Income Tax Debt: The Difference Between Priority and Non-Priority Tax Debt
When you fail to pay your tax, the balance indicated on your federal income tax return becomes tax debt when it is due. Most income tax debt is classified as a priority debt, meaning you must repay it entirely. Therefore, you will not get relief from priority debt despite filing for bankruptcy. However, Chapter 13 offers a flexible time to repay your debt as part of your Chapter 13 plan payment.
Depending on your income, and the plan, you can have between three and five years to repay the debt. Fortunately, when repaying a tax debt under Chapter 13, you pay less since the interest will stop accruing. The penalties might also stop accruing. On the other hand, non-priority tax debt is a tax debt that can be discharged for less than you owe in your Chapter 13 bankruptcy.
Once you file for Chapter 13 bankruptcy and have income tax debt, the IRS will classify your debt as priority or non-priority. You must repay the priority tax debt in full by adding it to your plan payment. If a debt is considered non-priority, it is treated similarly to an unsecured debt from a general unsecured creditor and could be discharged for less than you owe.
Under the Chapter 13 plan payment, you will be making payments to your unsecured creditor and the general unsecured creditor will receive a portion of their debts through the plan. On completion of the case, the balance owed is discharged through a bankruptcy discharge. A bankruptcy discharge is a court order relieving you of the obligation to continue paying the debt. Therefore, your creditor cannot take any collection efforts over the discharged debt.
The general unsecured debt you must pay in your payment plan will depend on your disposable income, expenses, assets, and recent financial transactions. Depending on your situation, you can pay anything between 1 to 100% of the debt, meaning you might get lucky and pay a cent on the dollar on your non-priority tax debt.
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How Is Tax Debt Classified as Non-priority?
As we explained earlier, a tax debt can be considered a priority or non-priority debt. But what criteria are used to classify a debt to be non-priority? The 3-2-240 rule.
What is 3-2-240?
It is a rule to determine if a debt qualifies as a non-priority debt. The rule states:
3: The income tax debt should have been due three years before the debtor filed for bankruptcy. Most income tax debts for the previous year are due on April 15th of the current year. However, there were changes after the coronavirus pandemic as the government granted extensions following the high unemployment rates. This might affect how debtors should count the three-year rule in the future.
2: The income tax returns for the outstanding tax debts should have been filed not less than two years before filing for Chapter 13. It doesn't matter if you filed your income tax returns later, but the filing date for the returns should be two years before the filing date.
240: The IRS should have charged the tax debt at least 240 days before filing your Chapter 13 bankruptcy case. Mostly, the tax is assessed on the date the IRS accepts the tax return or a few days later.
If the income tax debt meets the three requirements above, it is considered a non-priority debt and is dischargeable. The non-priority debt will have the same payment percentage as other unsecured debts.
For example, if you have $15,000 outstanding non-priority debt, and the court decides you should pay 10%, you will pay $1,500 to offset the income tax debt. Upon completing your Chapter 13 plan payment, the remaining $13,500 in non-priority debts will be discharged.
Note: To discharge your debts, you must not have willfully incurred the tax debt by filing fraudulent returns or trying to evade paying tax.
What are Tax Liens on Secured Tax Debts?
If your tax debt is secured, the IRS or the taxing authority you owe can file a tax lien. When there is a lien over your secured tax debt, you must repay the debt in full through your payment plan to release the lien. The secured tax debt is limited to the value of the lien on your asset. Any amount exceeding the value of the lien is considered a priority or unsecured tax debt if it meets the 3-2-240 rule.
Here is an illustration: You have tax debts amounting to $50,000, and the IRS files a tax lien against your tax debt. However, the lien only covers $10,000 of the net equity of your assets. So, in this case, the value of the lien is $10,000, which is the secured portion of your tax debt that you must repay in full. Depending on whether the remaining $40,000 meets the 3-2-240 rule, it may be considered a priority or unsecured debt.
How Chapter 13 Handled the Other Tax Debts
Besides priority and non-priority tax debts, there are more types of tax debts that are handled differently under Chapter 13. Some may be eligible for discharge, while others will need to be paid in full. Here are the rules on how these other debts are handled in Chapter 13.
● Employer payroll taxes- they are dischargeable in Chapter 13 bankruptcy.
● Employee payroll taxes- an employer is not allowed to discharge payroll taxes they did not withhold or those they withheld but did not follow through with the payment. Therefore, they are treated as non dischargeable debt.
● Property taxes- any property tax debts should be paid within a year after filing for bankruptcy.
● Erroneous tax refunds- a tax refund you receive by mistake is not-dischargeable
● Sales taxes- these are taxes collected from customers. If you have an outstanding sales tax, you collected the tax from customers but did not remit to the government and are non-dischargeable in bankruptcy.
● Tax penalties- penalties incurred on non-dischargeable tax debt are not dischargeable.
There are more taxes that are considered non-dischargeable in bankruptcy. We recommend consulting a Chapter 13 bankruptcy lawyer regarding your tax debts. Your lawyer will go through your tax debts and advise best if Chapter 13 bankruptcy can help discharge these debts or if it will help benefit you.
Will Filing Chapter 13 Bankruptcy Help Eliminate My Tax Debts?
If your tax debts are overwhelming, you need an effective solution to eliminating your debt through a flexible repayment plan or by getting a court to discharge the debt. Filing for bankruptcy is a great way to eliminate debt, especially if you are enrolled in an IRS Installment plan, as it costs less to repay your tax debt through Chapter 13 bankruptcy.
Due to the different types of tax debts handled differently, tax debts are complicated in bankruptcy. Therefore, it is best to consult a bankruptcy attorney to understand if Chapter 13 bankruptcy will help take care of your debt. Your lawyer understands the bankruptcy rules that apply to tax debts and can determine if you can receive a discharge.
Note: Failing to include tax debt in your Chapter 13 plan will hold you liable to repay the debt as it will survive the bankruptcy filing.
What Are the Other Options Available to Eliminate Tax Debt?
What next if you are not eligible for tax debt discharge or if your tax debts are non-dischargeable? Besides filing for bankruptcy, there are other debt-relief options available that can help with your tax debt.
Having helped thousands of debtors find the right debt relief option for them, we are confident we can help you too. Whether you need help reviewing various debt relief options or need help finding a bankruptcy attorney year you, we are here to help. Reach out to us online or on call and let us help you.
