Bankruptcy may be a popular remedy for towering balances on credit cards, getting houses out of foreclosure, and eliminating enormous medical bills. But bankruptcy can be used for more than that; it can also have a huge impact on reducing or solving tough IRS tax problems.
Properly utilized, bankruptcy can make a significant difference in IRS tax matters – bankruptcy can indeed solve many tax problems:
- Release IRS seizures and levies
- Stop the accrual of interest and penalties
- Reduce and improve terms of IRS installment agreements
- Eliminate tax liabilities within months
- Reduce the value of an offer in compromise (OIC)
- Solve the often inequitable use of IRS collection financial standards, and
- Take the playing field away from revenue officers and Automated Collection Service (ACS) employees.
Here are a number of situations where bankruptcy can make a difference in solving IRS tax problems:
1. Bankruptcy Creates a Stay, Which is the Immediate Release of IRS Seizures or Levy Action
Bankruptcy is a powerful way to stop the IRS collection machinery. Immediately, when bankruptcy is filed, the IRS is barred from taking any collection against you. This is called a bankruptcy “stay,” and, unless modified by the bankruptcy court, continues uninterrupted while the bankruptcy is pending. Bankruptcy can bring a degree of normalcy to difficult situations.
If the IRS has issued a wage levy, bank levy, or seizure of real or personal property, it must be released (wage and bank levy) or stopped (seizure of real or personal property) once a bankruptcy is filed. There should be no negotiation needed to obtain the release once the bankruptcy is filed. The release is absolute as required by bankruptcy law.
When the IRS refuses to yield and you are in a bind, bankruptcy law trumps IRS administrative action and forces levies and seizures to cease. In this context, bankruptcy has your back.
2. Chapter 13 Creates a Payment Option That Reduces the Amount the IRS Has to Be Paid
In many IRS payment plans, the wheel just goes ‘round and ‘round, with the payments never enough to actually pay off the tax debt before the IRS collection timeframe expires (10 years/120 months).
The solution is in making payments through a Chapter 13 bankruptcy. Chapter 13 is simply a debt repayment plan conducted by the approval of a bankruptcy judge. It can repay the tax debt, credit card debt, medical bills, and unpaid bills from a business.
If you have ever wondered how a house in foreclosure is saved in bankruptcy, it is usually by use of Chapter 13, which stops the foreclosure and forces a bank to enter into a payment plan for the missed mortgage payments. Chapter 13 once again is the hero: it can put the brakes on that spinning wheel of foreclosure.
In fact, Chapter 13 can do more than just stop interest and penalty accruals; it can actually reduce the amount the IRS gets paid in installment agreements.
Do you owe $30,000 but can only afford $250/month – an amount that will not pay the liability before the collection timeframe expires? Chapter 13 can force the IRS to take a discount on what is owed and accept the $250/ month as payment in full, even though it will only be paid over the course of the Chapter 13, which is thirty-six to sixty months. (The time it takes to complete a Chapter 13 payment plan – 36 to 60 months – often compares favorably with the time it takes to complete an IRS installment agreement.) Do you see how this timing aspect can benefit you and what the IRS can collect? Timing IS everything.
Here’s why the IRS can be forced to take a reduction if paid through a Chapter 13: Chapter 13 laws have what is known as a “cramdown.” In bankruptcy speak, cramdown means that a creditor can be forced to receive less than the full amount of its bill. The bankruptcy code determines that a debt is subject to cramdown based on the priority, or level of importance it is given. Credit cards and medical bills are given a low priority and importance in bankruptcy, in part based on their nature as used for household and family purposes; taxes are initially given a higher priority, which reduce over time to a lower priority level.
The cramdown permits low- priority debts to be repaid at a fraction of what was originally owed. This can include the IRS.
Taxes achieve a lower priority – at the same level as credit cards and doctor bills – with the passage of time. “Nonpriority” is the technical term given to taxes when they are "aged" to achieve a low priority equal to credit cards. Credit cards and doctor bills are automatically labeled as nonpriority debts; taxes take a little time to get there. In the bankruptcy world, taxes are like wine – they get better with age. Once taxes reach nonpriority status, they can be repaid like credit cards.
Let's look at an example: You have $55,000 in credit card debt, $30,000 in IRS and state taxes, and $250/month of disposable cash flow.
At first glance, there is a problem—how can $250/month repay $85,000? Even at the sixty-month maximum time a Chapter 13 can last, that is only $15,000. But under proper analysis, it will be determined that when the taxes have aged, they will have changed from priority to nonpriority debt status.
Here’s where Chapter 13 cramdown comes to the rescue. Since all the debts are nonpriority, the creditors have to accept payment of $250/ month, equal to just under 20% of what is owed. This includes the IRS, which will get approximately $6,000 on its $30,000 claim. The rest of what is owed gets dismissed when the Chapter 13 bankruptcy concludes (remember, 36 to 60 months) by operation of the bankruptcy cramdown laws. The balance that is not paid by the monthly payments—taxes, credit cards, medical bills—is discharged by the bankruptcy court, with an entry then made by the IRS in its books after the bankruptcy, reducing the account balance to zero.
3. Chapter 13 Also Results in a Payment Option that Shortens the IRS Collection Timeframe
Chapter 13 also shortens the length of repayment. As mentioned, Chapter 13 lasts between 36 to 60 months. By comparison, the IRS has up to twice as long to collect: 10 years/120 months, starting when the tax returns were filed and the amount was first owed. An installment agreement negotiated with the IRS that pays $250/month on a $30,000 liability will linger until the IRS collection timeframe expires (10 years). Interest and penalty accruals will eat up the payment. By comparison, this $250/month payment, when funneled through a Chapter 13 bankruptcy, will take between 36 to 60 months to complete if the taxes are eligible for cramdown. Chapter 13 bankruptcy can save time in comparison to IRS-negotiated installment agreements.
4. Another Chapter 13 Benefit: A Payment Option That Stops the Accrual of Interest and Penalties
Next to “Can I settle my debts with the IRS?,” the most popular question of a taxpayer in distress is, “How do I make the interest and penalties go away?” And these questions lead to another popular question: "Can bankruptcy solve my tax problems?"
The answer to the frustration caused by interest and penalty accruals is once again solved by Chapter 13 bankruptcy. Chapter 13 (named after the thirteenth chapter in the bankruptcy code, which contains the laws governing this type of bankruptcy) can stop the accrual of IRS interest and penalties in payment plans, which can be a tremendous savings of not only money but time.
As a general rule, interest and penalty accruals will double the amount owed every five years, making it impossible for a successful tax debt payoff with most IRS-approved installment agreements.
By comparison, a Chapter 13 bankruptcy can stop the interest and penalty accruals. That means the monthly payment goes to what was owed, not what will be owed.
5. When There Is No Ability to Make Payment, Chapter 7 Bankruptcy Provides an Option to IRS Uncollectible Status
If you can demonstrate that you have no ability to pay your debt to the IRS, they can agree to temporarily forbear on collection-enforcement activity. “Uncollectible” is the technical term the IRS uses when it places an account in financial hardship status.
With 10 years to collect the liability, the uncollectible status can linger on during that timeframe, or the IRS may review the account every two years, or request new financial disclosures on the ability to pay if there are indicators that income has been increasing. Uncollectible status is a temporary reprieve from IRS collections. The reprieve can be made permanent with Chapter 7 bankruptcy.
A Chapter 7 bankruptcy is the complete opposite of a Chapter 13 bankruptcy. Chapter 13 is for those with cash flow, and it imposes a repayment plan on the IRS. Chapter 7 is for those without cash flow, and it eliminates any nonpriority tax debt (taxes that have aged a little) without having to make any repayment of the liability.
Chapter 7 works best under the same circumstances that make an account uncollectible: no cash flow and assets that have no or minimal equity. The same bankruptcy schedules of income and expenses and assets and liabilities that are used for a Chapter 13 are used for a Chapter 7; but in Chapter 7, there is no cash flow for a repayment plan. Because the taxes cannot be repaid, and if they have nonpriority status, they are eliminated by bankruptcy law without payment. And Chapter 7 usually lasts 4 to 6 months, making it quick, efficient, and a lot shorter than IRS uncollectible status.
6. Chapter 7 Bankruptcy Can Be Used as Leverage in an OIC
Sec. 5.8.10.2.2 of the Internal Revenue Manual (IRM) permits the IRS to consider the impact of a potential bankruptcy on the settlement value of an OIC. In other words, if bankruptcy is a real option and could eliminate everything that is owed to the IRS, but you want to avoid it if possible, tell the IRS that you are considering bankruptcy, and then show IRS what they would get if a bankruptcy was filed. (you can see how complex these things can get, in negotiating with the IRS, and that's where having a top-notch Tax Attorney at your side through the process comes in handy...significantly. Contact me today for a FREE consultation)
If you are considering a Chapter 7, the IRM (Internal Revenue Manual) instructs the offer investigator to consider reducing the value of future income to reflect that a bankruptcy could eliminate the liability without any recovery. Bankruptcy can be used as leverage in reducing the value of an Offer In Compromise (OIC).
7. Bankruptcy Provides a Desirable Alternative to an OIC
An OIC with the IRS can be an effective tool to settle a tax liability in the right circumstances, but there are trade-offs involved. The acceptance rate – although on the rise in the last two years to 33 percent (2011) and 37 percent (2012) – is still low, especially in comparison to the more quantifiable results that bankruptcy offers. Bankruptcy results are based on bankruptcy law – whether seeking a better payment plan (Chapter 13) or to eliminate taxes without payment (Chapter 7). The analysis is objective; OIC results are more subjective as the results rest with the opinion and analysis of the IRS offer examiner.
Before diving in with an OIC, consider how long a bankruptcy takes and how long an OIC can take. A Chapter 7 bankruptcy takes 4 to 6 months to eliminate a tax liability, and a Chapter 13 takes 36 to 60 months to repay it. This can compare favorably with the time it takes to get an OIC accepted and paid, all without wondering whether the IRS will say yes (bankruptcy forces the IRS to say yes).
Depending on where the offer is worked and the volume of the IRS caseload, an OIC can take 6 to 12 months to be investigated. If the investigation results in a rejection of the offer, an appeal can take another 6 to 12 months. If a settlement is ultimately reached, you will be permitted up to 24 months to pay in the value to complete the compromise. And then you must stay current on all taxes and filings for 60 months thereafter. This is most certainly longer than a Chapter 7 and can rival a Chapter 13 in certain circumstances.
Most OICs also require a down payment when the offer is submitted; there's no such requirement in bankruptcy.
An OIC does, however, work to release tax liens, at least for Chapter 13. A successful Chapter 13 will also result in the release of tax liens. In Chapter 7, the IRS is not compelled to release the liens after the tax liability is eliminated but usually will do so in cases where there are no assets of any significant value.
8. Bankruptcy can Enhance IRS Negotiations by Deterring Application of IRS Financial Collection Standards
The IRS collection financial standards can have a burdensome impact on IRS negotiations. IRS collection financial standards cap the amount of monthly living expenses the IRS will administratively allow in determining the ability to make monthly payments.
The most common offender of the IRS collection financial standards are housing and utility expenses, where actual expenses often exceed the IRS’s more puritan allowances. This creates phantom cash flow; the IRS disallows the part of the expense that exceeds its allowance and asks for that disallowed expense to be part of a monthly payment.
These standards are IRS administrative standards, and in most cases do not affect a bankruptcy court’s view of cash flow. By comparison, reasonable expenses, which are not allowed by the IRS, are often permitted in bankruptcy. Bankruptcy can change the playing field and minimize the use of IRS’s expense caps.
9. Bankruptcy Can also Change the Playing Field When the IRS Is Being Unreasonable
If you have a revenue officer and don’t see eye-to-eye, or if ACS is running your client around, bankruptcy can bring impartiality to the process. IRS procedure defers to bankruptcy law, and claims that you are unable to negotiate with the IRS can be eliminated in a Chapter 7 or repaid in a Chapter 13. You will also change the parties, as revenue officers and ACS employees do not handle bankruptcies on behalf of the IRS. Bankruptcy changes the playing field.
10. Chapter 13 Bankruptcy can Work to Simultaneously Resolve both a Tax Problem and a Credit Card Problem
Clients with tax problems often have other financial problems, whether it is state and local taxes, credit cards, medical bills, or unpaid bills from a business. A Chapter 7 bankruptcy can eliminate all these debts, while an OIC alleviates only one aspect of the financial distress. Bankruptcy works well in situations that involve more than tax problems.
What do you do when your client is making $600/month payments on credit cards, and the IRS demands that money be paid to it an installment agreement, not to the credit cards? There isn’t enough to satisfy everyone, and not enough to pay everyone off.
The answer is again a Chapter 13, which reorganizes this quagmire and can take the $600 and permit it to be shared among all creditors. If all the debt is nonpriority, then all creditors share the $600 pro-rata in relation to the value of their claim—no fighting over the pot. If the IRS taxes are considered to have priority designation (that means they are more recent and have not yet aged), the bankruptcy court can order most of the $600 to go to the IRS and minimal amounts to the credit cards. The IRS now has a higher priority and claim to the money, and it will get the money before the lower priority claims. The lower nonpriority claims get the cramdown, and the IRS gets paid.
As you can see, bankruptcy is extremely useful in discharging IRS tax debt – bankruptcy can solve tax problems. But as we've outlined, the process can get complicated, and it would be a wise move to engage a Bankruptcy Attorney to guide you to your best conclusion. Fortunately, I'm both a Bankruptcy and Tax Attorney and know all the ins and outs in determining your specific situation and achieving your very best outcome. Click here for a FREE consultation and let's talk about what you're facing as well as your best path forward. You can also email me at Larry@TaxProblemSolver.com or phone my office at 855-BEAT IRS (855-232-5752). My Team and I are here to keep you free of any and all tax problems and explore whether bankruptcy is a suitable alternative to negotiating with the IRS.
