13 bankruptcy is a comprehensive debt consolidation program that focuses on:

• Organized debt repayment process with predictable payments, court protection from creditor actions or harassment and flexibility to modify payment plans as circumstances change.
• Becoming debt free (except secured debt obligations such as mortgages that are longer term notes) at the completion of the repayment program.
• Improved credit by impacting and improving the two main drivers of your credit score: recent payment history and debt-to-income ratio.

Chapter 7 bankruptcy  is a fresh start program that allows you to eliminate unsecured debt obligations with a court discharge.  Types of debts that can be eliminated:

• Credit cards
• Medical bills
• Personal loans
• Loan deficiency debt (such as a home foreclosure or vehicle repossession)
• Old utility bills
• Income tax debts over 3 years old IF the tax returns were filed on time and without any extensions (and no tax liens have been filed).

If the IRS or State of Michigan has already established tax liens, then that lien cannot be eliminated under a Chapter 7 bankruptcy.  It would need to be treated under a Chapter 13 bankruptcy or some other debt plan.

Conclusion

So the moral of the story is always file your tax returns on time, regardless of whether you can pay the debt at the time of filing.  If you have tax debt or any debt obligations, we advocate for resolution.  There are certain instances where non-bankruptcy resolution for tax liabilities is more favorable.  If you can resolve the debt on your own or with a non-bankruptcy program then great – get it done!  If you cannot resolve the debt on your own or with the assistance of a lawyer and you have other debts and creditor actions beyond the tax debt, then don’t wait for your credit to get worse or your stress to increase before considering a bankruptcy filing to bring resolution.

Have a question? Contact Venar Ayar.