Spouse Needs to Join Bankruptcy to Discharge Income Taxes, But Reluctant Because Has No Other Debts and Has Separate Asset

Finding the best way out of this seeming Catch-22 depends on a full understanding of your unique situation and your goals.

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The last blog explained that filing a bankruptcy by yourself immediately protects YOU from IRS collection activity but does NOT protect your spouse. Similarly the legal write-off (“discharge”) of any tax applies to the person(s) filing the bankruptcy but not to your spouse if he or she does not either join you in your bankruptcy case or else files his or her own case.

That makes perfect sense—you don’t get the benefit of bankruptcy if you don’t file bankruptcy! So the simple solution is for spouses to file bankruptcy together. But there are many situations where that’s not so simple. The next few blogs discuss some of the practical problems that can arise, and how to resolve them.

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One Spouse Has Most of the Debts, the Other May Have Assets

Often one spouse is the only one individually liable on most of the debt. Or is one is solely liable on the debt except they are jointly liable on the secured debts—their mortgage and/or vehicle loans–that the couple intend to keep paying on. These situations can happen when one spouse incurred all the debt from operated a business that failed or that spouse was simply the primary income source and/or the one with good credit.

In these situations only the spouse whose debts would be discharged would directly benefit from a bankruptcy filing, so the other is appropriately reluctant to be in a bankruptcy that appears to provide him or her no benefit.

But now add two more ingredients to this scenario: 1) a large personal income tax debt that is old enough and meets the other conditions so that it can be discharged in bankruptcy, which both spouses owe because they both signed the joint tax return; and 2) a significant asset not protected by the applicable exemption owned separately by the spouse with less debts. To make this clearer, let’s say the income tax debt is $25,000 for the 2008 tax year, and the one spouse’s separate asset is his or her share in the childhood vacation home, inherited before the marriage, with this spouse’s share being worth about $20,000.

Seeming Catch-22 for Spouse with Less Debt but Liable on Tax Debt

Without the joint income tax debt, the spouse with little or no other dischargeable debt would not want to join in a Chapter 7 bankruptcy case because his or her share of the old family vacation home could well be claimed by the bankruptcy trustee and sold to pay the couple’s creditors. But with the existence of the joint tax debt, a Chapter 7 filed by the other spouse alone would forever discharge that tax debt as to THAT spouse only, leaving the non-filing spouse owing all of the tax—and the continually accruing interest and penalties—by him- or herself. Clearly not a good result.

Indeed the situation on the surface looks like a Catch-22: the asset-owning spouse either joins in on the bankruptcy thus jeopardizes the asset, or else doesn’t join and is stuck with the tax.

Best Solution Depends on the Unique Facts of the Case

It’s in these tough situations that an experienced bankruptcy attorney becomes very valuable. Determining the best solution depends on thorough understanding of the law along with a careful analysis of all the facts of this case—such as whether the couple owed any other taxes and if so how much and for which years, whether they owed any other “priority” debts (including back child or spousal support payments from a prior marriage, or employee wages from the failed business), their current income and expenses, and lots of other potentially relevant facts.

The Best Solution in One Scenario

For example, people who owe one year of taxes often owe for other years. If the couple also owed joint income taxes in the amounts of $10,000 for 2009, $6,000 for 2010, and $4,000 for 2011—an additional $20,000—a Chapter 7 case would not discharge these newer taxes.  (This would be true until at least three years had passed since any particular tax’s return was due, along with a series of other conditions.) 

However, a jointly filed Chapter 13 case could well be their best solution in this scenario. It would 1) discharge their joint 2008 $25,000 income tax debt, 2) give them a favorable and protected way to take care of the newer $20,000 income taxes, AND 3) protect the one spouse’s emotionally (and financially) valuable asset:

1) The older $25,000 tax would be forever discharged at the completion of the Chapter 13 case, only requiring the couple to pay some share of that in the unlikely event they had extra money to do so.

2) Instead their financial effort would more likely be going into paying off the 2009, 2010 and 2011 income taxes, which they have five years to do. These are “priority” debts which must be paid in full during a Chapter 13 case. But this is often the very best way to pay such taxes, because:

a) the couple’s payments would be based on a more realistic budget than the IRS usually allows;

b) other creditors—such as back support or a mortgage arrearage- could be paid ahead of these taxes;

c) usually no ongoing interest and penalties would be added, likely saving thousands of dollars; and

d) throughout the payment period the IRS could take no further collection action against the couple.

 3) Lastly, the non-exempt share in the vacation home would likely be protected under Chapter 13 because of the couple’s payment of at least the value of that asset–$20,000—to these “priority” tax debts. 

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