Le Knapp: Dismissal After Passing Chapter 7 Means Test

Back when the bankruptcy laws were changed in 2005, a hard calculation was implemented, based on household income and household size, to determine whether or not a bankruptcy filer was making a “decent” living, and should be disqualified from discharging debts completely in Chapter 7 without repayment. This hard calculation has been dubbed The Means Test–i.e., Does the filer have the means available to repay at least a portion of their debts in a Chapter 13 payment plan? If the answer to this fundamental question is “yes”, then filers risk dismissal of their Chapter 7 case for “abuse.”

Passing the Means Test and Still Having Problems

What is perplexing to some prospective Chapter 7 filers is this: You can still “pass” The Means Test, but still run afoul of qualifying for a Chapter 7 bankruptcy case. The converse is also true: You can “fail” The Means Test, but still qualify for a Chapter 7 bankruptcy case. The Means Test is simply a burden-shifting mechanism. If you “pass” The Means Test, then there is a presumption that you qualify for Chapter 7 and anyone that disputes that fact has the burden of proof to demonstrate that you do not qualify. If you “fail” The Means Test, then there is a presumption that you do not qualify for Chapter 7, and now the burden of proof is on you to demonstrate that you do qualify for Chapter 7. In short, The Means Test is not as straight forward as most would like it to be.

Two Time Periods for Analyzing Chapter 7 Income

Income, for the purposes of Chapter 7, is analyzed within TWO different time periods. First, The Means Test measures the total “regular” income received in the six months prior to the Chapter 7 bankruptcy filing and averages that income (less social security types of income). Second, the “present day” income that exists on any given day during the administration of the Chapter 7 bankruptcy case is also taken into account.

Example: You’re Employed Leading Up to Bankruptcy

Example 1: If you have been employed leading up to filing bankruptcy, were making a good wages, were suddenly terminated, and then filed for Chapter 7 right away, there is most likely a “presumption” that you do not qualify for Chapter 7 based on your historical income–i.e., you will “fail” The Means Test. The reality is, though, you do qualify, because, as of the filing of the case, you are unemployed, and you do not have the means available to repay creditors in a Chapter 13 payment plan. So, the “present day” income dictates that you should be able to rebut the presumption that you do not qualify for Chapter 7. In this situation, you simply need to demonstrate to the US Trustee that you are not employed, have no pending prospects of future employment, and you do not have the ability to repay creditors in Chapter 13.

Example: You’ve Been Unemployed for 6 Months

Example 2: You have been unemployed for 6 months, only earning unemployment compensation. You file for bankruptcy and “pass” The Means Test easily. Two weeks after filing, you get a job making $150K a year. On the last day of your Chapter 7 case, the US Trustee files a motion to dismiss your case for abuse. This is a real-life fact pattern. Yes, The Means Test was “passed”, but the “present day” income dictated that my Client had the means available to repay at least a portion of the debt in a Chapter 13 payment plan.

What Happens to Tax Debt in Bankruptcy?

Will Bankruptcy Help With Tax Debts?

In some cases, bankruptcy can eliminate back taxes owed to the IRS as well as to state governments, however the devil is in the details. It is certainly not easy to eliminate tax debts in bankruptcy court. If your taxes don’t qualify for discharge and you file for bankruptcy, the IRS will be waiting for you on the other side with additional time to collect your taxes. Under normal circumstances, the IRS has ten years to collect tax bills, penalties and interest from you. Filing bankruptcy temporarily freezes IRS collection efforts, but the IRS then tacks on the 4-5 months bankruptcy period plus 180 days to their collection window. In essence, a bankruptcy filing that doesn’t discharge tax debts will give the IRS close to an extra year to chase you for back taxes.

So when can back taxes be wiped clean by a bankruptcy filing? There are three basic timing rules that apply:

Rule #1: The Three Year Rule

Your tax debts must be three years old from the date they were due. Note that this does not mean from the date you filed. Every year, tax returns are due for most Americans on April 15th. This means that your 2004 taxes are not eligible for discharge until April 15th of 2008. This is the case because your 04′ taxes weren’t technically due until April of 05′ and you calculate the three year period from that point forward.

Rule #2: Your Tax Returns Must Have Been Filed for Two Years Before Bankruptcy

This is where the IRS really puts the debtor between a rock and a hard place. The government knows all too well that many who have fallen behind on their tax bill have also failed to file tax returns. Requiring that the actual returns be filed for two years prior to the bankruptcy prevents seriously delinquent taxpayers from filing late returns one day and bankruptcy the next.

Rule #3: the Tax Must Have Been Assessed More Than 240 Days Ago

This will likely be the easiest requirement to satisfy and essentially requires that the IRS or state taxing authority has formally determined that you owe the taxes you’re trying to get rid of in bankruptcy more than 240 days before you file paperwork with the court. Note that an offer in compromise will delay the 240 day rule while it is pending plus an additional 30 days.

What About Tax Liens?

A tax lien is a public filing that the IRS uses to put the world on notice that you owe them money. Filing for chapter 7 bankruptcy will only eliminate your personal obligation for tax debts, not tax liens that have attached to your property. Any lien recorded prior to your bankruptcy case will survive the filing.

Free Consultation with a Utah Bankruptcy Attorney

If you have a bankruptcy question, or need to file a bankruptcy case, call Ascent Law now at (801) 676-5506. Attorneys in our office have filed over a thousand cases. We can help you now. Come in or call in for your free initial consultation.