Chapter 13: tax considerations.

• Author: Hibschweiler, Arlene

The challenging economic environment that has gripped the country since 2008 has forced tax advisers to confront the prospect of client bankruptcies. In many cases, clients who face dire financial circumstances use a liquidation, under Chapter 7 of the Bankruptcy Code, (1) to pay off creditors to the extent possible and obtain something of a fresh start. Since the bankruptcy law was amended in 2005, however, many individuals have been channeled to Chapter 13, under which a debtor typically pays off a greater amount of debt through a court-approved repayment plan.

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For the 12-month period ended Dec. 31, 2012, Chapter 13 petitions accounted for approximately 30% of all bankruptcy filings. (2) Although the percentage of Chapter 13 petitions is much lower for business bankruptcies, the significant number of individual taxpayer Chapter 13 petitions means that tax advisers should understand this type of bankruptcy proceeding, particularly the impact of a Chapter 13 filing on a debtor's tax obligations.

This article focuses on Chapter 13, after briefly describing the key differences between Chapter 7 and Chapter 13 bankruptcy proceedings. It also explains the "means test" under which an individual debtor may be eligible for debt relief in bankruptcy via a Chapter 13 proceeding and not a liquidation. After discussing the Chapter 13 bankruptcy process, the article focuses on the treatment of tax obligations in Chapter 13 cases, with particular attention paid to the dischargeability of income taxes. The article concludes with suggestions for the tax adviser representing an individual client who is considering filing a bankruptcy petition.

Chapter 13: Eligibility and Purpose

Only individuals, and not business entities such as corporations, limited liability companies, and partnerships, are eligible for relief under Chapter 13 of the Bankruptcy Code. (3) However, an individual who owns a business as a sole proprietorship can file a Chapter 13 petition and include the debts incurred in the sole proprietorship business. (4) To be eligible for Chapter 13, an individual must have regular income. (5) For this reason, a Chapter 13 plan is often referred to as a "wage earner's plan." (6) The purpose of Chapter 13 is to repay all or a part of the individual debtor's debts in installments over a three- or five-year period from the debtor's regular income received while the plan is in effect.

The eligibility rules for Chapter 13 relief also require that the individual debtor's noncontingent, liquidated debts not exceed certain dollar limitations, (7) which are currently $383,175 for unsecured debts and $1,149,525 for secured debts. (8) These debt limitations are adjusted every three years based on the Consumer Price Index and were most recently reset effective for bankruptcy petitions filed on or after April 1, 2013. (9)

An individual who had a prior bankruptcy petition dismissed during the preceding 180 days is not eligible to file a Chapter 13 petition if the dismissal was due to the debtor's willful failure to appear before the bankruptcy court or comply with bankruptcy court orders. This rule also applies if the prior bankruptcy petition was voluntarily dismissed after a creditor sought bankruptcy court permission to seize property (10) in which the creditor has a lien. (11) Additionally, unless an exception applies, all individual debtors must undergo credit counseling from an approved credit counseling provider within 180 days prior to filing a bankruptcy petition. (12)

Chapter 13 vs. Chapter 7 Generally

In an individual's Chapter 7 bankruptcy proceeding, the debtor's nonexempt assets are sold, and the proceeds are distributed to pay all or part of the debtor's creditors. (13) The focus in a Chapter 7 bankruptcy is on liquidating the debtor's nonexempt assets to pay creditors, whereas the focus in a Chapter 13 case is on the amount of the debtor's future, regular income available to pay creditors. As noted above, only an individual debtor can file a Chapter 13 petition, including an individual operating a business as a sole proprietorship. By contrast, an individual or a business entity debtor, such as a corporation or partnership, can file a Chapter 7 petition. (14) Another major difference between Chapter 7 and Chapter 13 is that while a debtor's creditors can file an involuntary Chapter 7 petition against the debtor, there is no involuntary Chapter 13 petition. (15) As a result, it is solely the debtor's choice whether to seek Chapter 13 relief.

While the decision of whether to file under Chapter 13 is the debtor's, a debtor does not always have a choice between filing a Chapter 7 or a Chapter 13 petition. An individual debtor's eligibility for filing a Chapter 7 petition is subject to passing a two-part "means test" or otherwise proving that the Chapter 7 petition is not abusive. The means test was added to the Bankruptcy Code by the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) (16) in 2005. The means test requires calculation of a debtor's annualized "current monthly income," (17) which is compared with the applicable state median income (18) amount.

If a debtor's annualized current monthly income exceeds the state median, the debtor generally must pass a second test to be eligible for. Chapter 7 relief. (19) In lieu of having the Chapter 7 petition dismissed, an individual debtor who fails the means test, and cannot otherwise prove that the Chapter 7 filing is not abusive, has the option of converting his or her bankruptcy case to a Chapter 11 or Chapter 13 proceeding. This conversion can occur only if the debtor consents. (20) An individual debtor who satisfies the means test can choose between Chapter 7 and Chapter 13.

Chapter 13 Plan Requirements

The debtor initiates a Chapter 13 bankruptcy by filing a petition with the bankruptcy court. (21) A trustee is appointed to administer the case. (22) Filing the petition triggers the "automatic stay," which, subject to some exceptions and possible creditor remedies, stops collection action against the debtor and the debtor's property. (23) The Chapter 13 petition may include the debtor's repayment plan. If it does not, unless the bankruptcy court grants an extension, the debtor has 14 days after filing the petition in which to file a repayment plan.

A Chapter 13 repayment plan is subject to bankruptcy court approval, following a hearing. (25) The plan must provide for payments of fixed amounts, generally over a three-year period. The bankruptcy court can extend the period to up to five years "for cause." In addition, if the debtor's current monthly income (described above under the "means test") equals or exceeds the applicable state median income, the payment period can be up to five years without a showing of cause.(26)

Section 1322(a) of the Bankruptcy Code requires a Chapter 13 plan to provide for submitting all or part of the debtor's future earnings or other future income to the Chapter 13 trustee as is necessary to fund the plan. In addition, Section 1322(a) requires the plan to provide for full payment of all priority claims, unless the holder of a priority claim agrees to different treatment. (27) Priority claims are defined by statute and include, among other items, unsecured claims for domestic support obligations, administrative expenses, certain taxes, and certain wages and consumer deposits. (28) A Chapter 13 plan also must provide the same treatment for each claim within a class (if the plan classifies claims).

Example 1: Debtor Q owes $15,000 to creditor A. $20,000 to creditor B, and $5,000 to creditor C, and the claims of creditors A, B, and C are all in the same class and are the only claims in that class. If the plan provides for an aggregate payment of $20,000 (or one-half of the total amount of the claims) to this class of creditors, the plan must provide that A receives $7,500, B receives $10,000, and C receives $2,500, so that each creditor in the class receives an amount equal to one-half of its claim. The Bankruptcy Code permits the Chapter 13 plan to modify the rights of holders of secured claims (29) or to leave those rights unchanged. A claim is secured if the creditor has the right to collect the debt against specific property of the debtor, such as through a mortgage, pledge, security interest, or other lien. Generally, in a Chapter 13 case a secured claim can be provided for in any of three ways: (1) by having the creditor take the collateral or receive the proceeds from its sale; (2) by having the debtor retain the collateral, cure any defaults, and make all current payments on the underlying debt as they become due; or (3) by having the debtor retain the collateral and paying the secured claim under the Chapter 13 plan. (30) Under the third option, the amount of the secured claim that must be paid under the Chapter 13 plan may be limited to the. value of the collateral (i.e., if the value of the collateral is less than the amount of the claim). (31)

A Chapter 13 plan is not required to provide for the payment of nonpriority, unsecured claims provided that the debtor pays to the Chapter 13 trustee all of his or her projected disposable income (32) over the three-or five-year life of the plan. (33) In addition, the value of property to be distributed under the Chapter 13 plan for an unsecured claim cannot be less than the amount that would have been paid on the claim if the debtor's assets were liquidated in a Chapter 7 bankruptcy proceeding. (34)

Timing of Discharge in a Chapter 13 Bankruptcy

In a Chapter 13 case, the debtor is discharged or released from any unpaid, dischargeable debts after completing all of the plan payments. (35) The discharge is subject to a number of conditions, including certification that the debtor paid certain domestic support obligations. (36) In addition, a debtor is not relieved of debts if a discharge was received within four years in a prior Chapter 7...