Chapter 13 Bankruptcy and IRS Debt – Giving the IRS a Haircut

crazy haircutTHE PROBLEM(S)

1.   IRS Offers in Compromise Don’t Work for Most People

Most people with serious tax debt just can’t make an IRS Offer in Compromise work.  Success is based on a formula and that formula is based on a number of facts about the taxpayer’s income, budget, assets in the past, the present and the future.

The formula uses a pre-determined budget and subtracts it from income.  The difference plus asset value is used to determine whether the debt can be paid over the remaining 10 year period on the statute of limitations for collection.

According to the formula most people who file offers in compromise can afford to pay the debt in full before the statute runs and for many who are able to show they can’t there are a number of other reasons why the offer in compromise doesn’t work.

In 2013, 58% of all offers in compromise cases filed – failed.  More from that year will fail as well because of the post acceptance requirements placed on successful deal-makers.

2.   IRS Payment Plans Are Like a Ferris Wheel That Never Stops

Many taxpayers are stuck in a ferris wheel that doesn’t let them off for 10 years or until the statute runs out.

They can’t afford to pay the debt in full, they aren’t good Offer in Compromise candidates for various reasons, so they struggle with what is often a very painful payment each month while they watch interest and penalty accrue on a debt that goes nowhere.


What is Chapter 13 Bankruptcy?

A Chapter 13 is really just a debt repayment plan subject to the approval of a bankruptcy judge. It can repay tax debt, consumer debt and business related debt.

It can also be used to do other things like save a home from foreclosure by stretching out the arrears over 3-5 years, stop IRS penalties and interest from accruing, or stripping away second mortgage and judgement liens.

Depending on the chapter 13 filer’s situation, it can do something else that is misunderstood if not completely overlooked.  It can give the IRS and other creditors a serious haircut.

What does Chapter 13 do to the IRS?  

1.   Cramdown – Here is the Haircut

Chapter 13 bankruptcy does more than stop the IRS interest and penalty from adding up.  It can, in many situations, reduce the amount the IRS is getting paid in installment agreements.

The bankruptcy code requires that creditors receive less than the full amount of the bill depending on it’s priority status.  Credit Cards are low priority and taxes start out with a high priority, but can end up in a low priority situation depending upon their type and age.

If the tax is income tax and is $75,000.00 and the card debt is $25,000.00 and all of the income tax is low or non-priority AND the Bankruptcy Judge determines that you can only afford $250.00 per month toward the tax and credit card debt,  $250.00 per month would be all you paid on those debts for 36-60 months depending on your income level, and at the end of the plan the rest of the debt with it’s penalty and interest would be discharged.

An example to make the cramdown clear:

If you have $75,000 in credit card debt, $60,000 in non-priority IRS and state taxes, and according to the Bankruptcy Code – $300 per month of “disposable” income.  You will only pay $300.00 per month for at most 60 months toward the $135,000.00 total.

You say wait just a minute—how can $300 per month pay back $135,000.00?

In this example – it doesn’t.  The debt is all non-priority and the Judge says you can only afford to pay $300.00 toward non-priority debt for 60 months.  You would only pay $18000.00 of the overall debt as a result.

Here’s where the cramdown makes the most sense. Since all the debts are non-priority, the creditors have to accept payment of $300 per month. The remainder is discharged when the case is over.

Even in cases where the situation requires the Judge to order a much higher payment, the chapter 13 filer is often better off in a chapter 13 case because the penalty and interest stop accruing.

In sum, the chapter 13 cramdown allows low- priority debts to be repaid at a fraction of what was originally owed and this can even include the IRS.


2.   Timeframe Shortened

As mentioned above the Chapter 13 case can also shorten the length of repayment.  The IRS has 10 years or 120 months to collect a debt and this time frame is extended anytime appeals are filed, offers in compromises are filed and in other cases.

An installment agreement at $300.00 per month at the beginning of this 120 month period will linger for 10 years assuming the debt is greater than about $36,000.00.

A Chapter 13 lasts between thirty-six to sixty months.

3.   Stops Accrual of Penalty and Interest

The second most common question I get is, “can you get rid of my penalty and interest?”

A chapter 13 bankruptcy stops both from accruing.  An IRS payment plan doesn’t.  Generally, interest and penalty will double the debt amount every 5 years making it difficult to pay the debt off before the 10 year mark.

In a chapter 13, the payment goes toward what is owed not the interest and penalty.


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