Let’s face it–events happen that you can’t control. Sometimes you’ve exhausted all means to get your financial life back in order – for you personally and/or your business. Bankruptcy now becomes an option, a legal process in which bad debts are either extinguished or a plan may be implemented for repayment depending on which chapter of bankruptcy you file your petition. On the personal side, a bankruptcy filing only discharges income tax debt – it does not discharge other types of taxes including payroll taxes, trust fund recovery penalties, etc.
Filing for a bankruptcy places an automatic stay on collection action by the IRS, but extends the IRS collection statute expiration date so that it has more time to collect on any remaining tax debt that was not discharged. Seldom is bankruptcy a better option than trying to negotiate directly with the IRS for moneys owed it. The exception would be if aggressive collection action is being taken against you, filing for bankruptcy will obtain a stay on the collection process. Depending on which chapter you file, you may force the IRS to accept a payment plan, which would include some or all of your income tax debt being reduced, or having it completely discharged.
Bankruptcy and Your Credit
The downside to filing a bankruptcy petition is that this action will last on your credit report for 10 years. This may prevent you from qualifying for various loans, as well as jobs. Prior to filing bankruptcy, you should weigh the pros and cons and determine whether it would cause more harm than good.
Differences Between Chapter 7 and Chapter 13 Bankruptcies
The two most common forms of bankruptcy that provides some assistance in resolving an IRS tax debt are Chapter 7 and Chapter 13 bankruptcy. It is important to understand that each form resolves IRS tax debt differently. Chapter 7 is the only bankruptcy option that may discharge some or all of your IRS tax debt, while Chapter 13 may either reduce a portion of your debt, and establish a payment plan to repay the remaining balance, or simply establish a repayment plan for paying off your IRS tax debt. In a bankruptcy proceeding, it is important to know that only income tax debt can be discharged. All other tax debts cannot be discharged by filing bankruptcy.
Chapter 7 Bankruptcy
In a Chapter 7 Bankruptcy, the court may either discharge all or a portion of your IRS income tax debt. However, in order for the income tax debt to be discharged, it must meet the following guidelines:
• The tax debt must have been due at least three years prior to your bankruptcy filing. This is called the Three-Year Rule.
• The tax return must be filed at least two years prior to your bankruptcy filing. This is called the Two-Year Rule.
• The taxes owed must have been assessed against you at least 240 days prior to your bankruptcy filing. This is called the 240-Day Rule.
• The tax debt cannot be the result of tax fraud or tax evasion.
• The tax debt must be income tax debt only.
If approved, a Chapter 7 discharge of income taxes will remove your obligation to pay back the taxes owed. However, if any tax liens were filed against you prior to bankruptcy, the tax lien will remain in effect up to the value of your equity in assets. For example, if a tax lien of $50,000 has been filed against you, but your remaining assets are valued at $10,000, the tax lien will remain in effect up to $10,000.
A Chapter 7 filing is not recommended for individuals who may have substantial assets, as some assets may be exempt while others are not. All assets not exempted will be included in the bankruptcy and may be used to satisfy outstanding debts.
Chapter 7 Bankruptcy can only be filed once every six years, but is the only bankruptcy option for discharging IRS income tax debt.
Chapter 13 Bankruptcy
The most common form of a bankruptcy filing is a Chapter 13. It is used for resolving IRS income tax debt within a repayment plan that will be determined by a court trustee. It does not discharge the income tax debt but will require that you make monthly payments for a specified amount and for a specified length of time which may be a minimum of three years to five years maximum.
The court trustee may also reduce the amount of the income tax debt if four conditions are met:
1. The debt must be income tax debt.
2. The Three-Year Rule must be met.
3. The 240-Day Rule must be met.
4. No liens were filed by the IRS, or if a lien was filed, there is no property upon which the lien may be applied.
If these conditions are not met, the tax debt must be paid in full, and the payment plan established in the bankruptcy proceeding will be adjusted in order for the tax debt to be paid in full within the allotted time. The Two-Year Rule requiring that all tax returns must be filed prior to filing a Chapter 7 is not applicable in Chapter 13.
The benefit of Chapter 13 is that it will stop all penalties and interests from continuing to accrue from the date the bankruptcy is filed, unlike an IRS Installment Agreement or Streamlined Installment Agreement where the penalties and interests will continue to accrue. It may also reduce penalties and interests owed to the IRS. Chapter 13 also forces the IRS to accept the repayment plan proposed by the Bankruptcy Court and cannot collect more than the judge approves. This option may also be beneficial in cases where a revenue officer is assigned that refuses to establish a reasonable Installment Agreement or resolution.
Divorced and Debt Aren’t Always Separate
Individuals are considered divorced on the date that the divorce is made final in a court of law. Contrary to what many believe, divorce does not discharge a tax debt. The IRS holds that husband and wife are jointly and severally liable for the tax debts in which a joint return was filed. As a result, it may pursue one or both parties in order to collect the full amount of tax debt owed as both are held liable for the tax debt that was created during the marriage.
If the husband or the wife paid the tax debt in full and the other did not contribute anything to its creation, his or her only recourse is to pursue a civil action in a court of law to collect the portion that should have been paid by the former spouse.
Debt and Separation
Sometimes divorced couples still reside in the same household. When this occurs, the IRS may establish a resolution with one party that protects the other from collection activity. If they are separated or living apart, the spouse setting up the resolution with the IRS may choose to establish a resolution only for him or her and exclude the other spouse. When this happens, the IRS will perform a task called Mirroring the Account in which case, the spouse establishing the resolution will be protected from further collection action, but the IRS will pursue collection action against the former spouse.
In Offer in Compromise cases, if the offer is accepted for one party where the taxes were owed jointly, the IRS will reduce the total debt by the amount of the offer, and pursue the other party for the remaining tax debt.
In some cases where parties are divorced and living apart, they may still be able to resolve the account jointly. In Offer and Compromise cases, both parties may submit the offer jointly using separate Forms 433-A OIC, or Form 433-A and then one Form 656 if resolving joint liabilities only.
In the case of Currently Not Collectible, parties living separately cannot submit a Currently Not Collectible on behalf of the spouse (or former spouse), each person would need to submit a request for Currently Not Collectible separately. However, one spouse may set up an Installment Agreement and agree to pay back the full amount of the joint tax liability if he or she chooses to do so. This would prevent the IRS from pursuing collection action against the other spouse. Chapter 21, Resolutions, Offers and Agreements would be helpful to review so that you have a clear understanding of what each agreement is.
Assisting Your Ex
The decision to help or not to help an ex-spouse is completely within your discretion. It can provide simplicity as Mirroring cases may cause confusion when two taxpayers are making payments on the same tax liability. In some cases, such as Offer in Compromise, it may be easier to have the case resolved when both spouses are eligible for the status rather than trying to resolve the tax debt separately. You should weigh the pros and cons of your decision and make an informed choice.
Seeking Non-Liable Status
You may be considered a Non-Liable Party (NLP) – someone who lives with and shares living expenses with a taxpayer who owes back taxes to the IRS. You though, don’t owe the IRS for the back taxes. NLPs can be a spouse, parent, or roommate. When you live with an NLP, a special calculation must be done and can affect your eligibility for the resolution you are seeking.
When an NLP resides in your household, you may be required to pro-rate your shared expenses based on the income of all parties residing in the household. A percentage will be determined for which you are responsible for the shared household expenses. This percentage is determined by adding the incomes of everyone in the household, then dividing your income by the total household income.
Pro-rationing is more likely to be demanded when a taxpayer shares expenses and co-mingles bank accounts, funds, etc. This is more common among married individuals and when negotiating an Offer in Compromise.
The Pro-Ration Formula is as Follows:
Taxpayer’s share = taxpayer’s monthly gross income ÷ (taxpayer’s monthly gross income + NLP’s monthly gross income) x 100.
Example: Stephan was married to Barbie. They lived in the same household with one minor child. Barbie was not liable for Stephan’s IRS tax debt he had incurred. They shared expenses for food, clothing and miscellaneous items, housing and utilities, and out-of-pocket health care expenses. His monthly gross income was $4,000 and hers $2,000.
The national standard for food, clothing and miscellaneous items for a household of three individuals (H + W + child = 3) is $1,249. Total housing and utilities was $2,000 and was within the IRS standard for their county. The national standard for out-of-pocket health care was $180 (60 x 3 = $180). With this information, Stephan’s portion of the shared expenses is calculated as:
Income share: $4,000 (taxpayer’s monthly gross income) ÷ ($4,000 (taxpayer’s monthly gross income) + $2000 (NLP’s income) x 100 = 67%. His portion of the shared expenses is 67%. Next, multiply the shared expenses by 0.67 or 67%.
Expense portion of food, clothing and miscellaneous items: $1,249 x 0.67 = $836.83 or $837. Stephan is responsible to pay $827 for this shared expense and would report this figure on his Form 433-A or 433-F.
Housing and utilities portion: $2,000 x 0.67 = $1,340. He will claim $1,340 for this item on his Form 433-A or 433-F.
Note: If Stephan’s housing and utilities exceeded the national standard for the housing and utilities for his household size based on his county, he would pro-rate his share based on the maximum allowed by the national standard if negotiating an Offer in Compromise. In Currently Not-Collectible or an Installment Agreement cases, he may be allowed to exceed the national standard if he provides proof of this expense.
Out-of-pocket health care portion: $180 x 0.67 = $120.60 or $121. As a result, he would claim $121 for this expense on his Form 433-A or 433-F.
Non-Disclosure of Income by a Non-Liable Individual
Some people are married; some are not. In a situation where one does not have a liability or responsibility for the debts of the other, the NLP may not want to include his or her income so that a proper pro-ration may be conducted. When that happens, the IRS may try to obtain what the income is internally if the NLP is a spouse. Previous joint tax returns would include income and the Social Security number. If information is obtained internally, the IRS will perform its own pro-rationing calculation. You should double check the representative’s calculation based on the information they have obtained as the representative may pro-rate incorrectly. In cases where the information cannot be obtained, the IRS will then use the default pro-ration of 50% of all shared expenses. The most common shared expense is housing and utilities. All other allowable expenses will be based on what you submitted to the IRS.
Example: Lars and Marisa were roommates but were not married. Lars owed the IRS but Marisa was not liable for his tax debt. She refused to provide her income to him so that he could pro-rate the shared expenses. When he informed the IRS representative of this, the representative tried to obtain her information internally, but was not successful. So the representative used the default pro-ration of 50% in order to determine his share of the housing and utilities expenses.
Lars reported that his total housing and utilities expense for him and his roommate was $1,400. The representative then determined that his share was $700 ($1,400 x 0.50 = $700). All other expenses were based on what he reported.
This is an excerpt from Tax Relief and Resolution by Steven Melnick, CPA. Melnick is a licensed attorney, LLM in Taxation. He is also a professor of tax law, and a Chairman of Continuing Education Programs for Tax Professionals at the City University of New York.