(US Law) On occasion, I will see a potential client who is not a good candidate for a bankruptcy filing. For example, the potential client might fail the “means test” imposed by § 707 of the federal bankruptcy code. Or, a bankruptcy filing will not solve the potential client’s major problem. For example, the majority of the potential client’s debt might be due to a student loan or a tax that is not dischargeable. Or, the majority of the potential client’s debt might be secured debt – that is, debt for which a house or an automobile is collateral. What are some options for the potential client who is not a good candidate for a bankruptcy filing?
Tax Debts
Under § 523(a)(1) of the bankruptcy code, only a limited type of tax liabilities are dischargeable in a bankruptcy filing. Essentially, to be dischargeable, as to income taxes, an original tax return must have been filed. A substitute for return filed by the IRS will not qualify for a chapter 7 discharge. In addition, the bankruptcy must be filed more than three years after the tax return for the underlying tax was due to be filed. When a petition is filed late, the tax will not be dischargeable unless the bankruptcy is filed more than two years from the date when the returns are filed. Finally, the bankruptcy must be filed 240 days after the assessment of a tax in order for the tax to be dischargeable. “Trust fund” taxes are never dischargeable in a Chapter 7 bankruptcy.
If bankruptcy is not an option, then the client could consider an installment agreement with the IRS; an Offer in Compromise, or try to convince the IRS that the tax debt should be put in “currently not collectible” status.
Installment Agreements. These are authorized by § 6159 of the Internal Revenue Code. The IRS can enter into a written installment agreement that enables the client to pay his or her tax liability over a period of time. An Installment Agreement will be allowed where a taxpayer has no assets with which to satisfy a tax liability, but does have a steady flow of disposable income. In determining the monthly payment, the IRS looks to the taxpayer’s monthly gross income, minus expenses and other exempt amounts, including alimony and child support.
In order to enter into an Installment Agreement, the client would need to prepare a Form 433-D Installment Agreement. In addition, the client probably would need to complete a Form 433-A, which is entitled “Collection Information Statement for Wage Earners and Self-Employed Individuals”, 433-B, entitled “Collection Information Statement for Businesses,” or 433-F, entitled “Collection Information Statement” (Short Form).
The advantage to an Installment Agreement is that the IRS will not continue to take action (garnishment of wages, for example) while the Installment Agreement is in place and being adhered to. However, there are some drawbacks. During the Installment Agreement, penalties and interest continue to accrue. Payments made under an Installment Agreement will be credited to the most recent penalty or interest before being credited to the underlying debt. Statutes of limitation are suspended. And, while the IRS may not levy on any of a taxpayer’s assets while an Installment Agreement is in effect, the IRS may still file a Notice of Federal Tax Lien to protect the government’s interest.
Offer In Compromise. Offers in Compromise are authorized by § 7122 of the Internal Revenue Code. An Offer in Compromise is a written agreement between the IRS and a taxpayer that allows the taxpayer to pay a lesser amount in full satisfaction of the taxpayer’s tax liability. Offers in Compromise are submitted on Form 656. The IRS will consider an Offer in Compromise when it is clear that the taxpayer will be unable to fully satisfy his or her tax liability now or in the future. The IRS looks at the taxpayer’s current assets, current income, future income, and allowable expenses. For example, if it appeared that a potential client would never be able to pay the tax liability, but if a relative who did not owe the IRS were able to put up money to pay the IRS, (and therefore the payment under the Offer in Compromise was money that the IRS couldn’t otherwise get), then the IRS would consider an Offer in Compromise. For example, I once had a client who was disabled; who was ineligible for Worker’s Compensation, and whose father (who did not owe the IRS) offered to pay a fraction of the son’s IRS bill if the IRS would accept the Offer in Compromise.
Currently Not Collectible. Sometimes, a taxpayer’s liability will be determined to be “currently not collectible.” For example, if collection would create an “undue hardship” for the taxpayer by leaving him unable to meet necessary living expenses. The IRS calls this a “Code 53.” For example, I had a client who was 63 years old, had significant medical conditions, and it was clear that the client could never make even a dint in the tax liability. However, beware that when a taxpayer files the next tax return, if the income shown is greater than the coded amount, the account will be re-issued for collections.
Student Loans
Under § 523(a)(8)(B) of the federal bankruptcy code, student loans can be discharged in bankruptcy only if the debtor can show that the debt would impose an “undue hardship” on the debtor. While the phrase “undue hardship” is not defined in the bankruptcy code, most courts have adopted the “Brunner Test,” based on a case entitled Brunner v. New York State Higher Education Services Corp., 831 F.2d 395 (2nd Cir. 1987). Under the “Brunner Test,” a Debtor seeking to discharge a student loan would have to prove (1) that the Debtor cannot maintain, based on current income and expenses, a “minimal” standard of living for himself and his dependents, if forced to repay the loan; (2) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of the student loans; and (3) that the Debtor made a good faith effort to repay the loan.
A potential client with primarily student loans could seek a deferment under certain circumstances, including unemployment. Alternatively, the client could see whether he or she would benefit from the Income Based Repayment Plan. Eligibility for the Income Based Repayment Plan is determined by the lender. Last, a client could try to consolidate student loans to lower monthly payments by combining several loans into one packaged loan and extending the repayment period.
If a student loan has already defaulted, then the government has broad collection powers, including: seizing the client’s tax refund; garnishing a portion of the client’s wages; taking a portion of certain federal retirement benefits, such as Social Security; or suing the client in court. There is no statute of limitations on suing to collect on federal student loans. A client could try to “rehabilitate” the defaulted student loan, which would consist of entering into an agreement and making at least nine qualifying, on-time student loan payments.
Mortgage Options
Modification. If the client’s debts are primarily mortgage debts and the client does not qualify for bankruptcy, then the client should determine whether he is eligible for a mortgage modification, either through the Home Affordable Refinance Program (HARP), through the Homeowner Affordable Modification Program (HAMP), or through a private modification.
HARP. This stands for Home Affordable Refinance Program. The client may be eligible for HARP if (1) the mortgage is owned or guaranteed by Freddie Mac or Fannie Mae; the mortgage was sold to Fannie Mae or Freddie Mac on or before May 31, 2009; the mortgage was not refinanced under HARP previously unless it is a Fannie Mae loan that was refinanced under HARP from March – May 2009; the loan-to-value (LTV) ration must be greater than 80%; and the borrower must be current on the mortgage at the time of the refinance, with a good payment history in the past 12 months.
HAMP. This stands for Home Affordable Modification Program. The client should contact his lender to see whether he qualifies for a HAMP modification. As of June 1, 2012, the government expanded the population of homeowners who may be eligible for HAMP, to include homeowners who are applying for a modification on a home that is not their primary residence, but the property is currently rented or the homeowner intends to rent it; (2) homeowners who previously did not qualify for HAMP because their debt-to-income ratio was 31% or lower; (3) homeowners who previously received a HAMP trial priod plan but defaulted in their trial payments; and (4) homeowners who previously received a HAMP permanent modification, but defaulted in their payments, therefore losing good standing.
For more information on HARP and HAMP, go to www.makinghomeaffordable.gov.
Short sale. A short sale is a sale of real estate in which the proceeds from sale are less than the balance of the mortgages or other liens against the property, but the lienholders agree to release their lien on the real estate and accept less than the amount owed on the debt. A short sale is sometimes used as an alternative to foreclosure because it lowers additional fees and costs to both the lender and the debtor. However, note that short sale agreements do not necessarily release borrowers from obligations to repay any deficiencies of the loans, unless specifically agreed to between the parties. In addition, each lienholder has to agree to the short sale.
Deed in Lieu of Foreclosure. In a Deed in Lieu of Foreclosure, the debtor simply deeds the property back to the lender. However, the problem with a Deed in Lieu is that the debtor can only transfer what he has – so that if there are junior liens on the property (for example, a second mortgage) then a Deed in Lieu will not take care of the second mortgage. Therefore, to clear title, a lender usually would prefer a foreclosure.
Consumer Credit Counseling Options
A potential client who is unable to file bankruptcy may benefit from credit counseling through a non-profit organization such a local Consumer Credit Counseling Service. Generally, the client meets with a consumer debt counselor, develops a budget, and then the service contacts the lender (usually a credit card company) to try to lower the debt, to make monthly payments more affordable, to lower the interest rate on the debt, or a combination of the three.
However, there are several warnings and drawbacks to this. First, the potential client needs to make sure that the service is a true non-profit organization (such as a United Way agency). There are a number of so-called “services” that do more harm than good. For example, in some programs, the lenders are not contacted or paid any money until all of the service’s “fees” are paid. The client is told to do nothing. I have had a number of clients come to my office after entering into an arrangement with a sketchy “service,” only to find that they have been sued by the credit card company.
In North Carolina, only a true “consumer credit counseling service” that provides individualized credit counseling and budgeting assistance to the client without charge prior to the client’s enrollment in a debt management plan provided by the organization, or an attorney may “adjust debts.” N.C.G.S. § 14-26.
Forgiveness of Indebtedness Income. This is another consideration in working through any type of debt. When a lender decides to forgive all or a portion of a debt and accept less than what is owed, the forgiven amount is considered as income for the borrower and is taxed. There are several exceptions to the general rule:
Qualified Principal Residence Indebtedness. This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners. It applies to workouts of mortgages on primary residences. The Mortgage Forgiveness Debt Relief Act applies to debt forgiven in 2007 – 2012. Up to $2 million of forgiven debt is eligible for this exclusion. However, it only applies to principal residence indebtedness.
Bankruptcy – Debts discharged through bankruptcy are not considered taxable income.
Insolvency – If the taxpayer is insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable income. Insolvency is defined as when total debts are more than the fair market value of total assets.
Certain Farm Debts – If the taxpayer incurred the debt directly in operation of a farm, and more than half of the taxpayer’s income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, the cancelled debt is generally not considered taxable income.
Non-recourse loans – a non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. In a non-recourse loan, the lender cannot sue the Debtor personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.
Disclaimer: No legal advice is hereby given by reading this blog entry. In order to comply with certain IRS regulations concerning tax advice, we inform you that , unless expressly stated otherwise, any tax advice contained in this blog posting is not intended or written to be used and cannot be used, for the purposes of (i) avoiding penalties under the Internal Revenue Code; or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Pursuant to the federal bankruptcy code, this is a notice that we are a debt relief agency. We help people file for bankruptcy under the federal bankruptcy law.
G. Martin Hunter is Charlotte, NC bankruptcy attorney with an expertise in debtor-creditor matters. He has an AV rating from the Martindale-Hubbell® Law Directory, the highest level of recognition possible. He offers bankruptcy advice in Charlotte and throughout Western North Carolina. He serves a wide range of clients, including individuals and businesses. G. Martin Hunter is certified as a Specialist in Business and Consumer Bankruptcy Law.
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