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Tax Debt, Credit Card Debt, and Bankruptcy

Michael S. Anderson July 17, 2015

Many of our clients have both serious tax debt and other debt at the same time. These other debts may be student loans, state taxes, credit cards, medical bills, business debt or some combination.

If you read this blog you know that the IRS tries to use it's own budget in determining how much someone can afford to pay toward the tax debt…both in an offer in compromise and in certain payment plans. When that budget is used, it almost never includes credit card payments.

When those credit card payments are disallowed by the IRS as part of the budget, the amount being paid on those credit cards becomes part of the IRS payment plan and creates what is often called “phantom income”. As a result, the taxpayer now has a new payment plan with the IRS and no money to make the credit card payments. There isn't enough money left to go around.

The Solution

Unfortunately, the taxpayer is often so afraid of the IRS he or she will accept the IRS payment plan and start dealing with credit card company phone calls and lawsuits. No lottery win or rich uncle? Sleepless nights ensue followed by wage garnishment…once the creditor(s) obtain a judgment.

Believe it or not, bankruptcy often solves this problem.

If the taxpayer qualifies for a chapter 7 bankruptcy, the bankruptcy will discharge or get rid of the credit card obligations and in some cases the income tax debt. An Offer in Compromise doesn't deal with both, only the IRS debt, assuming it's successful.

If the taxpayer doesn't qualify for a chapter 7 bankruptcy a chapter 13 bankruptcy may make a difference.

In a chapter 13 bankruptcy, all non-priority debt like old income tax debt and credit card debt share the “left-over” money. If debt is left when the plan is over, it is discharged like in a chapter 7 bankruptcy. If the IRS debt is “priority” it will be treated better than the credit card debt and get paid first. If any funds remain, some credit card debt gets paid with it and the remainder of the credit card debt will be discharged.

What Next

If you have serious tax debt and credit card debt and you find yourself in a phantom income situation, you need to have an experienced attorney:

a. Determine whether you qualify for a chapter 7 bankruptcy

b. Determine whether a chapter 7 bankruptcy would make sense if you do qualify to file

c. If a chapter 7 bankruptcy doesn't make sense, compare a chapter 13 bankruptcy plan to non-bankruptcy alternatives.