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By Michael S. Anderson of Anderson Tax Law logo for Arizona tax attorney Michael S. Anderson P.C.
  • IRS income tax debt? Chapter 7 Bankruptcy could be the real “Wizard”

    oz-thumb-375x291-55023There are several legal options to deal with IRS debt

    If you’ve been reading our blog, you will have noticed that we share lots of information about the legal options you have to deal with income tax debt. You also may have discovered that the IRS offer in compromise program is the proverbial “Oz” at the end of the yellow brick road.

    What I mean by that is that most people with serious income tax debt want to try to settle the tax debt for pennies on the dollar like the advertisements promise, but when they get to the middle of the offer process they realize that only a few have actually qualified in the past on a nationwide basis. Historically only about 25% of Offers filed were ultimately successful. There have been a number of recent changes in the law that should increase the average rate. For many though, the man behind the curtain isn’t going to be a wizard at all, just as Dorothy found out; he will continue to just be a guy in a funny suit.

    So…what do people do when the Offer fails? They have to eat their losses and go back to a payment plan with the IRS. Many quickly find out that because the IRS limits the budget to it’s own standards, the payment plan is unrealistic as well and they either have to drastically cut their budget to match it or risk IRS levy and garnishment by not paying.

    As a general rule, people with low incomes and few assets make the best candidates for offers in compromise and good payment plans. People with upper middle incomes though often have a more complex situation.

    We help both of course, and every client situation is unique so it is difficult to lay down hard and fast rules that govern every person. For many people with higher incomes, there are 4 primary reasons when chapter 7 Bankruptcy becomes a very strong candidate for the reduction or elimination of income tax debt.

    Some quick background about bankruptcy and IRS income tax debt

    As you may recall, income tax debt can be wiped away in bankruptcy if a few things are true:

    1. The return that created the tax debt was due to be filed 3 years before the bankruptcy was filed
    2. The return that created the tax debt was filed by the taxpayer more than 2 years before the bankruptcy was filed.
    3. The tax debt was assessed by the IRS more than 240 days prior to the date the bankruptcy case was filed.
    4. No history of fraud or attempt to evade paying the tax exists

    The Bankruptcy Code has been written in a way that indicates our desire as a society to give people a fresh start that have gotten into trouble with debt, even income tax debt. It tries to balance the creditors ability to collect the debt with the debtor’s need and even societies need, for the debtor’s “fresh start”.

    The four common reasons

    A recent client in our office was a good example of a person who had four common reasons to consider a chapter 7 Bankruptcy to deal with his tax debt. His name has been changed and some of the facts slightly fudged in order to protect his identity…of course.

    Example:

    Mr. Gale was a married account executive. Prior to his marriage he had made some mistakes. He quit withholding as much income tax from his paycheck in order to help a family member, and even cashed out some retirement accounts and didn’t pay the tax.

    Over the years, his income grew and the tax debt grew along with it. His income grew to an amount just over 120,000.00 per year and his tax debt grew to about $150,000.00. He had also managed to create about $45,000.00 in credit card debt.

    Over the course of a few years he tried to file an offer in compromise, with the aid of a CPA – twice. He learned one of the primary rules of an offer in compromise…if you can afford to pay the tax debt over the course of the remainder of the statute of limitations period for collection, the IRS won’t consider your offer in compromise.

    Because the IRS uses a relatively low standard budget for most people, it believed that Mr. Gale could afford to pay about enough per month toward his tax debt that he could full pay it before the statute period ran out. Two Offers in Compromise – two bad results.

    When he visited me, we re-worked the numbers and looked closely at his budget to see if there would be a way to:

    a. Overcome the rule mentioned above and prove to the IRS that he couldn’t afford to pay all the tax debt within the statute period and;

    b. To determine whether we could make any changes to his budget so that an IRS payment plan would be as low as possible if any Offer in Compromise still wouldn’t make sense.

    We also looked at the history of his tax return filings. We did this to determine if and when his tax debt would meet the date and other criteria mentioned above for discharge in a chapter 7 Bankruptcy.

    We learned the following about Mr. Gale…among other things:

    a. An Offer in Compromise didn’t make a lot of sense. Even with budget planning, his excess would likely always remain high enough that the IRS would not consider it and at the time, the Multipliers that the IRS used to determine the amount of the offer would have made the offer so high that it would have been difficult for Mr. Gale to make it work even if he could overcome the statute of limitations rule.

    b. A payment plan…if based just on the numbers as they existed or even with some budget planning would have been quite high and would have paid all the debt back before the statute of limitations on collection had run out.

    c. His tax debt would meet the criteria for discharge in a chapter 7 Bankruptcy about a year after he met with us.

    d. The only other debt he had was the credit card debt and two car loans. No mortgage debt.

    When we sat back down to discuss our final findings with Mr. Gale we explained the 4 reasons to him why a chapter 7 bankruptcy made a lot of sense for him. They were as follows:

    Mr. Gale didn’t make a good offer in compromise candidate

    No matter how we sliced it, the odds of winning an offer in compromise or at least coming away with a settlement amount that was reasonable weren’t great. Not even good enough to justify the fee, let alone the additional time the 3rd offer would added to the statute of limitations on collection period for the IRS.

    His non-bankruptcy option was to make a very large payment each month until the debt was paid off with interest.

    Mr. Gale had other dischargeable debt

    Mr. Gale had credit card debt that was difficult for him manage as in a typical IRS payment plan it would not have been included as a budget item. He would have had to pay the IRS the amount needed to pay the credit cards and the credit cards companies would have sued him and levied his wage.

    He qualified for a chapter 7 Bankruptcy even though he was a high wage earner.

    In order to qualify to file a chapter 7 Bankruptcy, the Court has to be convinced that you pass what is called a “means test“. The Law doesn’t allow just anyone to file a chapter 7 Bankruptcy and it is especially careful about those that make what it considers an “upper middle income”. Under normal circumstances Mr. Gale wouldn’t have passed the means test.

    However, in Arizona, if the majority of your debt is tax debt you don’t have to take the means test. Mr. Gale’s debt was primarily…income tax debt. He was able to file a chapter 7 bankruptcy despite his income level.

    He had few non-exempt assets

    Mr. Gale hadn’t been able to purchase a home and had not made many investments over the years, at least that he kept.

    What did we do?

    Mr. Gale made the hard choice to file for bankruptcy. There were still some hurdles though. His debt wouldn’t be dischargeable for another year or so and he feared that he would have to make the very high installment agreement payment to the IRS which would have taken money he needed to keep his other creditors at bay.

    What he didn’t know was that the IRS rules allow for a different type of payment plan.

    One that allows a taxpayer to use his or her actual budget, including credit card payments for a period of one year in order to get their situation settled. At the end of the year, the payment jumps up to what it would have been had the standard IRS budget been used.

    Mr. Gale was able to arrange the 1-year payment plan using his entire actual budget. The payment was much lower and while he was making the payment the “clock” on the dischargeability of the tax debt continued to run.

    When all of his tax debt became dischargeable in bankruptcy, he filed and was able to eliminate the entire tax debt and all of his credit card debt, a savings of about $200,000.00

    Conclusion

    There are many people in Arizona that are struggling inside of an IRS payment plan that they can’t afford or that is delaying a fresh start.

    If the IRS debt is serious and other parts of their situation are similar to Mr. Gale’s they should at least look into a bankruptcy. For Mr. Gale there really was a “wizard” behind the curtain.