Using Bankruptcy to Manage Non-Dischargeable Taxes

Get a handle on your taxes with a Chapter 13 bankruptcy.

Nondischargeable income taxes can be managed with a Chapter 13 plan. Getty Images

You’ll find lots of information on discharging debts, and particularly about discharging tax debts. Some tax debts, though, are not dischargeable. For instance, income taxes are not dischargeable if they relatively recent, that is they were due on a return that was due to be filed less than three years before the bankruptcy case. An employer is liable for any payroll taxes that the employer fails to turn over to the taxing authority.

Those are never dischargeable.

Even though you might not be able to discharge a chunk of tax debt, you still may be able to use a type of bankruptcy called Chapter 13 to manage that debt and get it paid off.

How Chapter 13 Works

Unless the IRS or another taxing authority has placed a valid lien on your property, your tax debt is unsecured. Unsecured debt has no collateral attached to it. It’s more akin to a credit card balance than a car loan. With a lien, the taxing authority could either sell the property to get the funds necessary to pay off the tax debt, or it can wait until the property is sold then hope that the selling price is enough to cover the amount of the debt.

If you file a Chapter 13 case, you (also known as the "debtor") will propose a payment plan. Under the payment plan, you will make a monthly payment for three to five years to a trustee appointed by the bankruptcy court.

The trustee then distributes your payments among the creditors who have filed proper claims in your case.

Chapter 13 contains all the protections of other types of bankruptcy, like Chapter 7 straight bankruptcy and Chapter 11 reorganizations. Creditors must come into bankruptcy court if they hope to ever collect the debt.

They cannot take action on their own without bankruptcy court approval. This applies even to the IRS and other taxing authorities.

Although you make payments over a three to five year period, in a Chapter 13 case it is possible to end your plan still owing unsecured debt, like credit cards, medical bills, payday loans, and personal loans from the bank. These are called non-priority unsecured debts. As long as you have paid according to your ability to pay, based on a formula that considers your income, reasonable expenses, and the amount and types of debt you owe, you should be discharged of the remaining non-prioirty unsecured debt.

Some unsecured debt cannot be discharged in this way, however. Those debts are called priority debts. Priority debts are unsecured debts that get special handling in a Chapter 13 case. In general, they must be paid in full over the course of the three to five year plan. Most tax debts that are not dischargeable in a Chapter 7 case are priority debts for a Chapter 13 case.

Charlie's Chapter 13 Plan

It will be helpful to look at an example of how a Chapter 13 plan works. Charlie makes $4,000 per month. We also have to look at the Charlie’s expenses for a typical month, including his mortgage, utilities, and home maintenance, food, child care, medical costs, cell phone, transportation and recreation.

In our example, Charles has expenses that total $3,700 per month. Notice that we left out credit card accounts. Those are not considered expenses because they will be paid as part of the Chapter 13 plan, as explained above.  

The difference between Charlie’s current paycheck and his total expenses is his “disposable income”. Charlie’s plan will have to provide that he pay over to the Chapter 13 trustee his disposable income each month. The length of the plan, three or five years or something in between, depends largely on Charlie’s income level and family size.

How Can Chapter 13 Help Manage Nondischargeable Priority Tax Debt?

So how does a Chapter 13 help? Instead of continuing to struggle with a disposable income too small to cover both this tax debt and his credit cards, Charlie just pays the trustee one payment a month of $300.

The Trustee will then distribute that $300 to Charlie’s creditors. In our scenario, because the tax debt is a priority debt, the taxing authority will be paid first until that claim is paid in full. Once the taxing authority is satisfied, the payments will go toward the other nonpriority unsecured debts.

At the end of Charlie’s payment plan, he may still owe some of those creditors. But, he will have paid off the priority tax debt. Any nonpriority debt that remains will most probably be discharged, with the exception of a few debts like student loans.

Chapter 13 will allow Charlie to pay out his unsecured tax debt over a three to five year period. But that is not the only advantage to filing a Chapter 13 case. Interest on the debt does not run during the Chapter 13 case. Therefore, the tax debt can be spread out over a longer period than the taxing authority allows, and be paid at -0- percent interest.

To learn more about Chapter 13 plans, see our article What is Chapter 13 Bankruptcy?

Lots of different factors affect how Chapter 13 plans work and who gets paid. To have your circumstances evaluated, call a qualified consumer bankruptcy attorney. Most offer a free consultation with no obligations.