No one likes bankruptcy, except bankruptcy attorneys. For most Americans, it remains a very negative process. In fact…many of our clients refuse to even consider bankruptcy during a first meeting. I don't blame them. It is interesting however, how many of those who are initially so opposed, change their minds once they see the potential benefits.
Why is bankruptcy such a mind changer? Some quick background:
The Bankruptcy Code, which is updated occasionally by Congress, reflects our Nation's desire to provide a fresh start for debtors. The Code attempts to create a system that forces those that can afford to pay their debt out, and allows those that can't…in.
This balancing process between “who should and who shouldn't” is applied to tax as well. Certain types of tax debts are considered so important that the bankruptcy code doesn't allow for them to be wiped away (discharged). “Trust fund” taxes like taxes that are withheld from an employee paycheck to be forwarded to the government by the employer, are an example.
Income taxes don't warrant the same concern, and therefore the bankruptcy code provides for their discharge in specific circumstances. Those circumstances are as follows:
- The tax return had to be filed more than two years before the bankruptcy filing.
- The tax return had to be due for filing more than three years before the bankruptcy filing.
- The tax debt had to have been “assessed” or entered into the IRS record as a debt, more than 240 days before the bankruptcy filing
- The taxpayer didn't file a fraudulent return.
- The taxpayer didn't commit “willful evasion”.
These dates are found in the Bankruptcy Code sections 507(a)(8)(A)(i), 523 (a)(1)(B) and 507(a)(8)(A)(ii).Of course you realized while reading this list that nothing is ever that simple, and for a number of reasons you are right.
- The first reason is that in an effort to be fair to the debt collectors at the IRS, the Bankruptcy Code requires that the clock stop ticking in certain circumstances. Circumstances like time spent in a previous bankruptcy, collection due process appeal, or offer in compromise. It is not always easy to calculate these time periods as a result. Also, the taxpayer has to wait for these time periods to pass. In the meantime, the IRS is aggressively looking for money.
- Even if the debt meets the date requirements, the existence of a properly filed Notice of Federal Tax Lien can negatively affect the benefits of bankruptcy. The filed tax lien attaches to all real and personal property. That lien and it's value on the date of filing will survive the bankruptcy. Those with significant assets prior to the bankruptcy filing date may regret the filing as a result, even if the underlying tax debt was wiped out.
So if the date calculations are complex, and the tax lien can negate many benefits of the discharge…why such a mind changer? The primary reasons:
1. The Bankruptcy Code controls the Tax Code
If the taxpayer meets the various bankruptcy qualification criteria and the tax debt meets the requirements for discharge, the IRS can't collect on the discharged debt after the case over. If it tries to collect the debt when it wasn't supposed to, the taxpayer can challenge it. This is as opposed to trying to deal with the IRS directly in an offer/installment/other situation where the IRS is in control.
2. Bankruptcy can be a “one-stop” shop
Many people with tax debt have other serious debt as well. If planned well, bankruptcy can deal with all of the problems at one time and some that many don't realize were “fixable”. Not only can income tax and consumer debt be dealt with, but cars can be “crammed down” to market value, homes saved, and assets protected. All legal options provided by the tax code, deal with the tax debt only.
3. The lowest debt settlement program is the no asset chapter 7 bankruptcy
Where the bankruptcy trustee in a chapter 7 bankruptcy is unable to collect any assets for liquidation and distribution to creditors, which is a common occurrence, the IRS will get nothing as well. This amount is always less than the settlement amount in an offer in compromise.
4. Offers in Compromise don't work for many
The vast majority of offers in compromise filed in the U.S. fail. There are a number of reasons. Some of them are:
a. Legal standards exist that govern how the IRS should view the offer to compromise the debt, but they are…a bit loose. Loose enough that the IRS is able to inject a great amount of subjectivity into the process. Bankruptcy on the other hand, creates quantifiable results based on objective criteria. Offer in compromise results are all over the place.
b. These legal standards have a lot to do with what the IRS thinks you can afford to pay toward the debt over time. The starting point for household budgets is very low and is usually much lower than the taxpayer's actual budget. The IRS doesn't have to consider certain budget items at all, like consumer debt payments and savings plans. This usually results in a large discrepancy between what the IRS thinks the taxpayer can afford and what the taxpayer thinks he can afford.
c. Failure is costly. Most need legal representation and that costs money. Most/all of which doesn't get refunded when the offer fails. Most have to pay some large amount to file the offer (20% of cash offer amount, or monthly payments based on the offer amount) which isn't refundable when the offer fails. The debt continues to grow in the background thanks to interest, and when the offer fails all the new debt is waiting with hat in hand and even a smile.
5. Higher income taxpayers don't always have to “qualify” for a chapter 7 bankruptcy
There is an exception in the bankruptcy code to the requirement that all who file chapter 7 bankruptcy must pass a test of ability to pay debt. Where the majority of the debt is tax debt or business debt, this rule doesn't always apply. As a result, many who wouldn't be able to even hope for an offer in compromise, are able to use bankruptcy to discharge the debt.
6. Many with serious tax debt don't have large assets
Most taxpayers with serious tax debt, will see the IRS record a Notice of Federal Tax Lien. As mentioned above, that lien attaches to all assets. When the bankruptcy is filed and the underlying debt is discharged, the tax lien remains and is in essence a secured debt. It's value is based on the value of the assets on the date of the bankruptcy filing. If the taxpayer owned a home that was “underwater”, a car with $5000.00 in equity and some furniture, the lien is almost worthless and the IRS will often remove it.
7. Chapter 13 bankruptcy is often a “cheaper” solution then an installment agreement.
The taxpayer may not be a good offer in compromise candidate, and may not be a good chapter 7 candidate because the tax debt is not the greatest part of the overall debt or for another reason. The taxpayer is left with two options: An installment agreement to pay the tax over time and wait out the statute of limitations period, or a chapter 13 bankruptcy.
The installment agreement amount is often much higher than the taxpayer would like. The chapter 13 bankruptcy payment on the other hand, can be based on friendlier budget criteria. In many cases the taxpayer can deal with all of his debt with a smaller monthly payment than the IRS was requiring to deal with the tax debt alone.