Taxation & Estate Planning

Filing Chapter 7 bankruptcy on the IRS? A step by step guide to getting it done

By howardlevy

Chapter 7 bankruptcy is a powerful tool when facing the IRS – it can eliminate an entire tax liability if properly done. 

To help with your understanding of how a Chapter 7 bankruptcy can help you end an IRS problem, here is a step by step guide.  Hopefully, it will make the process a  little less intimidating.

Step 1.     Have you filed a tax return? If you have not filed a return, or if the IRS filed a an estimated return for you (substite for return), you are not eligible for a Chapter 7 tax discharge.  An original return must first be on record with the IRS. 

Step 2.    If you have filed a return, how long has it been?  Bankruptcy law requires that two years pass between when you filed your return and start your bankruptcy to discharge taxes.

Step 3.    When were your tax returns required to be filed with the IRS?  Bankruptcy law also requires that three years pass from the due date of the return, including extensions, and the start of your bankruptcy.

Step 4.    Have you done anything to extend the timing rules of Steps 2 and 3?  Be careful in making a move that will cause you to wait longer to qualify for filing bankruptcy on the IRS.  If you were involved in a timely filed collection due process hearing with the IRS, the rules of Steps 2 and 3 stood still while the collection appeal was pending.  The clock also stopped ticking if you filed an offer in compromise within 240 days of filing your returns.  If you were in a Chapter 13 bankruptcy and now want to file a Chapter 7, the tax discharge timing rules were tolled while you were in the Chapter 13.

Step 5.    What kind of taxes do you owe?  If you make it through Steps 1-4 and owe income taxes, you are on the right path.   But if you had a business and owe employment taxes from IRS Form 941, Chapter 7 will only provide you partial relief.  Here’s why:  The employment taxes you deducted from your employees’ paychecks for their social security and medicare cannot be discharged in a Chapter 7 bankruptcy.  However, your  employer contributions to social security and medicare can be discharged in bankruptcy. 

Step 6.    Do you have  any money left over after paying your bills each month?  Chapter 7 bankruptcy is primarily for those that cannot afford to repay their debts – that is, they have no money left over every month after paying reasonable living expenses.  But note this:  Bankruptcy law uses real budgets to arrive a cash flow, not IRS standardized guidelines.  It does not matter that the IRS thinks you have cash flow.  If your living expenses are reasonable and you have nothing left over every month, you should qualify for Chapter 7.    

Step 7.    How much have earned in the six months prior to filing the bankruptcy?  Bankruptcy law has what is known as “means testing.”  Means testing makes a presumption that you do not qualify for Chapter 7 if you made too much money in the six months prior to filing  the case.  But even if you did make too much money, means testing can go from “fail” to “pass” by claiming certain living expenses off your income.  If your income varies, the means testing factor can eliminated by waiting to file after a few slow months.

Step 8.     Do you have any assets with substantial equity?  Chapter 7 is a liquidating bankruptcy.  If you have an asset that could be sold and would result in money to pay your creditors, you could lose that asset in return for the tax discharge.  But this is rare.  Federal and state law provides for what is known as “exemptions” to enable you to keep your property – even valuable assets with equity.  Remember this:  Exemptions shield equity.  Exemptions are why most people keep everything in bankruptcy. 

Example of assets, equity and exemptions:  If you have a car loan, and the amount owed is equal to or greater than what the vehicle is worth, you have no equity -you keep the car.  If there is some equity – meaning it is worth more than you owe, then the federal or state exemption laws could still protect the equity, and you would keep the property.  The same applies to your house.  In Ohio, a house owned by husband and wife would have up to $40,400 of equity protected.  Qualified retirement accounts are not subject to the liquidating powers of a bankruptcy court – you keep the accounts.

Step 9.    Should you consider the benefits of a Chapter 13 if you do not qualify for Chapter 7?  If you do not qualify for a Chapter 7 – maybe too much cash flow - then a Chapter 13 repayment plan could be a better option for you.  Chapter 13 has significant benefits for those with cash flow:  It can stop the accruals of interest and penalties the IRS charges.  At the same, Chapter 13 can lower the amount you have to repay on older income tax debts.  Although loss of assets in Chapter 7 is rare, Chapter 13 also has the added benefit of preventing asset liquidation (it is a repayment plan, not a liquidation, so you keep all of your assets).   Chapter 13 is also a good alternative to an IRS installment agreement.  It can also reorganize and reduce the payment of other debt you may have, like credit cards.

Understanding how to file bankruptcy on the IRS can appear to be overwhelming, but it does not have be with proper planning.  Taking it one step at at time and carefully analyzing the pros and cons is key to a sucessful outcome.

Full post as published by IRS and the Law on April 04, 2010 (boomark / email).