Discharging Income Tax Debt: How Chapter 7 and Chapter 13 Differ

Consult with a qualified consumer bankruptcy attorney about whether Chapter 13 or Chapter 7 is better for you. Getty Images

It is true that income tax debts can be discharged in Chapter 7 and in Chapter 13, but how each chapter treats income taxes is significantly different. To understand the treatment, it is important to understand that Chapter 7 and Chapter 13 are designed to accomplish different goals and each chapter employs different processes to get there.

Chapter 7 is also known as straight bankruptcy. It usually takes four to six months from filing to discharge.

The goal for most debtors (the people who file a bankruptcy case) is a discharge, which is an order of the court telling the world that the debtor has completed all requirements in the case and is no longer liable for payment of the debt. It does not officially wipe out the debt or make it disappear. It just relieves the debtor from the responsibility of having to pay it back.

A Chapter 13 is also designed to result in a discharge, but the way it goes about it is significantly different. In a Chapter 13 case, the debtor proposes a plan to repay debts over a period of three to five years. The payments are usually made monthly to a trustee appointed by the court. The funds are then transmitted by the trustee to the debtor’s creditors who have claims that meet certain criteria and have been allowed by the bankruptcy court. The amount of the plan payments depends on the debtor’s income, expenses, and the type and amount of debt to be repaid.

At the end of the repayment plan, any unsecured debt that has not been paid is discharged.

Debts are also classified in different ways. Some debts are secured, meaning the debtor has put up collateral that the creditor can use to pay the debt if the debtor stops making payments. Other debts are unsecured, meaning they are not secured by collateral.

Unsecured debts are further classified into priority and non-priority because, in truth, some debts are considered more important or more vital to repay than others. The bankruptcy code recognizes a difference between recent and older income tax debts, with recent taxes having priority status.

Treatment of Income Tax Debts in Chapter 13

Priority debts have to be paid in full in a Chapter 13 case. Non-priority debts are paid on a pro rata basis, meaning that all the non-priority debts are lumped together, and to the extent that there are funds to pay them in the plan, the claims are each paid the same percentage.

For instance, income tax debts that are newer than three years old are priority debts. They have to be paid in full over the course of the Chapter 13 three to five-year repayment plan. Income tax debts older than three years* are generally non-priority debts.

Example: Margaret owes $5,000 in priority tax debt and $10,000 in non-priority tax debt and $12,000 in other unsecured debt like credit cards and medical bills. When her income and expenses are considered, the court determines that she can afford a Chapter 13 payment of $200 per month for a total of $12,000 over five years.

Out of that $12,000, the $5,000 claim for priority taxes would be paid in full, leaving $7,000 to pay on non-priority debt. But there’s a total of $22,000 in non-priority debt. That means each non-priority debt will receive just over 30 percent of its claim. But if all the payments are made, and all the other requirements of Chapter 13 are adhered to, Margaret would receive a discharge that would relieve her of the liability for the remaining 70 percent.

Treatment of Income Tax Debts in Chapter 7

In a Chapter 7 case, most of the non-priority debt would also be dischargeable. If you qualify for a Chapter 7 case, most of the income tax debt more than three years old would be considered discharged along with associated interest and penalties. Most of the newer tax debt, along with interest and penalties on the newer debt, would not be discharged.

To learn more about the rules for dischargeable vs. nondischargeable debt and priority vs. nonpriority debt, see Discharging Debts: General Discharge vs. Dischargeability.

Discharging Income Tax Debt: File a Chapter 7 or Chapter 13?

Although there are many reasons to file a bankruptcy case, the goal for most people is a discharge of debt. When the debt is discharged, the bankruptcy laws will relieve the debtor (that’s what we call the person who files the bankruptcy case) of the liability for repaying it. Income taxes can be included in a bankruptcy case and can be discharged. Many people who file bankruptcy have income taxes that are overdue. In fact, some people use bankruptcy to manage their income tax debts.

Not all taxes can be discharged, however. Whether they can be discharged and how they can be discharged depends on their type, their age, the type of bankruptcy you file, and some administrative issues with the taxes and returns themselves.

Disclaimer: Of course, every taxpayer’s situation is unique. Any rules reflected here may or may not apply to your issues, and we caution you against relying solely on this article or any other article to help you determine how these rules affect you. If you owe income taxes, we strongly encourage you to consult with a qualified consumer bankruptcy attorney or tax professional who can advise you specifically with regard to your personal tax issues.

Are There Other Reasons to File Either a Chapter 7 or a Chapter 13 Case?

Before we can get to the actual tax debt, however, we have to ask a foundation question. Are there other factors that would influence whether you should file either a Chapter 7 or a Chapter 13 case? Chapter 7 and Chapter 13 cases are designed to accomplish different goals, and they accomplish those in different ways. A straight Chapter 7 is a relatively short term, four to six-month process in which the debtor (you) receives a discharge in exchange for any non-exempt property you may have. A Chapter 13 case is a longer term case in which the debtor devotes future income and resources to funding a three to five-year repayment plan to pay back a portion of all of the debt.

Some of the factors to consider in determining the best chapter under which to file include

  1. Whether you’re trying to save a house from foreclosure or other collateral like a car from repossession. A Chapter 13 might be appropriate for that because it would allow you to include the arrearages in a payment plan. A Chapter 7 has no provision for that and would not stop a foreclosure in the long term.

  2. If you have a lot of non-exempt property, a Chapter 13 might be a better choice for you because a Chapter 13 does not require that you turn over any non-exempt property immediately to a trustee like you would in a Chapter 7 case. Instead, you pay out the value of the non-exempt property over the three to five-year course of the Chapter 13 case,

  3. Whether you can you qualify for a Chapter 7 under the Means Test.

  4. If you have a co-debtor on a personal debt, you may be able to protect that co-debtor in Chapter 13, but not in Chapter 7.

  5. Whether you have income tax debt that would not qualify to discharge in a Chapter 7 case.

  6. If you have a significant amount of student loan debt, you may be able to use Chapter 13 to manage it.

  7. Whether you received a discharge in a Chapter 7 case or a Chapter 13 case previously. Depending on the type of the previous case and the type of new case, there are varying minimum time limits to which you will have to adhere.  

For more on which chapter might be best for your situation, see When to Consider Filing Under Chapter 13 Instead of Chapter 7.

Of course, much of the decision may be a balancing act. It may be that the answer is clearly a Chapter 13 because you want to save a house. Or it could be that you have a lot of student loan debt, but even more tax debt that can be discharged efficiently in a Chapter 7 case.

It may also be possible under certain circumstances to file a Chapter 7 case, obtain a discharge of all debt that can be discharged, then immediately file a Chapter 13 case to manage debt that could not be discharged in Chapter 7. This is sometimes referred to as a Chapter 20 case (because 7 plus 13 equals 20).