To help with your understanding of how a Chapter 7 bankruptcy can help you end an IRS problem, here is a step by step guide.  Hopefully, it will make the process a  little less intimidating.

Step 1.     Have you filed a tax return? If you have not filed a return, or if the IRS filed a an estimated return for you (substite for return), you are not eligible for a Chapter 7 tax discharge.  An original return must first be on record with the IRS. 

Step 2.    If you have filed a return, how long has it been?  Bankruptcy law requires that two years pass between when you filed your return and start your bankruptcy to discharge taxes.

Step 3.    When were your tax returns required to be filed with the IRS?  Bankruptcy law also requires that three years pass from the due date of the return, including extensions, and the start of your bankruptcy.

Step 4.    Have you done anything to extend the timing rules of Steps 2 and 3?  Be careful in making a move that will cause you to wait longer to qualify for filing bankruptcy on the IRS.  If you were involved in a timely filed collection due process hearing with the IRS, the rules of Steps 2 and 3 stood still while the collection appeal was pending.  The clock also stopped ticking if you filed an offer in compromise within 240 days of the IRS putting the money you owe on their books.  If you were in a Chapter 13 bankruptcy and now want to file a Chapter 7, the tax discharge timing rules were tolled while you were in the Chapter 13.

Step 5.     Are the taxes you owe from an audit?  In addition to the timing rules of Steps 2 and 3, you have to wait 240 days after the IRS puts the money you owe on its books.  For practical purposes, this usually applies in audit scenarios when there is a later assessment after you have filed your return.          

Step 6.    What kind of taxes do you owe?  If you make it through Steps 1-5 and owe income taxes, you are on the right path.   But if you had a business and owe employment taxes from IRS Form 941, Chapter 7 will only provide you partial relief.  Here’s why:  The employment taxes you deducted from your employees’ paychecks for their social security and medicare cannot be discharged in a Chapter 7 bankruptcy.  However, your  employer contributions to social security and medicare can be discharged in bankruptcy. 

Step 7.    Do you have  any money left over after paying your bills each month?  Chapter 7 bankruptcy is primarily for those that cannot afford to repay their debts – that is, they have no money left over every month after paying reasonable living expenses.  But note this:  Bankruptcy law uses real budgets to arrive a cash flow, not IRS standardized guidelines.  It does not matter that the IRS thinks you have cash flow.  If your living expenses are reasonable and you have nothing left over every month, you should qualify for Chapter 7.    

Step 8.    How much have earned in the six months prior to filing the bankruptcy?  Bankruptcy law has what is known as “means testing.”  Means testing makes a presumption that you do not qualify for Chapter 7 if you made too much money in the six months prior to filing  the case.  But even if you did make too much money, means testing can go from “fail” to “pass” by claiming certain living expenses off your income.  If your income varies, the means testing factor can eliminated by waiting to file after a few slow months.

Step 9.     Do you have any assets with substantial equity?  Chapter 7 is a liquidating bankruptcy.  If you have an asset that could be sold and would result in money to pay your creditors, you could lose that asset in return for the tax discharge.  But this is rare.  Federal and state law provides for what is known as “exemptions” to enable you to keep your property – even valuable assets with equity.  Remember this:  Exemptions shield equity.  Exemptions are why most people keep everything in bankruptcy. 

Example of assets, equity and exemptions:  If you have a car loan, and the amount owed is equal to or greater than what the vehicle is worth, you have no equity -you keep the car.  If there is some equity – meaning it is worth more than you owe, then the federal or state exemption laws could still protect the equity, and you would keep the property.  The same applies to your house.  In Ohio, a house owned by husband and wife would have up to $40,400 of equity protected.  Qualified retirement accounts are not subject to the liquidating powers of a bankruptcy court – you keep the accounts.

Step 10.    Should you consider the benefits of a Chapter 13 if you do not qualify for Chapter 7?  If you do not qualify for a Chapter 7 – maybe too much cash flow - then a Chapter 13 repayment plan could be a better option for you.  Chapter 13 has significant benefits for those with cash flow:  It can stop the accruals of interest and penalties the IRS charges.  At the same, Chapter 13 can lower the amount you have to repay on older income tax debts.  Although loss of assets in Chapter 7 is rare, Chapter 13 also has the added benefit of preventing asset liquidation (it is a repayment plan, not a liquidation, so you keep all of your assets).   Chapter 13 is also a good alternative to an IRS installment agreement.  It can also reorganize and reduce the payment of other debt you may have, like credit cards.

Understanding how to file bankruptcy on the IRS can appear to be overwhelming, but it does not have be with proper planning.  Taking it one step at at time and carefully analyzing the pros and cons is key to a sucessful outcome.

Two basic rules on owing the IRS and credit cards:

The credit cards are usually firing blanks but make you believe they have a cannon. 

The IRS, on the other hand, has a cannon. 

Like many things in life, how the IRS and credit card companies appear to you bears little resemblance to their reality.

CREDIT CARDS

Every month, credit card companies send a statement for payment – along with all of the interest charges.  If you do not make the monthly payment, the dunning letters and telephone calls start.  Your account is sent out to a debt collector, and the phone rings.  Nerve-wracking. 

The immediate pressure credit card companies put on you for payment can result in them getting more attention than the IRS.  It should be the other way around.

Here is the important part to know:  The credit card companies have to file a lawsuit against you in court to be able to take your wages or bank accounts.   This not something that they do readily or even all the time.   

Remember this:  Until you hear from a lawyer who has filed a court action against you, you are under no risk of losing your wages or property from a credit card debt.  And most cases simply go the route of debt collectors without court action – attempting to collect by pressure.

COMPARE TO THE IRS

The IRS is usually less aggressive than credit cards at the outset.  The IRS will send you several collection notices after your tax return is filed, then stop.  After that, you may receive mail from them only once a year (an annual statement of your account).  

Unless you are on an installment agreement, the IRS does not stay in front of you with monthly statements like the credit cards.  And the IRS rarely makes outbound phone calls seeking payment.  But the IRS can be a sleeping giant.    

Those few collection notices the IRS sends you at the outset of your case can allow the IRS to immediately start levying on your wages and bank accounts.  No calls asking for payment, no monthly bills in the mail, no wondering about lawsuits like the credit cards  - just a simple letter - the Final Notice of Intent to Levy.  

After the IRS letter stream ends, you can get a wage or bank levy without any further notice. 

It may seem like the IRS is trailing behind the credit cards, but they are actually ahead of the game, and should be at the head of the line.  It can be deceiving.  And the stakes are high.

As I have written in prior posts, the IRS can be slowed down by appealing the Final Notice of Intent to Levy.  If you are interested in learing about the stream of IRS collection letters, see my post ”What do all of these IRS collection letters mean?”  For more on how bankruptcy can eliminate or reorganize IRS and credit card problems, read more here about Chapter 7 and Chapter 13.

Mr. Levy – I hope you can help me.  I owe back taxes and filed a Chapter 13 to repay the IRS.  The Chapter 13 was dismissed because I could not keep up with the payments.  Now I would like to file a Chapter 7 to eliminate what I did not pay.  My attorney mentioned something about a stopwatch while I was in the Chapter 13.   What is this all about?

You are correct in recognizing that eliminating taxes in bankruptcy is all about timing - keeping an eye on the “stopwatch.”  You are referring to the requirement that taxes can be discharged in bankruptcy only if your return was due to be filed at least three years before your bankruptcy started and was actually filed at least two years before your bankruptcy. 

But if you file a bankruptcy before these timing rules are met (like you apparently did with your Chapter 13), does the “discharge clock” keep ticking?  Are taxes that were not eligible for a tax discharge when you entered the Chapter 13 now eligible when you come out of it and want to file a Chapter 7?  Was time on your side? 

The U.S. Supreme Court resolved this issue in 2002 in the case of Young v. U.S., 535 U.S. 43.  In that case, Cornelius and Suzanne Young filed a Chapter 13 bankruptcy to try to repay their debts, including $13,000 to the IRS.  The Chapter 13 was filed before the tax discharge timing rules were met. 

Unable to make their bankruptcy payments, the Youngs dismissed their Chapter 13 and filed a Chapter 7 instead.  By the time the Youngs had filed their Chapter 7, the taxes had aged to the point of being old enough for a discharge under the bankruptcy tax timing rules.  

The IRS argued that the bankruptcy discharge rules were “tolled” during the Young’s Chapter 13.   The government also argued that since it was prevented from collecting during the Chapter 13, the tax discharge stopwatch should be treated the same way – tolled.

The court agreed with the IRS, recognizing that any other ruling would create a loophole for taxpayers - filing a Chapter 13, getting time on the discharge rules without any risk of collection, and then filing a Chapter 7 when the time was right.   

The prior Chapter 13 never happened for purposes of bankruptcy discharge timing rules.

In 2005, Congress codified the Supreme Court’s ruling in Young  – see Bankruptcy Code 507(a)(8)(a)(i) - and added an additional 90 days to the tolling period.   

Summary:  If you filed a Chapter 13 too early to eliminate your taxes, had it dismissed and now want to try a Chapter 7, ou cannot add in the time the Chapter 13 was pending to your tax discharge calculations.

Your installment agreement may keep the IRS at bay, but your tax liability does not get paid off.

The tax code and the IRS offers no real way of stopping interest and penalty accruals.  That is frustrating, but there are solutions.

The solution for many is in the bankruptcy code.  An IRS repayment plan made through a Chapter 13 bankruptcy can stop IRS interest and eliminate penalties. Chapter 13 can even reduce the amount of tax you pay.  This often results in a shortening the time it will take you to repay the IRS.

No one really wants to file bankruptcy, but making your installment payments by bankruptcy law, not tax law, can result in substantial benefits to you.

A Chapter 13 bankruptcy repayment plan can help you with the IRS.  Here’s how:

(1)     Interest stops.  Chapter 13 stops the IRS from charging you interest while you make your payments.  The interest you already owe the IRS can also be reduced by bankruptcy law.

(2)     Penalties can be reduced.  Chapter 13 can stop the accrual of IRS penalties.  Bankruptcy law can also force the IRS to accept a reduction in the penalties already charged.

(3)     Repay a percentage of what you owe to the IRS.   The amount of tax, interest and penalties repaid to the IRS can be as little as 1% by Chapter 13 bankruptcy law (vs. 100% in IRS installment agreements).  This is accomplished by use of the Chapter 13 bankruptcy “cramdown” rules.  You pay back olny what you can afford on older income tax debts in a Chapter 13.  Anything you cannot afford to repay on the older taxes is eliminated.

(4)     IRS collections stop.  Once you file a Chapter 13, the IRS is prevented from levying your property.  Bankruptcy creates a “stay” on the IRS.  You keep everything in a Chapter 13 tax bankruptcy.

(5)     Your budget.  If the IRS will not allow some of your expenses in an installment agreement, bankruptcy law could.  A Chapter 13 tax bankruptcy means you pay the IRS what your reasonable budget permits under bankruptcy law standards.  You eliminate much of the use of IRS “living expense standards.”

In most cases, the Chapter 13 bankruptcy results in you paying back much less than what you would in an IRS installment agreement.  What you pay does not double by tax law, but can be reduced by bankruptcy law.  Comparison of a Chapter 13 repayment plan vs. IRS installment agreement can save you time and money.

A centerpiece of bankruptcy law is the concept of an “automatic stay.”    The automatic stay stops creditors from calling and writing to enforce or collect a debt from you.  The “stay” on your creditors – including the IRS – starts the minute you file bankruptcy. 

The automatic stay is why the IRS will immediately release a levy if you file for bankruptcy protection. 

But can bankruptcy stop the IRS from conducting an audit?

Bad news first:  Although bankruptcy can be pretty absolute on the IRS, it falls short of being able to slow down an IRS audit.  The bankruptcy stay does not apply to IRS audits and will not stop them (Bankruptcy Code section 362(b)(9)). 

Here’s the good news:  Bankruptcy can, however, eliminate any taxes, interest and penalties you might end up owing after an audit is completed.  The timing of the filing of the bankruptcy is important – among other conditions, you have to wait 240 days after the audit is final to be able to bankrupt an audit result.  

IRS audits are often painstaking, but there can be light at the end of the tunnel.  You may not be able to stop the machine, but bankruptcy can clean up the damage.

To help in understanding taxes and bankruptcy, I thought it would be helpful to provide real life examples, starting here with a “bankruptcy timing” question I recieved from an enrolled agent on behelf of his client:

Howard, I have a client considering Chapter 7 bankruptcy on her IRS income tax debt.

2001 – owes $59,000.  Her return was due on 4-15-02, but she did not file it until 9-15-08.

2003 – owes $9,800.  Her return was due on 4-15-04, but she did not file it until 9-1-08.

2006 – owes $1,400.  Her return was due on 4-15-07, but she did not file it until 8-25-08.

She is in currently non-collectible status with the IRS.

When would she first be eligible for a Chapter 7 bankruptcy?

This illustrates Rule No. 1 in eliminating taxes in bankruptcy:  To be successful, tax returns must have (1) a due date that is three years before the bankruptcy is filed and (2) been actually filed two years before the bankruptcy starts.

In this example, it has been more than three years since the returns were due. But it has not been two years since they were filed.

The result: She could have all of the taxes discharged in a Chapter 7 bankruptcy on 9-15-10.  This is two years after the returns were filed.

If the returns were filed on time, then she would not have wait any longer – both the three year and two year rules would have been met – and bankruptcy could be filed immediately.

The non-collectible status will keep the IRS on hold while awaiting the bankruptcy filing date.

Stay tuned – I will be periodically posting more real examples of how bankruptcy, taxes and the IRS works.  You can also read my other blog entries on it and my articles.

1.   Offer in compromise.  This is the first option on every one’s mind.  But it can be difficult to obtain an compromise under current IRS procedures – it is not for everyone.  Many compromises are initially rejected by the IRS and have to be appealed.  And with IRS expense allowances lower than what most people need to live, the best chance of success is to be pretty much broke.  The IRS compromise program is not dead, but caution needs to be exercised and other options reviewed first to avoid disappointment.

2.     Tax bankruptcy.   I emphasize this all the time – with the results of the IRS compromise program difficult to predict, bankruptcy is often the next best option.  A Chapter 7 bankruptcy can eliminate an income tax liability without any recovery to the IRS and without losing any of your property. A Chapter 13 bankruptcy can allow you to continue or set up an installment agreement to repay your taxes without interest and penalties.  In many Chapter 13’s, the amount of tax repaid is less than what you actually owe.

3.     Uncollectible.  The IRS does make “bad debt” decisions on its collection inventory.  This is known as being uncollectible.  To be a bad debt, the IRS will require a financial statement listing income, living expenses, assets and liabilities to prove that any attempt to collect the debt would result in a hardship. Sometimes, the IRS will put an older tax debt in its nonactive queue on its own. It is important to carefully analyze and understand when to call the IRS, and when to let sleeping dogs lie.

Next: IRS installment agreements, statute of limitations and interest/penalty abatements (Part II).

The IRS comes first.  Here’s why:

1.     Unpaid credit cards can be annoying – harassing debt collectors calling for money.  But it is important to remember that credit card companies and debt collectors cannot take your wages, bank accounts or property.  That can only be done by the filing of a lawsuit, which the debt collector cannot do (they are not lawyers).  Once we are retained, the debt collectors are directed to confirm that all calls are to be directed through our office, which they are obligated to follow by law.

2.     The only restriction that the IRS has in taking your wages or bank accounts is to issue a notice of intent to levy to you first. And have you ever seen a debt collector appear at your home or business demanding payment like the IRS does?

3.    In legal terms, IRS taxes are considered priority debts, while credit cards are categorized as lower unsecured general debts.  That means credit cards can be readily eliminated in bankruptcy.  Taxes can be eliminated in bankruptcy too, but the rules for taxes are much more stringent because of their “priority” status.

No one sets out to file bankruptcy, but when the IRS and credit card companies compete for limited cash, bankruptcy is often the complete solution.  A Chapter 7 bankruptcy eliminates the credit cards and older taxes if your budget does not permit monthly payments.  If you can pay a little bit back, a Chapter 13 can be the answer. Chapter 13 is a debt reorganization, where bankruptcy law determines who gets your cash flow.  It divides the pie by law, so you do not have to.  Chapter 13 can also stop the accrual of credit card interest and IRS penalties.  Anything you cannot afford to repay is eliminated by bankruptcy law.

I owe $25,000 in tax, but the interest and penalties have made the amount I owe almost double.  Won’t the IRS be happy just to get the principal I owe back and forgive the interest and penalties?

In an offer in compromise, the IRS considers all of your liabilities – tax, penalty, interest – as being of equal stature.   The amount you owe in penalties is as equally important to the IRS in an offer in compromise as the tax.  Although it may seem logical to assume that the penalties and interest are “extras” and more easily forgiven, this is simply not true with the IRS. 

To the IRS, the tax, penalty and interest all bear equal weight.  There is no formula to abate interest and/or penalties in an offer in compromise.  It is purely a collection formula.  If the IRS believes they can collect it, they will not compromise it.  The IRS does not consider “tax only” offers unless for some reason that is the exact amount that can be collected.  

If you believe the IRS should not have charged you penalties, then the proper course is to request abatement outside of the compromise process.  This involves an administrative decision of the IRS to forgive penalties they have already determined you are responsible for.  Penalty abatement involves proving to the IRS factors that there were beyond your control that prevented timely payment or filing.  Interest can be abated if the IRS unreasonably fails to perform a ministerial or administrative function.  The additional interest can be abated during the period of delay. 

A better option on eliminating interest and penalties is often bankruptcy.  A Chapter 7 bankruptcy can completely eliminate tax, interest and penalties.   A Chapter 13 bankruptcy repayment plan can stop IRS interest accruals and force the IRS to accept a reduced amount of penalties by bankruptcy law, not tax law. An offer in compromise can result in the IRS forgiving tax, penalties and interest, but only if the collection is in doubt.

The unfortunate result of this pressure is that more and more clients are turning to a tax bankruptcy to resolve IRS problems.  The advantages of a tax bankruptcy are often significant.  Here are a few:

     1.     Bankruptcy stops the IRS and releases levies and seizures. 

     A tax bankruptcy immediately secures the release of an IRS levy on bank accounts and wages, and stops seizures of assets like houses, cars and business equipment.  This is absolute under bankruptcy law – once bankruptcy is filed, all collection actions must stop, including those of the IRS (this is referred to as a “stay”).  In most cases, bankruptcy frees property from the IRS the same day it is filed.

     2.     Bankruptcy ends IRS discretion in its case handling.

     Once bankruptcy is chosen, it is no longer just up to the IRS.  IRS personalities and procedures yield to bankruptcy law.  Installment agreements that could not be agreed to under IRS standards may be obtained in a Chapter 13 repayment plan.  Chapter 13 adds the benefit of stopping the accruals of interest and penalties while payments are made, a virtual impossibility with direct IRS negotiations.  Taxes that could not be solved by an administrative IRS offer in compromise can be eliminated in a Chapter 7. 

     3.     Bankruptcy eliminates taxes, interest and penalties.

     Income taxes owed on returns that were actually filed with the IRS more than 2 years before the bankruptcy and were due to be filed with the IRS more than 3 years before the bankruptcy can be wiped out in a Chapter 7.  Bankruptcy is a powerful means of IRS resolution on these older income taxes.  If the bankruptcy rules are met, all the taxes, interest and penalties will be gone after a Chapter 7 bankruptcy is completed (usually 4-6 months).  

     4.     Bankruptcy is an alternative to an offer in compromise. 

     The IRS is accepting only 25% of compromises.  The IRS offer in compromise program has historically been an good source for resolving unpaid taxes.  With the current low acceptance rate, the reality is the IRS offer program is now broken.  Because of that, filing a tax bankruptcy on the government has become a viable option for a fresh start with the IRS.   

     5.     Bankruptcy is a complete solution to all debt problems.

      A tax bankruptcy solves IRS problems, but it also can eliminate state taxes, overwhelming credit card debt, well-intentioned medical bills, debt from a failed business – and it stops foreclosures.  With the present state of the economy, a comprehensive “all in one” solution to financial problems can take priority.

More details on handling taxes in bankruptcy can be found in my recent article for the Journal of the National Association of Enrolled Agents.