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Tax Withholding Pitfalls to Avoid When Preparing Chapter 13 Petitions

May 29, 2016 by Shannon Doyle

Often as a person experiences financial difficulty, the first thing they do is have their payroll department adjust their income tax withholding to take out less taxes. People do this thinking it will be a short-term solution to their problem. However, typically this leads to tax debt.

When drafting petitions, this is something that is very important to watch out for, as not accounting for this income tax liability on the Means Test could be detrimental for the debtor in causing them to be in a Chapter 13, when they might otherwise qualify for a Chapter 7. Or you may end up proposing an overestimated Chapter 13 Plan payment tax debtand creating new tax issues during the course of debtor’s plan.

When drafting the petition, avoid blindly entering the information from the debtor’s pay stubs into Schedule I and the Means Test. Rather, analyze the data you are entering to look for this type of issue.  If a debtor has tax debt from the prior year, most likely he needs to adjust his withholdings to avoid future tax debt.  If the debtor’s financial situation mirrors that of the previous tax year (same income and tax deductions), you can take the tax liability that is owed from the prior year and divide that amount by 12. This will give you a monthly average of the amount debtor is under withholding. Or as you look over the six months of pay stubs provided by the debtor, look for a higher amount of income tax being withheld several months ago, and less income taxes being withheld later, which may indicate that not enough taxes are currently being withheld. Or you just may sense it is too low. A good way to check this, is to go to the ADP calculator  and enter the debtor’s pay check and withholding allowance into the salary pay check calculator to get an idea how much debtor may be under withholding. Make sure to check with the debtor as to what their correct withholding allowance should be. The more allowances a person claims the less taxes are taken out of their check.

For example, debtor’s gross pay is $1553 every two weeks which calculates to $3364.83 per month ($1553 x 26 pay periods, divided by 12). Debtor is only withholding $200 per pay period or $433.33 per month.  According to the ADP calculator, debtor should be withholding $841.20 per month.

Once you ascertain an accurate withholding for the debtor, enter the data in the petition as follows:

  1. Enter the information from the most recent pay stub into Schedule I, just as it is reported on the pay stub.
  2. Figure out the difference between what is being withheld for income taxes, and what should be withheld for income taxes.

In our example, debtor is withholding $433.33 but should be withholding $841.20 so the difference is $407.87.

  1. Account for this additional tax liability on Schedule I and the Means Test so that the court can see this additional tax liability.

In Schedule I, the additional income tax amount not being deducted by payroll, can be entered in the Other Wage Deduction Details. On the Means Test, add the additional income tax withholding to the current amount being withheld and enter is as the actual tax withholding.

CAVEAT: Please note, unless you are a CPA or tax attorney, I am not suggesting that you ever give debtor tax advice or tell them what their withholding allowance should be.  The above analysis is simply meant to help the bankruptcy professional identify potential tax issues and how to enter that data into the petition. If you are a paralegal, bankruptcy assistant, or virtual bankruptcy assistant, you want to flag the petition with a memo to the attorney as follows:

“The client’s income tax withholding is only $433.33 per month.  Debtor believes his withholding allowance should be 1 but changed it last year to 3 when he was trying to pay off debt. I entered his pay stub information into Schedule I, but also calculated an additional income tax liability of $407.87 per the ADP pay check calculator, and entered this amount in the Other Wage Deduction Details of Schedule I, and added it to the actual withholding in the Means Test”

If you are an attorney, you want to refer your debtor to a CPA to get an accurate withholding amount so as to propose the most accurate chapter 7 petition or chapter 13 plan as possible and avoid future tax liability for your debtor.

eBankruptcy Assistants, Inc. does not engage in the unauthorized practice of law. We never give your clients legal advice. All case analyses’ are done in a consulting capacity for the attorney of record. We do not represent individual debtors. We work solely for bankruptcy attorneys.