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How Does Chapter 13 Bankruptcy Affect Tax Debts?

tax debts

If you owe unpaid taxes to the IRS, the balances together with late penalties and interest can quickly get away from you. You might wonder whether bankruptcy will put an end to IRS collections efforts or discharge what you owe. Here is how a Chapter 13 bankruptcy affects tax debt and what you can do during your payment plan period to reduce even non-dischargeable tax debt.

Can IRS Debt be Discharged in Bankruptcy?

When most people talk about IRS debt, they most often are referring to unpaid income tax obligations, along with the late penalties and interest that comes with missing your tax deadlines. Salaried or hourly employees generally have their taxes withheld from their paychecks, but self-employed workers, gig-economy workers, those who receive cash tips, and others often must estimate and pay taxes on their own. When they don’t, it can create a large IRS tax debt all at once, which will only grow larger if it is not resolved quickly.

Unfortunately, newer income tax debts -- incurred within the last 3 years -- are generally not dischargeable in bankruptcy. The IRS considers these “priority debts” similar to child support. Other “priority” tax debts include:

  • FICA and Medicare taxes generally withheld from your paycheck
  • Sales taxes collected from customers of self-employed workers
  • Employment taxes, excise taxes, and custom duties on international shipments
  • Penalties on non-dischargeable tax debts
  • Improper tax refunds or credits granted on non-dischargeable tax debts

If you were to file for a Chapter 7 bankruptcy, you would still owe these priority tax debts even after the bankruptcy is discharged. In addition, property taxes are treated as “secured” debts -- backed by the value of your home. These property taxes will also survive a Chapter 7 bankruptcy.

Because of this, a Chapter 13 repayment plan may be best if much of what you owe is IRS newer tax debt. The bankruptcy court still treats newer income tax debts as “priority debts” within a Chapter 13 bankruptcy. However, that means something different in the Chapter 13 context.

How Will Chapter 13 Affect My Taxes?

Remember, that in Chapter 13, you and your bankruptcy attorney will create a budget based on your disposable income to pay off as much of your debt as possible. Secured and priority debts, like property taxes and newer tax debt, must be paid in full as part of your Chapter 13 payment plan. However, depending on your financial situation, this could simply shift how your payment is distributed to creditors, to pay off “priority debts” first. At the end of the 3 to 5 year payment period, other, “non-priority debts” -- including older tax debts -- can be discharged if there is not enough money to cover everything you owed.

This means that your bankruptcy attorney will generally prioritize the payment of your non-dischargeable tax debts over other debts, such as credit cards or medical bills. The goal is that, at the end of the payment period, your tax debt will be reduced to $0, and your other debts will be discharged, leaving you with a clean balance sheet going forward.

Should I Avoid Filing My Taxes if I Plan to File for Bankruptcy?

Since new tax debt is nondischargeable, you may wonder if the easy answer is to simply avoid filing your taxes until after the bankruptcy trustee approves your payment plan. However, this is both illegal and unhelpful.

You must submit your most recent tax returns along with your Chapter 13 bankruptcy petition. The trustee uses this information, along with other documentation of your income, to determine if your payment plan is appropriate. If you avoid filing your taxes, it will only delay the approval of your payment plan and run the risk of an audit and additional penalties from the IRS. It is better to file all outstanding tax returns and include the unpaid taxes in your Chapter 13 payment plan, so that everything can be resolved together.

What If I Owe New Taxes During a Chapter 13 Payment Plan?

Many families count on their annual tax refund to make bigger purchases or pay off secured debts (like their property taxes) every spring. However, other taxpayers, including self-employed workers, owe taxes to the IRS every year. New tax debts incurred while you are paying on a Chapter 13 payment plan are called “post-petition” tax debts.

Generally, a bankruptcy petitioner must get approval from the bankruptcy court before incurring new debts. Approval is based on your family’s reasonable needs. Post-petition tax debts are almost always approved. That means the debt gets rolled into your existing payment plan, where it receives priority like other newer tax debt. However, if the amount you owe is more than you and your attorney anticipated in your original filing, you may need to amend your payment plan to increase the portion dedicated to taxes, reducing the amount paid to unsecured creditors and other non-priority debts.

At John A. Steinberger & Associates, P.C., we are a full-service bankruptcy law firm in Southeast MI. We help debtors and families in Southfield, throughout Metro Detroit, and in the surrounding communities. We are committed to helping new and existing clients get relief from tax debts and satisfying the IRS. We work remotely with our clients, using a secure client portal to upload past tax returns, IRS delinquency notices, and other confidential materials, so that you can get relief from your unpaid tax debt. Call us toll-free at (866) 690-2140 or contact us online to schedule a free initial phone consultation.

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