debt relief

How Taxes Are Handed In Bankruptcy and Debt Relief

What next when you fall behind on your payments and your income is barely enough to meet your obligations? Have you fallen behind on your debt payments? Are you unsure of how you can get back on top of your payments? hen it may be time to look at what your debt relief options are. You can file for bankruptcy. Although most people file for bankruptcy as a last resort, it does offer some benefits. A major benefit of filing for Chapter 13 bankruptcy is you get to spread out your tax debt and pay it over the time of your repayment plan. Therefore, you don’t need to worry about the IRS seizing your bank accounts or enacting wage garnishment orders. Chapter 13 bankruptcy allows you to create an actionable payment plan with reasonable interest than IRS installment plan costs for defaulters. So, how are taxes handled in Chapter 13? Read on to find out.

Priority Tax Debt vs. Non-Priority Tax Debt

Income tax debt can be considered priority tax debt or non-priority tax debt. However, most income tax debts are considered priority debts. Priority tax debts are those you must pay in full over your Chapter 13 payment plan. Once you file for Chapter 13 bankruptcy, the interest in your tax debt stops accumulating, and it can also prevent penalties from accruing on your outstanding tax debt.

On the other hand, non-priority debt is debt that the court can discharge if you file for bankruptcy, and you might end up paying less than you owe. After filing Chapter 13 bankruptcy, the IRS will receive a notification of your filing. They will divide your income tax debt and classify it into a priority or non-priority debt.

Non-priority tax debt is treated similarly to a general unsecured creditor. Under Chapter 13 bankruptcy, general unsecured creditors get a percentage of their outstanding debts cleared through a Chapter 13 plan. So, when you complete payment according to your new plan, the court discharges the remaining amount owed. When the court grants you a bankruptcy discharge, it relieves you of the legal obligation to repay the debt. Therefore, your creditors cannot take any action to collect the discharged debt.

However, there is a percentage of unsecured debts that you must pay. The percentage will depend on different factors like your assets, disposable income, and recent financial transactions. The percentage will vary between 1 and 100. So, depending on your situation, you might need to repay as little as a cent on the dollar.

How Can I Tell if Chapter 13 Bankruptcy Will Affect My Plan?

If you decide to file for Chapter 13 bankruptcy, you need to know how it affects your plan. Use this Chapter 13 calculator to help estimate your monthly cost if you decide to pursue a Chapter 13 bankruptcy.

If you’re considering filing for bankruptcy, you’ll also want to consider the cost of filing for bankruptcy. Keep in mind that costs are relative to where you live. So, depending on where you live, you need to be wondering how much does it cost to file bankruptcy in Michigan, or how much does it cost to file bankruptcy in Oregon, specifically. Make sure you are looking specifically at the cost in your state instead of general costs. Doing so can help you more accurately predict what you are looking at paying. 

What Criteria Does the IRS Use to Classify a Tax Debt as Non Priority?

When you file for bankruptcy, the IRS will need to classify your income tax debt either as priority or non-priority. To classify the debt, the IRS uses the 3-2-240 rule. Here is a breakdown of the rule and what it states;

  •     Three Years- to be considered non-priority, the income tax debt should have become due three years before filing Chapter 13 bankruptcy. Usually, income tax debts are due on the 15th of April the following year. However, there have been extensions on filing since the coronavirus pandemic, so you need to be careful when calculating the years to avoid making mistakes.
  •     Two Years – a debt can only be considered a non-priority if the income tax returns that resulted in tax debt were filed two or more years before filing for Chapter 13 bankruptcy. Although it is acceptable if you file the returns late, the filing date needs to be two years or more before filing Chapter 13.
  •     240 Days – the last qualification is that the tax debt needs to have been charged by the IRS 240 days or more before filing Chapter 13 bankruptcy. Usually, the tax is assessed on the day the taxing authority accepts the tax return or several days after.

If your income tax debt meets these three requirements, it is considered dischargeable. A non-priority debt will receive the same percentage as other unsecured debts.

For example, if your total non-priority debts are $11,000, and your unsecured debts payment percentage is 10%, you will be required to pay $1,100 to non-priority income tax debt. So, when you complete your payments and your Chapter 13 case is closed, the remaining $9,900 will be discharged.

However, your non-priority income tax debt can only be discharged if it’s genuine. So, if you filed fraudulent returns or tried evading taxes, you are not eligible for a discharge. You will repay your tax debt in full.

What is a Tax Lien in Secured Tax Debts?

Sometimes, a taxing authority can file a tax lien if your tax debt is secured. You need to fully pay secured tax debt despite filing for bankruptcy by adding it to your Chapter 13 patent plan. Once you complete paying the tax debt, the lien on your asset will be released.

Luckily, secured tax debts are limited to the value of the taxing authorities’ lien on the property. So, any value above the lien is considered an unsecured or priority debt depending on whether it meets the 3-2-240 rule.

To understand this better, here is an illustration. Let us assume the IRS files a $60,000 tax lien against you in back taxes. But the total net equity on your assets covered by the lien is $20,000. The secured portion of the lien you must pay in full is $20,000. The remaining $40,000 will be analyzed using the 3-2-240 rule and classified as a priority or non-property debt. If it is classified as a priority debt, you will need to fully repay it. In contrast, it can be discharged if classified as a non-priority debt.

How Chapter 13 Handles Other Types of Tax Debts

There are other types of tax debts other than priority and non-priority. However, Chapter 13 handles debt differently. There are special rules used when handling different kinds of debts. Some of these debts may need to be paid in full, while some are eligible for discharge. Here is a breakdown of the other types of tax debts and how they are treated under Chapter 13;

  •     Tax Penalties- are considered to be non-dischargeable tax debts
  •     Employee Payroll Taxes- aren’t eligible for bankruptcy discharge because employers cannot be allowed to discharge payroll taxes they withheld and didn’t pay or failed to withhold
  •     Tax Refunds- if you received the tax refund erroneously, it is not dischargeable.
  •     Sales Taxes-if the tax was collected from customers and wasn’t paid to the government, they cannot be discharged
  •     Property Taxes- are payable within a year of the bankruptcy filing.

While you might get some tax debts discharged under Chapter 13, there are some taxes you cannot discharge. So, consult a Chapter 13 bankruptcy lawyer for help reviewing your tax debts before filing.

Should You File Chapter 13 Bankruptcy to Get Rid of Tax Debts?

Are you in debt and looking for the best way to get rid of tax debts? For some, filing Chapter 13 bankruptcy is an affordable way to get rid of tax debts since a Chapter 13 payment plan is cheaper than IRS installment plans. You may also want to understand what your payment plan may look like. To get an estimate, you can use a specific calculator to create a Chapter 13 calculation of your disposable income which will directly affect how much you will end up paying. 

There are numerous forms of tax debts, which can get complicated in bankruptcy cases. So, you need to understand how taxes are handled in Chapter 13 and the bankruptcy rules to know if you’re eligible for discharge. Additionally, you need to add all tax debts when filing Chapter 13 bankruptcy. Failing to file a tax debt, make it survive the bankruptcy charges,

If you are convinced filing for bankruptcy is the best option out of debt and to repay tax debts, you should also consider the cost of filing for bankruptcy. Filing for bankruptcy comes with court fees and other charges that depend on where you live. 

Other Options You Can Consider to Eliminate Tax Debt

Have you fallen behind on your debt payments and are unsure how to manage your outstanding debts? You need to consider a debt-relief option to get back on top of your payments. Fortunately, there are different options to consider, each offering unique advantages. 

A common debt relief option is debt settlement. However, you need to be cautious when choosing a debt settlement company to work with. Some companies have alleged malpractice cases clearly outlined in the Freedom Debt Relief Lawsuit in 2021. If you begin receiving mail from an address like PO box 1259 oaks pa 19456, you need to be careful with how you proceed.  So you need to do background research and look into the prospective company you would like to work with before moving forward with debt settlement.

One thing to consider with debt relief as well is tax consequences on settled debt via a 1099-c cancellation of debt IRS form.

With numerous debt relief options available, you probably have many questions. Call us today to speak to us about your financial situation to get expert help and top recommendations according to your needs.

About the Author

Dylan Roberge

Dylan Roberge is a San Francisco-based writer and editor with over a decade of experience covering money saving and deal hunting. Before going freelance, he got his start as an editor at Yahoo Finance. These days he writes about mobile, tech gadgets, and lifestyle subjects for a variety of publications.