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Chapter 13 Handles Tough Income Tax Debts

Law Office of Robert L. Firth Nov. 11, 2013

If you owe recent income taxes, or multiple years of taxes, Chapter 13 can provide huge advantages over Chapter 7, and over other options.

This blog post will illustrate this with an example, which will be more fully explained in my next blog.

The Example

Consider a husband and wife with the following scenario:

  • Husband lost his job in 2008, so he started a business, which, after a few promising years in which it generated some income, failed in late 2012.

  • The wife was consistently employed throughout this time, with pay raises only enough to keep up with inflation.

  • They did not have the money to pay the quarterly estimated taxes while husband’s business was in operation, and also could not pay the amount due when they filed their joint tax returns for 2008, 2009, 2010, 2011 and 2012. To simplify the facts, for each of those five years they owe the IRS $4,000 in taxes, $750 in penalties, and $250 in interest. So their total IRS debt for those years is $25,000—including $20,000 in the tax itself, $3,750 in penalties, and $1,250 in interest.

  • Husband found a reliable job six months ago, although earning 20% less than he did at the one he lost before he started his business.

  • They filed every one of their joint tax returns in mid-April when they were due, and have been making modest payments on their tax balance when they have been able to.

  • They have no debts with collateral—no mortgage, no vehicle loans.

  • They owe $35,000 in medical bills and credit cards.

  • They can currently afford to pay about $500 a month to all of their creditors, which is not nearly enough to pay their regular creditors, and that’s before paying a dime to the IRS.

  • They are in big financial trouble.

Without Any Kind of Bankruptcy

  • If they tried to enter into an installment payment plan with the IRS, they would be required to pay the entire tax obligation, with interest and penalties continuing to accrue until all was paid in full.

  • The IRS monthly payment amount would be imposed likely without regard to the other debts they owe.

  • If the couple failed to make their payments, the IRS would try to collect through garnishments and tax liens.

  • Depending how long paying all these taxes would take, the couple could easily end up paying $30,000 to $35,000 with the additional interest and penalties.

  • This would be in addition to their $35,000 medical and credit card debts, which could easily increase to $45,000 or more when debts went to collections or lawsuits.

  • So the couple would eventually end up being forced to pay at least $75,000 to their creditors.

Under Chapter 13

  • The 2008 and 2009 taxes, interest and penalties would very likely be paid nothing and discharged at the end of the case. Same with the penalties for 2010, 2011, and 2012. That covers $11,500 of the $25,000 present tax debt.

  • The remaining $13,500 of taxes and interest for 2010, 2011, and 2012 would have to be paid as a “priority” debt, although without any additional interest or penalties once the Chapter 13 case is filed.

  • Assuming that their income qualified them for a three-year Chapter 13 plan, this couple would likely be allowed to pay about $500 per month for 36 months, or about $18,000, even though they owe many times that to all their creditors.

  • This would be enough to pay the $13,500 “priority” portion of the taxes and interest, plus the “administrative expenses” (the Chapter 13 trustee fees and your attorney fees).

  • Then after three years of payments, they’d be completely done. The “priority” portion of the IRS debt would have been paid in full, but the older IRS debt and all the penalties would be discharged (written off), likely without being paid anything. So would the credit card and medical debts.

After the three years, under Chapter 13 the couple would have paid a total of around $18,000, instead of eventually paying at least $75,000 without the Chapter 13 case. They’d be done—debt-free—instead of just barely starting to pay their mountain of debt. And they would have not spent the last three years worrying about IRS garnishments and tax liens, lawsuits and harassing phone calls, and the constant lack of money for necessary living expenses.

The next blog post will show how all this works. I have used this technique several times with clients in the Coachella Valley of California (the Greater Palm Springs area) where I practice, but the same plan should work anywhere in the country.