Discharging Income Tax Debt: How Chapter 7 and Chapter 13 Differ

Consult with a qualified consumer bankruptcy attorney about whether Chapter 13 or Chapter 7 is better for you. Getty Images

It is true that income tax debts can be discharged in Chapter 7 and in Chapter 13, but how each chapter treats income taxes is significantly different. To understand the treatment, it is important to understand that Chapter 7 and Chapter 13 are designed to accomplish different goals and each chapter employs different processes to get there.

Chapter 7 is also known as straight bankruptcy. It usually takes four to six months from filing to discharge.

The goal for most debtors (the people who file a bankruptcy case) is a discharge, which is an order of the court telling the world that the debtor has completed all requirements in the case and is no longer liable for payment of the debt. It does not officially wipe out the debt or make it disappear. It just relieves the debtor from the responsibility of having to pay it back.

A Chapter 13 is also designed to result in a discharge, but the way it goes about it is significantly different. In a Chapter 13 case, the debtor proposes a plan to repay debts over a period of three to five years. The payments are usually made monthly to a trustee appointed by the court. The funds are then transmitted by the trustee to the debtor’s creditors who have claims that meet certain criteria and have been allowed by the bankruptcy court. The amount of the plan payments depends on the debtor’s income, expenses, and the type and amount of debt to be repaid.

At the end of the repayment plan, any unsecured debt that has not been paid is discharged.

Debts are also classified in different ways. Some debts are secured, meaning the debtor has put up collateral that the creditor can use to pay the debt if the debtor stops making payments. Other debts are unsecured, meaning they are not secured by collateral.

Unsecured debts are further classified into priority and non-priority because, in truth, some debts are considered more important or more vital to repay than others. The bankruptcy code recognizes a difference between recent and older income tax debts, with recent taxes having priority status.

Treatment of Income Tax Debts in Chapter 13

Priority debts have to be paid in full in a Chapter 13 case. Non-priority debts are paid on a pro rata basis, meaning that all the non-priority debts are lumped together, and to the extent that there are funds to pay them in the plan, the claims are each paid the same percentage.

For instance, income tax debts that are newer than three years old are priority debts. They have to be paid in full over the course of the Chapter 13 three to five-year repayment plan. Income tax debts older than three years* are generally non-priority debts.

Example: Margaret owes $5,000 in priority tax debt and $10,000 in non-priority tax debt and $12,000 in other unsecured debt like credit cards and medical bills. When her income and expenses are considered, the court determines that she can afford a Chapter 13 payment of $200 per month for a total of $12,000 over five years.

Out of that $12,000, the $5,000 claim for priority taxes would be paid in full, leaving $7,000 to pay on non-priority debt. But there’s a total of $22,000 in non-priority debt. That means each non-priority debt will receive just over 30 percent of its claim. But if all the payments are made, and all the other requirements of Chapter 13 are adhered to, Margaret would receive a discharge that would relieve her of the liability for the remaining 70 percent.

Treatment of Income Tax Debts in Chapter 7

In a Chapter 7 case, most of the non-priority debt would also be dischargeable. If you qualify for a Chapter 7 case, most of the income tax debt more than three years old would be considered discharged along with associated interest and penalties. Most of the newer tax debt, along with interest and penalties on the newer debt, would not be discharged.

Determining which chapter is best can be complicated. The rules for discharging income tax debts are tricky. You can learn more here: *************************************, but nothing can substitute for the advice of a qualified consumer bankruptcy attorney or tax professional.

To learn more about the rules for dischargeable vs. nondischargeable debt and priority vs. nonpriority debt, see Discharging Debts: General Discharge vs. Dischargeability.