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Unfiled Tax Returns and Bankruptcy

June 29th, 2020 at 7:00 am

  

If you’re considering filing bankruptcy, should you first prepare and submit any unfiled income tax returns? Should you prioritize paying them? 


Our last two blog posts have been about what you should and should not do before filing bankruptcy. These are important to consider even if you hope to avoid bankruptcy but are sensibly admitting it’s possible.

So two weeks ago we focused on keeping, and not selling or giving up your:

  1. assets
  2. especially any retirement funds
  3. collateral on debts, such as your home, vehicles, or furniture

Last week we discussed whether to take on more debt to buy time and maybe avoid needing to file bankruptcy.

Today we look at whether you should file any unfiled income tax returns, and possibly prioritize paying unpaid income taxes.

The Quick Answer

In general you should:

  1. prepare but not submit your tax returns to the IRS/state before seeing your bankruptcy lawyer;
  2. not hold off on getting advice from a lawyer if you can’t get your tax return(s) prepared beforehand;
  3. avoid paying any income taxes before getting advice about doing so from a lawyer;
  4. if you’ve recently paid income taxes or are being forced to, all the more reason to get legal advice about how to proceed now.

Prepare Tax Returns

There’s a simple reason why it’s good to have any unfiled tax returns prepared before seeing a lawyer. The more information you can provide to your lawyer the more concrete his or her advice to you can be.

Bankruptcy can be a surprising good way to solve your tax problems, in numerous ways. It can virtually always stop tax collection, both forced (garnishments) and voluntary (installment payments). Bankruptcy can sometimes reduce payment of tax interest and penalties. Bankruptcy can buy you time, and protect you while you prioritize who you pay. And under the right conditions bankruptcy can even completely wipe out (“discharge”) an income tax debt.

But as you might expect the interplay between tax law and bankruptcy law can get complicated. For example, whether bankruptcy discharges an income tax debt depends on whether that tax meets some detailed conditions. So the more details about your taxes you bring to your lawyer the more specific the legal advice you’ll receive.

Therefore, if you haven’t prepared any outstanding tax returns, it helps to do so before visiting your lawyer.

But Do Not Submit the Tax Returns

There’s just as simple of a reason not to submit your tax returns to the IRS/state tax authority before seeing your lawyer. Once you submit them you can’t un-submit them.

Of course you are legally compelled to send in your income tax returns. And there’s a legal deadline to do so. And you can submit an amended return if you need to correct the original return.

But submitting a tax return is in effect a legal act which has consequences. For example, it may affect the timing of your bankruptcy filing, and impose otherwise avoidable timing pressure.  

So, when possible, it generally makes sense to see your lawyer before submitting the outstanding tax return(s).

Don’t Delay Getting Legal Advice

Life can get complicated, financial and otherwise. You may have big roadblocks to getting your tax returns prepared. You may not have the necessary information or documents available to do so. Your tax returns may need the help of a tax preparer and you don’t have the money.

However, your financial circumstances may be crying out for bankruptcy and/or other legal advice. You may simply not be able to prepare the tax return(s) beforehand. While doing so would likely be helpful, this should not stop you from getting advice when you need it.

Prioritizing Paying Income Taxes

Every situation is different but, generally, see your bankruptcy lawyer before paying taxes.

Again, obviously you have a legal obligation to pay your income taxes.

However, if you have more debts than you can pay, it’s legitimate to ask which you should pay first. What order should you pay an income tax debt vs. an unpaid home mortgage vs. a late vehicle loan payment?

If you owe more than one income tax, which should you pay first? The IRS or the state? The older or newer one? Can you earmark the payment and should you do so between the tax itself vs. the unpaid interest vs. accrued penalties?  

How does the timing of tax payments affect the timing of the possible bankruptcy filing?

So you can see that there are various fair questions about paying your income taxes when you’re considering bankruptcy. All of these questions, and likely more, would greatly benefit from legal advice.

If Paying Taxes Now

So what if you are making income tax payments now. Consider three scenarios.

First, you’re making agreed monthly installment payments on an older unpaid income tax. You know the IRS/state will come after you hard and fast if you stop paying.

However, the tax you’re paying may qualify for discharge—a complete legal write off. It may make sense to stop paying the monthly payments so you can put that money for better use. You need to determine your game plan and coordinate the timing with your bankruptcy lawyer.

Second, the IRS/state is garnishing your paycheck for an income tax debt. Whether or not that tax debt qualifies for discharge, a bankruptcy filing would stop the garnishments. Clearly you would benefit from learning about how this works, and especially the pertinent timing. Plus of course you need to learn about the different bankruptcy options for your entire financial situation.

Third, you’re paying an older income tax monthly, either voluntarily or by garnishment. As a result you’re not paying any or enough current tax withholding or quarterly estimated payments. As a consequence, you may be paying an older tax debt that bankruptcy would discharge and not paying one that you could not discharge. You may be using your precious money to pay a not-required-to-pay debt instead of one you must pay after bankruptcy. It would certainly make sense to get legal advice to prevent such a less-than-best use of your money.

 

A Chapter 13 Plan to Pay Income Tax

December 30th, 2019 at 8:00 am

Here’s an example of a Chapter 13 payment plan to pay income tax, showing how you pay what you can afford and avoid some interest, penalties. 

 

Today we put the facts of last week’s blog post into a Chapter 13 plan, showing how it actually works. You’ll see how Chapter 13 saves you money and avoids stress as you pay off your priority income taxes.

The Example: The Tax, Interest, and Penalties

Assume you owe $10,000 to the IRS for income taxes from the 2016 tax year. That’s for the tax alone without the penalties and interest. Plus you owe interest of $1,200 (currently 5% annually), $2,000 for a failure-to-file penalty (which the IRS assesses  at 5% per month of being late), and $1,650 for a failure-to-pay penalty (calculated at 0.5% per month). So including the current interest of $1,200 and a total of $3,650 in penalties this $10,000 tax has turned into a total debt to the IRS of $14,850. And the interest and failure-to-pay penalty just keep on accruing.

As we showed two weeks ago, this relatively recent $10,000 income tax itself can’t be discharged (written off) in bankruptcy. You’d have to figure out a way to pay it after completing a Chapter 7 “straight bankruptcy” case. In a Chapter 13 case you pay that amount through your court-approved payment plan.

The Tax and Interest vs. the Penalties

In either a Chapter 7 or Chapter 13 case the $1,200 in accrued interest has to be paid in full as well. The interest continues accruing nonstop during and after a Chapter 7 case. The difference is that interest effectively stops accruing under Chapter 13. You don’t have to pay any interest beyond the case filing date as long as you successfully complete your case.

The situation is usually the same with any penalties that accrue beyond the bankruptcy case filing date. Under Chapter 7 the penalties continue to accrue, during the case and after it’s completed. Penalties keep getting added on until the tax is paid in full. But under Chapter 13 the penalties generally stop accruing. This is true as long as the IRS did not record a lien on this specific tax before you filed the Chapter 13 case.  (Prior-recorded tax liens create a number of complications that we don’t get into here.)

So, in a Chapter 7 case (or outside of bankruptcy altogether) you’d have to pay the full $14,850 of tax/interest/penalties. Plus the interest and penalties would continue to accrue until you finished paying off the entire debt. If you’d pay it off slowly in an extended monthly payment plan, the additional interest and penalties would be substantial. Conceivably you could end up paying around $20,000 for the $10,000 tax.

In contrast, in a Chapter 13 case you may only pay the $10,000 tax plus prior-accrued $1,200 of interest. Assuming no tax lien and a successfully completed 0% Chapter 13 case, you’d be paying about $11,200 instead of as much as $20,000. (In a 0% case there’s no money for the general unsecured debts.)

The Chapter 13 Plan

To keep this explanation as straightforward as possible, assume you owe this IRS tax debt and only other simple debts. That is, all your other debts are “general unsecured” ones. They are not secured—such as a vehicle loan, home mortgage, and a debt with any other collateral. They are not special, priority debts like unpaid child support or other recent tax debts. Chapter 13 is actually often very good at handling multiple secured and priority debts. In fact it’s often the very best tool if your situation is complicated with such other tough debts. But for the sake of this example we focus on how Chapter 13 handles this single income tax debt.

So assume you have a lot of medical bills, credit cards, and/or other general unsecured debts—say $90,000 total. Your prior accrued income tax penalties of $3,650 are also general unsecured debts, so now the total is $93,650. This plus the 2016 tax-plus-interest amount of $11,200 means you have just under $105,000 in debt. Here’s how a Chapter 13 plan with these debts could look like.

You and your bankruptcy lawyer would put together your monthly budget. Let’s say that after subtracting you and family’s reasonable living expenses from your monthly income, you’d have $385 per month left in “disposable income.” That would not even come close to paying monthly payments on your $105,000 or so of debt.

The Great Result Here

But this $385 amount would be enough—just enough—to pay off your IRS debt in full in just 3 years. $385 for 36 months is enough to pay off the $10,000 base tax, plus the $1,200 in already accrued interest. It would also pay a relatively modest amount of Chapter 13 trustee’s fees (generally a set percentage of whatever you pay into your payment plan) and your own attorney’s fees (whatever you didn’t pay before filing your case). The law usually allows (indeed requires) these “administrative costs” to get paid before the general unsecured debts receive anything.

So in this example $385 per month for 36 months would pay off the $11,200 priority portion of your tax debt. ($10,000 + $1,200.) But beyond that there would not be any money for the general unsecured debts. This means there would be nothing for the $3,850 in prior accrued tax penalties.

As a result all of your “disposable income” during the 3 years of the plan would go just to pay the tax and prior interest. (Plus the mandatory “administrative costs.”)  Then after the 36th month of payments, your Chapter 13 plan would be finished. At that point all of your general unsecured debts would be legally discharged. This includes the $3,850 in prior tax penalties. In addition, the IRS would then wipe off its books any penalties and interest that would have accrued since the date of your Chapter 13 filing.

After only paying the $10,000 tax plus $1,200 in prior interest, you’d owe the IRS nothing. You’d also be free and clear of all the rest of your debts. After paying only as much as your budget allowed for 3 years, you’d have a completely fresh financial start.

 

Paying Income Taxes through Chapter 13

December 23rd, 2019 at 8:00 am

Chapter 13’s advantages in paying off your priority income taxes become clearer when you see what you don’t have to pay.

 

Last week we got into the advantages of paying priority income taxes through a Chapter 13 “adjustment of debts” case. Those are the usually-recent income taxes which cannot be written off (“discharged”) in bankruptcy. Today we show more clearly how Chapter 13 can be tremendously helpful with income taxes.

The Example: The Tax Breakdown

This example expands on one we introduced last week. Assume that you owe $10,000 to the IRS for income taxes from the 2016 tax year.

In addition there’s a failure-to-file penalty of $2,000 for filing 4 months late without getting an extension. The IRS assesses that penalty  at 5% per month of being late. So here, 4 months at $500 per month = $2,000.

Plus there’s a failure-to-pay penalty of $1,650. That’s calculated at 0.05% each calendar month or partial month that the tax remains unpaid. So here, 33 months or partial months from the April 2017 payment due date to December 2019, at $50 per month = $1,650. (Note that this penalty is reduced to 0.025% per month if you’re in an IRS payment plan.)

You also owe interest on the unpaid tax. It’s more complicated to calculate because the rate changes. It’s been at 5% per year since April 1, 2018 and 4% for two years before that. Plus it compounds daily. To keep it simple, assume for this example that $1,200 of interest has accrued on the $10,000 tax owed.

So combining these, assume you owe $10,000 in 2016 income tax, plus $3,650 in penalties ($2,000 + $1,650), plus $1,200 in interest, a total of $14,850 owed to the IRS for this tax year.

The Tax and Interest vs. the Penalties

1. Accrued interest. If an income tax does not qualify for discharge (under the rules discussed last week), neither does the interest. So during a Chapter 13 case you’d have to pay the tax and the interest (accrued up to the date of bankruptcy) in full. In our example that’s the $10,000 in straight tax plus the $1,650 of interest, or $11,650.

2. Accrued penalties. But the accrued penalties are quite different. These are usually not treated as priority debt but rather as general unsecured debt. (This assumes there’s no recorded tax lien on the tax, which could make the debt partly or fully secured.) In a Chapter 13 case you pay general unsecured debt only to the extent you can afford to do so. This is AFTER paying all priority and appropriate secured debts. Often you don’t have to pay general unsecured debts, including tax penalties, much. It’s not uncommon that you pay nothing.

In our example the $3,650 in penalties is general unsecured debt. So during the course of your 3-to-5-year case you pay this portion only as much as you can afford. You may pay nothing.

3. Ongoing interest and penalties. Usually you don’t pay any ongoing interest or penalties on the tax during the Chapter 13 case. The IRS continues to track it. But as long as you finish the case successfully you will not have to pay any of it. This lack of ongoing interest for 3 to 5 years saves you a lot of money. It also often enables you to end your case more quickly.

Filing the Chapter 13 Case

Now assume you filed a bankruptcy case on December 10, 2019. You were in a hurry to file because the IRS was threatening to garnish your paycheck. The 2016 income tax is not discharged in bankruptcy because it’s  less than 3 years from the tax return filing deadline of April 15, 2017 and the December 10, 2019 filing date.

If you filed a Chapter 7 “straight bankruptcy” that would have provided only limited help. It would have stopped the IRS’s garnishment threat for 3 or 4 months while the Chapter 7 case was active. Then if discharging your other debts would free up enough cash flow so that you could reliably get on an installment payment plan with the IRS to pay off the $14,850 reasonably quickly, then Chapter 7 might make sense.

But that’s a big “if” which doesn’t happen often in the real world.  And even if this scenario were possible, you’d likely pay much more than under Chapter 13. After a Chapter 7 case, you’d have to pay the $3,650 in accrued penalties in full (instead of only in part or not at all under Chapter 13). Interest, and the failure-to-pay penalty, would continue accruing non-stop, until paid off. This adds to the amount you eventually have to pay. Each time you’d make a payment, part would go to that month’s new interest and penalties. So you have to keep paying longer.

Chapter 13 Instead

We’ve explained why his situation should play out much better under Chapter 13. But we’ll show how it actually works over the course of a payment plan in our blog post next week.

 

Priority Income Tax Debts under Chapter 13

December 16th, 2019 at 8:00 am

Chapter 13 gives you huge advantages for paying off your priority income tax debts. You’re protected while you pay what you can afford.


Last week we discussed the advantages of paying priority debts through a Chapter 13 “adjustment of debts” case. We referred to recent income taxes as one of the most important kinds of priority debt. Today we show how Chapter 13 can greatly help you take care of recent income tax debts.

Recent Income Taxes Can’t Be Discharged

The law treats some, usually more recent, income tax debts very differently than other, usually older, income tax debts. Generally, new income taxes are “priority” debts and can’t be discharged (written off) in bankruptcy.

There are two conditions determining whether a tax debt can be discharged. (There are a few other conditions but they are not very common so we don’t address them here.) Bankruptcy does NOT discharge an income tax debt:

1. if the tax return for that tax debt was legally due less than 3 years before you file your bankruptcy case (after adding the time for any tax return-filing extensions) U.S. Bankruptcy Code Section 507(a)(8)(A)(i).

OR

2. if you actually submitted the tax return to the IRS/state less than 2 years before you file the bankruptcy case. Bankruptcy Code Section 523(a)(1)(B)(ii).

Two Examples

Assume you filed a bankruptcy case on December 10, 2019. You owe income taxes for the 2017 tax year. The tax return for that tax was due on April 17, 2018 (because of a weekend and holiday). (This assumes no tax return filing extension.) That’s much less than 3 years before the December 1, 2019 bankruptcy filing date. So, no discharge of the 2017 tax debt, because of the first 3-year condition above.

As for the second condition above, assume again that you filed your bankruptcy case on December 10, 2019.  This time change the facts so that you submitted the tax return late for the 2015 taxes, on October 1, 2018. That’s less than two years before the December 10, 2019 bankruptcy filing date. So because of the second condition above, taxes due for 2015 would not get discharged in bankruptcy

Meeting either of the two conditions makes the tax debt not dischargeable. In the second example immediately above, more than 3 years had passed since the deadline to submit the tax return. (The 2015 tax return was due on or about April 15, 2016.) But less than two years had passed since the actual submission of the tax return. So, no discharge of the tax debt.

With no discharge, you would have to pay that income tax debt after finishing a Chapter 7 case. But there are advantages of paying this priority debt in a Chapter 13 case.

Advantages of Paying Priority Income Tax Debts in Chapter 13

Under Chapter 13:

  1. You are protected from aggressive collection by the IRS/state not for 3-4 months as in Chapter 7 but rather 3-5 years.
  2. This includes preventing any new recorded tax liens, and getting out of any installment payment plans.
  3. The amount you pay monthly to all your creditors, including the priority tax, is based on your actual budget. It’s not based on the often unreasonable requirements of the IRS/state.
  4. The amount your priority tax gets paid each month (if any) among your other debts is flexible. You do have to pay all of the priority tax debt(s) by the time you finish your Chapter 13 case. That’s up to a maximum 5 years. But other more urgent debts (such as catching up on a home mortgage) can often get paid ahead of the taxes.
  5. Usually you don’t pay any ongoing interest or penalties on the tax during the Chapter 13 case. That takes away the need to pay it quickly. Plus the lack of additional interest and penalties significantly reduces the amount needed to pay off the tax debt.
  6. If the IRS/state recorded a tax lien against your home or other assets before you filed bankruptcy, Chapter 13 provides a very efficient and favorable forum to value and pay off that secured portion of the priority debt.

 

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