It is complicated enough to understand when taxes can be discharged in a bankruptcy. But once it is determined that your taxes can be done away with in bankruptcy, another potential hurdle rears its ugly head: Bankruptcy means testing.
Means testing determines what type of bankruptcy you qualify to file – Chapter 7, which eliminates debts (including taxes) without repayment, or Chapter 13, which forces you to repay a percent of your debt through a payment plan approved by the bankruptcy court.
Means testing is a financial calculation that “tests” whether your income is higher than the median income for a family of your size in your state. The purpose of the test is to determine if you make too much money to eliminate your debts without repayment (Chapter 7), and if repayment is appropriate, what the minimum amount should potentially be. If you “flunk” the test – meaning you make more than the average family – there is a presumption that you can afford to repay your debts (Chapter 13) rather than wipe the slate clean (Chapter 7).
The good news is that a tax debt to the IRS can help you avoid the effects of means testing (yes, owing the IRS can be a good thing). Here’s why:
The means test applies only to what is known as consumer debts. Consumer debt is defined in Section 101(8) of the bankruptcy code to be a debt that is primarily incurred by an individual for personal, family or household purposes. This typically includes debts such as credit cards, home mortgages and car loans. But not taxes.
If over half of your debt is not consumer debt (taxes), the means testing calculations do not apply. Pass go, collect $200. You are not subject to bankruptcy means testing.
Example: You have a mortgage on your house with $120,000 owed, $25,000 of credit cards and a car loan with an unpaid balance of $5,000. This is $150,000 of consumer debt. But you also owe the IRS, say, $175,000. This is not consumer debt. Your total debt is $325,000, and over half ($175,000) is non-consumer debt. You can check the box on your bankruptcy petition that the means testing does not apply because the majority of your debt is not from consumer purchases. (Business debt, like guaranteed loans, are also non-consumer debt.)
There are three distinguishing factors that makes tax debt a non-consumer debt: Consumer debt is considered to be voluntary; taxes are not. Taxes are for the public welfare, and consumer debt is for personal and household purposes. And taxes are imposed on earnings, while consumer debt is based on consumption. A good court decision on this is In re Westberry, 215 F.3d 589 (6th Cir. 2000).
Tax debt for bankruptcy means testing purposes includes money owed to the IRS and state and local taxing authorities. When considering bankruptcy, know that your tax debt can help you avoid jumping through hoops.