Use Chapter 7 or Chapter 13 to Resolve Your Tax Debts from a Closed or About-to-Close Business

If you had struggled to keep a business open, but have decided to throw in the towel, there’s a good chance you owe taxes. Here’s how to deal with them.

 

The Basic Choice

Let’s assume that you are seriously considering filing bankruptcy, but want to know your options.

You have two choices within bankruptcy for addressing tax debts after closing down a small business:

1. File a Chapter 7 case to discharge (legally write-off) all the debt that you can, which may include some of your tax debt, and then deal directly with the IRS and any other tax authorities to either pay the rest of the taxes in monthly installment payments or to negotiate a settlement (called an Offer in Compromise in the case of the IRS).

2. File a Chapter 13 case to deal with all your debts, which again may include the discharge of some of your tax debt, while you pay the rest of the taxes through a court-approved Chapter 13 plan, and being protected throughout the process from collection actions by the IRS and any other tax authorities.

Putting aside the many factors distinct from taxes, choosing between Chapter 7 or 13 comes down to this key question: Would the amount of tax that you would still owe after completing a Chapter 7 case be small enough so that you could reliably make reasonable payments to the Internal Revenue Service (or other tax authority) which would satisfy that obligation within a sensible time period?

Answering that Question

The idea is that Chapter 7 is likely the way to go if you don’t need the long-term protection that comes with Chapter 13. In a Chapter 7 case, once that case is completed—usually only about three to four months after it is filed—the IRS/state can resume collection activity on the taxes that were not discharged in bankruptcy. You clearly want to avoid that. So a Chapter 7 makes sense ONLY IF before any collection activity begins you have arranged with the IRS/state to make payments, and 1) those payments are reasonable in amount, 2) your circumstances are stable enough so that you are confident that you will be able to pay them consistently, and 3) the length of time you would be making payments does not stretch out so long that the interest and penalties get too high.

Your attorney will be able to tell you—usually with high reliability—which tax debts will and will not be discharged in a Chapter 7 case, and thus how much in taxes you still owe. Then the next step is determining what the IRS/state would require you to pay in monthly payments, or possibly would accept in settlement. Your bankruptcy attorney may be able to give you guidance about this, or may need to refer you to a tax collection/settlement specialist. Once you know the likely monthly installment payment amount—assuming you go that route—then you need to seriously consider whether that would be an amount you could reliably, reasonably pay, without incurring too much in interest and penalties before you paid it off.

If so, Chapter 7 likely is more appropriate. If not, then Chapter 13 is likely better because it gives you much more protection.

Keep in mind that beyond this much longer period of protection from the tax authorities, you would likely pay less per month towards the not-discharged taxes in a Chapter 13 case. That’s because your allowed expenses would likely be more reasonable than if you’re dealing directly with the IRS after a Chapter 7 case. Also, other important debts—such as mortgage and vehicle arrearage—can usually be paid ahead of the taxes. Furthermore, unlike in the after-Chapter 7 situation, under Chapter 13 penalties would not continue to accrue, and usually neither would interest. As a result, in a Chapter 13 case most likely you would pay less money to finish off the tax debt.

Conclusion

Please remember that many non-tax factors affect whether a Chapter 7 or 13 is better for you. And this blog has just presented a general rule of thumb about deciding between those two in the context of tax debts. Put even more bluntly, use a Chapter 7 case when that will solve your tax situation adequately, otherwise use the broader powers of Chapter 13. Be sure to see a highly competent bankruptcy attorney to apply these principles to your personal circumstances. 

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