For various reasons, people can find themselves with serious financial problems, which most likely will also include tax, penalties and interest owed to the IRS. These people try to reduce the amount owed, but nothing seems to work. Then the thought of filing bankruptcy crosses their mind.
But, the bankruptcy rules related to discharging tax debt may surprise them, and you. The following outlines the different types of bankruptcy formats available and suggests other options that may provide a better solution.
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Types of BankruptcyChapter 7 Bankruptcy: This is a liquidation of assets designed to cancel out most, or all, debts. This type of bankruptcy may be an excellent fit for someone with a large amount of debt unrelated to taxes. But, federal taxes in a Chapter 7 will not be discharged in cases where:
- The tax due is not income tax
- Fraud is, or was, involved
- The tax debt is less than three years old
- The tax return creating the debt was not timely filed
- The timing of the assessment of tax by the IRS comes into question
As a result, a taxpayer could be left with an outstanding IRS liability after the bankruptcy is discharged, having more disposable income than they had before, giving the IRS the upper hand in post-bankruptcy negotiations to reduce the undischarged tax debt.
Chapter 11 Bankruptcy: While this chapter of bankruptcy is typically used by businesses, some high-income individuals may also find it desirable to reorganize their finances and debt. There are a lot of factors involved in deciding to use a Chapter 11 bankruptcy, including assets, cash flow, projected future income, and the amount of debt owed.
The courts also consider compliance with filing and paying current taxes, as well as the ability to stay current and compliant. If a business or individual are unable to comply with the terms of their Chapter 11 Bankruptcy, it may be converted to a Chapter 7 bankruptcy. And, similar to a Chapter 7 bankruptcy, not all taxes may be discharged in a Chapter 11 bankruptcy because only certain taxes are eligible.
Chapter 13 Bankruptcy: This is a voluntary reorganization of debt for individuals, typically preferred by wage-earners and sole proprietors. It requires the person filing for bankruptcy under Chapter 13 to have regular, reliable income. However, unlike Chapter 7, assets are not required to be liquidated. But like Chapter 11, anyone filing under Chapter 13 must be complaint with filing and paying current taxes and have the ability to stay current throughout the course of the bankruptcy. Depending on income and other factors, a Chapter 13 bankruptcy can last from three to five years, depending on the cash flow available to pay debts, including taxes. And, while not always the case, sometimes the IRS can collect beyond the three to five years granted to other debtors.
Alternatives to Bankruptcy
But, before making the move to file bankruptcy and the overall financial considerations that can be imposed to reduce or eliminate tax debt, consider the alternatives that are available through the taxing authority that is owed the tax.
Installment Agreements: This is the most common approach the IRS takes with individuals and businesses owing back taxes. It is like a Chapter 13 bankruptcy for an individual, in that it allows for repayment of the debt over the course of several months, up to 84 months in some cases.
Like bankruptcy, a taxpayer must catch up all delinquent filings and pay their current taxes in order to qualify for an installment arrangement. Depending on how much is owed, the IRS may ask a taxpayer to complete financial disclosure forms to give the IRS a clear picture of the taxpayer’s financial situation.
Once an installment arrangement is established, the taxpayer is safe from aggressive collections (levies, wage garnishment, accounts receivables levies, etc.). However, the taxpayer is required to file and pay current taxes, or the installment arrangement may default, leaving the taxpayer to be once again subject to aggressive collections measures.
Partial Payment Installment Agreements (PPIA): Of course, the IRS wants taxpayers to pay off their liabilities immediately whenever possible, or as quickly as possible through an installment agreement. But, sometimes a taxpayer does not have the ability to satisfy a liability fully, even if given a longer time to pay, such as 72 or 84 months. In these cases, a PPIA may be the right solution. The IRS will thoroughly examine the financial situation of any taxpayer seeking a PPIA. Similar to how a Chapter 11 bankruptcy can be converted into a Chapter 7 bankruptcy, an applicant may be asked to liquidate assets or use the equity they have in assets to pay off as much of the liability as possible. Plus, unless other factors are involved, the taxpayer won’t be asked to sell assets, if doing so would create a financial hardship or the taxpayer doesn’t have the authority to do so.
Offer In Compromise (OIC): The Offer In Compromise is a great solution for a select group of taxpayers who owe back taxes. The OIC, much like a combination of a Chapter 7 and Chapter 11 bankruptcy, looks at a taxpayer’s assets and projected future income. If the tax liability is more than can reasonably repaid over available time because of limited or burdened assets, then an OIC may be the right fit. There are a lot of factors the IRS looks at in determining whether an applicant qualifies for an OIC. Obviously, the IRS is not going to accept less for a debt than is owed if an individual or business has the ability to pay that liability over the course of a reasonable period of time. And, it should be noted, the consequences for submitting a frivolous OIC are severe, including the ability for the IRS to add 12 months to the Collection Statute Expiration Dates, giving them an additional year to collect the tax before the statute of limitations expire. It’s a wise move to have representation help put together an OIC.
What’s Right for You?
There is no one-size-fits-all solution when it comes to tax debt. It is sometimes possible to reduce tax debt through installment agreements, PPIAs, or OICs. The general consensus among tax professionals, whether they are CPAs, EAs, tax attorneys, and even knowledgeable bankruptcy attorneys, is that bankruptcy is the last resort when it comes to tax debt and therefore, it is worth exploring other options first.
Unsure what avenue is right for you in dealing with tax debt and tax relief help? Our professionals can help you work through your unique situation.