By Walter Metzen
Federal and Michigan state tax debt is, under the right circumstances, dischargeable in bankruptcy.
However, even when it is not, a Chapter 13 bankruptcy can help you to repay delinquent tax debt—and at 0% interest. Without the need to negotiate directly either with the Internal Revenue Service or with the Michigan Department of Treasury.
How does this work?
The discussion first requires a brief overview of Chapter 13 bankruptcy.
Chapter 13 Bankruptcy: Restructuring Your Tax Debt
The purpose of a Chapter 13 bankruptcy is to allow you to restructure your debt. It is a reorganization bankruptcy. It is not unlike a Chapter 11 corporate bankruptcy, except that it works on an individual, human level.
In a Chapter 13 bankruptcy, you do not simply discharge your debt—or fail to when a debt in question falls into one of the categories of debt that is not dischargeable.
That is what happens in a Chapter 7 “liquidation” bankruptcy.
In a Chapter 7, debts such as credit cards and medical debt (and many more) are simply discharged, meaning that you do not, afterward, have any further legal obligation to pay those debts.
However, the US Bankruptcy Code lists multiple categories of debt which are not so easily discharged.
Among these non-dischargeable debts are student loans, child or spousal support obligations, criminal penalties, and—recent tax debt.
A tax debt is not dischargeable if it was incurred within the 3 years prior to the filing of the bankruptcy case, as well as in other circumstances. (The question of whether a tax debt is dischargeable in any given case requires the expert input of a highly experienced bankruptcy attorney. It is a complicated analysis.)
Thus, if a tax debt is a primary source of financial duress for you, a Chapter 7 bankruptcy will not do much to help you—other than to discharge other forms of debt so that you can better afford the tax payment.
In a Chapter 13 bankruptcy, however, even when a debt is not dischargeable, it may be restructured.
That is, the terms of repayment and the interest-rate associated with the debt can be modified.
In the case of tax debt, this modification is automatic. It happens because the Bankruptcy Code says that it does.
It requires no agreement from the IRS or Michigan Treasury.
How Chapter 13 Bankruptcy Works
The first and most immediate effect of the filing of a Chapter 13 bankruptcy is the enforcement of what is known as the “Automatic Stay.”
The Automatic Stay is a Federal injunction that activates when either a Chapter 7 or Chapter 13 bankruptcy case is filed.
It prevents any creditor from engaging in any direct collection activity for the duration of the bankruptcy case.
This includes the IRS or Michigan Treasury.
Any tax seizure, tax levy, or tax lien perfection underway must be halted immediately upon filing of the bankruptcy case.
With the assistance of your bankruptcy lawyer, you then file with the Bankruptcy Court a Chapter 13 Payment Plan.
This Chapter 13 Plan is the document in which you reorganize and restructure your debt.
In the Chapter 13 Plan, you propose a monthly payment amount to be paid to the Chapter 13 Trustee who is assigned to your case by the Bankruptcy Court upon filing.
You also list your creditors in an order of priority of payment required by the Bankruptcy Code.
Your creditors are then paid, in whole or in part, by the Chapter 13 Trustee from that monthly Chapter 13 Plan payment that you send in.
You do not—except in certain cases—pay your creditors directly while in a Chapter 13 bankruptcy. They are paid only by the Chapter 13 Trustee.
Creditors are paid according to the terms of your Chapter 13 Plan, in a priority order established by the Bankruptcy Code.
This priority debt payment order is as follows:
- Your bankruptcy attorney’s fees and the Chapter 13 Trustee’s fees.
- Mortgage payments, mortgage arrearages, and other “secured” debts.
- Lease and executory contract payments.
- “Priority” unsecured debts.
- Non-Priority unsecured debts.
Secured debts are those whose obligation to repay is “secured” by some property pledged as collateral. Your home is generally the collateral, for instance, securing a mortgage payment obligation.
An unsecured debt is a debt owed due to contractual or other obligation, without any collateral pledged. A credit card or medical debt are unsecured debts.
They are also “non-priority” unsecured debts.
A “priority” unsecured debt is a debt without pledged collateral securing but which is among those listed in the Bankruptcy Code as “priority.”
These debts must be paid by the Chapter 13 Trustee in full before your non-priority unsecured debts receive a penny.
The maximum length of a Chapter 13 Payment Plan is 60 months, or 5 years.
Treatment of Non-Dischargeable Tax Debt in Chapter 13 Bankruptcy
If a tax debt qualifies as dischargeable, it is treated as a non-priority unsecured debt just like a credit card balance is.
Those debts receive only what is remaining from your monthly Chapter 13 Plan payments after all higher priority debts are paid. Whatever is remaining, non-priority unsecured creditors split amongst themselves.
Any balance they are still owed “on paper” is then totally discharged as it would be in a Chapter 7 bankruptcy.
If a tax debt is not dischargeable, it is classified in a Chapter 13 bankruptcy as a priority unsecured debt.
This means, as noted above, that the debt must be paid in full through the Chapter 13 Plan.
The possible downside here is that, if the tax debt is significant but your income is modest, you may not be able to afford the resulting required Chapter 13 Plan payment on a monthly average basis.
However, a priority tax debt is paid with 0% interest in Chapter 13 bankruptcy. With no further late charges or penalties applied (so long as you successfully complete the Chapter 13 process).
Thus, in Chapter 13 bankruptcy, you pay the amount owed as of the date of filing of the case—and nothing more.
This can be a significantly better deal than you will ever get from the IRS or Michigan Treasury directly.
It is possible to alternatively negotiate an “Offer in Compromise” (tax settlement) with the IRS—but you will always pay at least 2% interest in those agreements, when successful.
Further, in a Chapter 13 bankruptcy, it is possible that you may hold some priority non-dischargeable tax debt arising from recent tax years along with non-priority dischargeable tax debt arising from older tax years.
In this case, you would “bifurcate” or split the total tax debt, treating the non-dischargeable portion as priority and the dischargeable portion as non-priority.
Again, this is not something you need to negotiate with the IRS or Michigan Treasury to achieve.
It is simply how Chapter 13 Bankruptcy works.
Delinquent Tax Debt in Chapter 13: The Bottom Line
The bottom line is that a Chapter 13 bankruptcy can be an excellent way to dispose of delinquent tax debt.
Given the severe penalties available to the IRS in particular, tax debt is a problem that should not be ignored.
However, a full analysis of whether or not Chapter 13 bankruptcy is right for you requires the input of a highly experienced Michigan bankruptcy attorney.
Attorney Walter Metzen is a Board Certified bankruptcy expert who has successfully serviced the needs of thousands of Metro Detroit Chapter 7 and Chapter 13 clients for over 28 years.
Contact us now to schedule your free initial consultation.