I wrote in an earlier blog, Death, Taxes & Maple Grove MN Bankruptcy, that under certain circumstances, an individual who has tax liabilities can sometimes have these tax liabilities discharged in a bankruptcy case. I noted, though, that discharge is available only in very specific circumstances: the tax owed must be income tax, the tax liability must be “old” and returns must have been filed in a timely fashion. While some people who have tax problems meet these criteria, most of my clients do not. So the tax problem that they have is not going to disappear simply by filing a bankruptcy case. So what can we do about tax liability that isn’t discharged in a bankruptcy case?
WHERE DO THESE PROBLEMS COME FROM?
Why do people end up with tax problems? It is very common for individuals who have other financial problems to also have tax problems, and so often the tax problem is a direct result of choice-making by individuals with budget problems. Think about a typical payroll employee: this person receives a paycheck from her employer. The employer withholds state and federal income tax and social security and medicare taxes. Because our tax system is voluntary, the individual has a choice of how much the employer withholds in income taxes. Whether she is married or single and whether she has children or not, the employee has the choice of withholding as a single or married person, with as few as zero dependent exemptions or as many as ten dependent exemptions.
Now imagine that this employee is experiencing financial pressures - it’s a struggle every month to meet daily living expenses while still paying medical bills, credit cards and student loans. Our employee needs relief from the stress of the budget, but adding more income is difficult: the employer doesn’t offer overtime and/or it is difficult to find a second, part-time job. One solution for the person looking for an increase in take-home pay is to withhold less income tax. The single employee with one child in this example could stop withholding as a single person with one exemption, and instead withhold as a married person with ten exemptions. Since this is the employee’s sole choice, she can decrease her tax withholding, and thus bring more money home every pay period. That may solve the short-term budget problem, but next year the employee is going to face the consequences of under-withholding her taxes: it is very likely in this scenario that she will owe state and federal income tax. And it is just as likely that while her budget stress has lessened, she hasn’t been able to save enough money to pay the tax bill that is now due.
Or let’s imagine an employee with the same kind of monthly expense problem, but with the additional feature that this employee has been contributing for a significant period of time to a defined-contribution retirement plan, such as a 401(k), 403(b), ESOP or SEP IRA. All of these plans are distinguished from pension plans, which are called defined-benefit plans. People who have defined-contribution retirement plans have the option of cashing in all or a portion of their plans. An employee with financial headaches might opt to do just that to pay off credit card, line of credit or medical obligations. Yes, the retirement fund is invaded, but the individual solves financial problems by paying off high-interest obligations in full.
But just like the employee who under-withholds, the year after the retirement plan is cashed in brings with it tax obligations. An individual cashing-in all or part of a retirement account will pay a penalty for early withdrawal, and will be given the option of withholding federal taxes. The federal tax withheld is often less than the federal tax liability that accompanies the withdrawal. And state income taxes are typically not withheld. So the person cashing in the retirement account can be left with a fairly big tax bill, just like the under-withholding employee. And just like the under-withholding employee, it is typical that the retirement cash-in employee is facing a tax bill and she doesn’t have the money to pay it.
And last, let’s imagine a self-employed individual who operates his own small business. Cash flow for small businesses can be challenging. Small business owners have to stay current with vendors on their accounts payable, have to make small business loan payments, have to pay their employees and keep the lights on, the building heated and cooled, the water running and businesses have to pay to market themselves - to get noticed in a competitive business environment. And business owners have to pay withholding taxes for their employees, as well as contribute to workers compensation and unemployment compensation funds. With these types of financial obligations “front and center” in the business owner’s mind, it is not uncommon that the owner simply doesn’t pay the quarterly estimated income tax payments that the IRS and State expect (but don’t require). Again, in a voluntary tax system, there is not immediate enforcement of income tax rules. Theoretically, the business owner can pay all of his income tax liability at the end of the year, when his personal income tax return is filed. But for many business owners, the cash-flow challenges of the business have left them without the cash to pay the tax bill. So it’s a common theme in all three of these examples. For a number of very understandable reasons, other financial challenges crowd out the ability for an individual to pay their income tax obligations.
Non-Bankruptcy Options
So what is a person who owes taxes and does not have the present ability to pay do? Whoever has a tax problem has several options. And there are non-bankruptcy options available. Perhaps the simplest non-bankruptcy option is to simply contact the taxing authority - the Internal Revenue Service, and the State tax service (in Minnesota, it’s the Minnesota Department of Revenue). The taxing authority has agents who will work with you to set up a repayment program by making installment payments to pay the past-due taxes.
There are also tax professionals who work in tax resolution. They represent you in negotiating resolution of back taxes. If you choose to use a resolution service, do so with care. Check the backround of these services to make sure the service you are thinking of using is a legitimate service. Reputable services will do their best to either reduce your tax debt, set up affordable monthly payment or both.
For individuals with high tax debt and very little realistic hope of paying it, a good solution is an offer in compromise. An offer in compromise is a proposal made by the taxpayer to the taxing authority proposing to pay less than the total amount due. Offers in compromise can be very effective when tax liabilities are high. While individual taxpayers can make the offer in compromise themselves, most are well-advised to seek the assistance of a professional who handles offers in compromise to make sure that the offer made has the greatest chance of success.
One thing for all individuals who are looking at a tax bill they can’t afford to pay to remember is to file your tax return, even though you can’t afford to pay the tax. Failing to file a timely return exposes you to penalties from the taxing authority, which leads to higher tax bills. Always file your return.
Bankruptcy Options
For many people, tax problems are just part of the financial problems they face. As shown in the earlier examples, tax problems often happen when a person’s overall finances are challenging - these individuals put their tax obligations on the “back burner” because they have other, more pressing financial issues.
For individuals who have these problems, bankruptcy offers an option to deal with their financial situation holistically. People in these situations can use a bankruptcy case to resolve their tax issues as well as the other issues - such as high credit card debt, medical bills or open lines of credit.
Both chapter 7 and chapter 13 can present a way to manage and pay tax debt. Let’s look at the ways bankruptcy can assist individuals with tax problems. First, let’s look at what chapter 7 bankruptcy can do. Let’s assume that the tax liability a person is facing is not dischargeable - either the tax liability is less than three years old, or tax returns were not filed in a timely way or the tax liability is for something other than income tax (this happens often with small businesspeople who owe withholding or sales taxes). Often, individuals in this situation have other financial obligations that can be discharged in a chapter 7 bankruptcy case - credit cards, medical or legal bills, open lines of credit. For an individual trying to pay these dischargeable obligations, they can find themselves without a lot of income to dedicate to pay tax liability. Discharging these other debts can often create enough “space” in a person’s budget that they can enter into a repayment agreement with the IRS or state taxing authority that will allow them to more quickly pay the tax liability. So a chapter 7 bankruptcy case can be used in a case where discharging other debt can be used to make repaying tax debt more easily affordable.
Also, since often people owe taxes for multiple years, they may be in a situation where some, but not all of the tax liability may be discharged. Discharging some of the tax debt can relieve some of the financial pressure an individual faces and make it easier, both financially and emotionally, to pay back the non-discharged debt.
So chapter 7 can work well for certain people who need to free-up money to make payments. But chapter 13 is the more commonly-used chapter for people who are looking at using bankruptcy to resolve unpaid taxes.
Chapter 13 is a payment plan. In a chapter 13 case, people pay a monthly payment to a bankruptcy trustee and the trustee, in turn, pays that person’s creditors. The monthly payment is based on that person’s budget - how much does the person have available as disposable income to pay creditors.
Creditors are classified into three categories. There are secured creditors, such as home mortgages. There are unsecured creditors, such as credit cards. And there are priority creditors. Taxes are usually priority debts. Priority tax debt is fairly recent debt - the tax return was due less than three years before the bankruptcy case is filed.
In a chapter 13 case, all priority claims must be paid in full. The longest period an individual can be in a chapter 13 payment plan is 60 months (five years). The shortest period of time an individual can be in a chapter 13 plan is 36 months (three years). So all priority tax debt must be paid in full during the chapter 13. Assuming that paying the tax debt in full is affordable for an individual’s budget, a chapter 13 offers several advantages: first, the taxing authority cannot assess penalty against the taxpayer/chapter 13 debtor while the chapter 13 case is in progress. Second, the taxing authority is prohibited from taking any action to collect on the tax liability which the chapter 13 case is in progress. The taxing authority is limited to accepting the payments made by the taxpayer/debtor to pay down the tax liability. So individuals in a chapter 13 do not need to worry about wage levies or bank levies. The debtor is protected from that by the automatic stay that applies to all creditors when a case is filed.
So chapter 13 offers a very sensible way to pay down tax debt while protected by the automatic stay. For tax liability that can be repaid over the three - to - five year period, it is a very useful tool
Some Cautionary Words
There are a couple of things to be mindful of if you are thinking about using a Maple Grove MN Bankruptcy as a way of resolving tax liability. First, be aware that the taxing authority can file tax liens against your property - both real and personal - for unpaid taxes. The taxing authority will generally wait several years to file the lien, but if it does, the tax debt, that may otherwise be discharged, now becomes a secured debt, like a mortgage or car loan. The lien is secured to the extent of the equity a person has in real estate or personal property. A bankruptcy discharge may discharge an individual’s personal liability to pay the taxes, but if a lien is in place, the taxing authority can sell property to satisfy the tax debt.
Also, if individuals have not been timely in filing their tax returns, they could find themselves in a situation where the taxes they owe are not priority debts (the tax liability is too “old”) and the debts can’t be discharged (the returns weren’t filed). So you end up being “stuck” with an old tax liability that you can’t erase.
What to do if there’s a lien or you have non-priority, non-dischargeable taxes? That’s the subject of the next blog.
