Often as a person’s or couple’s financial situation experiences difficulty, the first thing they do to have more money available, is have their payroll department adjust their income tax withholding by adjusting the exemptions they claim, by filling out a new W-4 form, so that the money that would have been going toward the income taxes they owe, is instead given to them in their paycheck.
People do this thinking it will be a short-term solution to their problem, while a permanent solution is found.
Usually however, what this does is make their situation worse, as a permanent solution is often further away than expected, and months later, they’re not only still having the same financial difficulty they were experiencing, but now they’re also in a position of having to figure out where to come up with additional monies to cover the income tax that is due, but was not withheld.
When drafting petitions, this is something that is VERY important for the Virtual Bankruptcy Assistant (VBA) to watch out for, as even though these income taxes have not been withheld and paid, they are still due to the government, and must be accounted for, both because this income tax liability must be paid (income taxes are a priority debt), AND 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 have a much larger Chapter 13 Plan payment than they should have.
When drafting the petition, we can’t just blindly enter the information on the debtor’s pay stubs into Schedule I and the Means Test, and call it good, but rather, we must analyze the data we’re entering to look for things like this. If the amount of income taxes compared to the gross pay appears too low, it is a good idea to figure out what percentage of income tax is being withheld.
To do this, divide the amount of income taxes being withheld by the gross pay. For example, if the debtor’s gross pay for a two week period is $1,553 and the amount of income tax being withheld is $75 and you think this appears to be too low, use a calculator to divide the $75 withheld for income taxes by the $1,553 of gross pay, which results in .048, or 4.8%.
Everyone’s income tax bracket is different, but in communications with attorneys regarding what trustees are looking for, I have been told that it’s safe to assume a 25% income tax liability. This means that in the example above, that the debtor is paying less than 1/5 of the income taxes he/she should be.
So how do you enter the income tax due into the petition, when the pay stubs show what is being withheld for income tax, but debtor owes more?
In petitions that I have drafted when this situation occurs, I have done the following:
1. As you look over the six months of pay stubs provided by the debtors, 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 being withheld
TIP: It’s also possible that the debtor’s income tax withholding being too low goes further back than the six months, so if the income tax being withheld doesn’t look like enough, use the formula: income tax withheld divided by gross pay, to reveal the percentage of income tax being withheld.
2. Enter the information from the most recent pay stub into Schedule I, just as it is reported on the pay stub
3. Figure out the difference between what is being withheld for income taxes, and an approximation of what should be withheld for income taxes
Using the example earlier in this article, if the debtor only has 4.8% of their gross pay being withheld, the difference between what is being withheld and an approximation of 25% would be 20.2%. 20.2% the $1,553 gross pay would be $313.70
4. 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, this additional income tax due that is not being payroll deducted, can be entered in the Other Wage Deduction Details
On the Means Test, you would need to add this additional income tax due to the amount already being withheld (in our example, $344.77 + $75 = $388.70), keeping in mind that the values entered into the Means Test are for a full month, so you need to adjust the withholding to be the value for a full month (in our example, if the debtor is paid every 2 weeks, that’s 26 pay days per year, so you would multiply the $388.70 by 26 pay days in the year, then divide that by 12 months in the year, to arrive at a full month value, which is $842.19)
As with all important items such as this, make a note of this on the attorney cover page for the attorney. For example, you might make an entry in the cover page that reads something like:
“The client’s income tax withholding is only 4.8%. I entered their pay stub information into Schedule I, but also calculated an additional income tax liability of 20.2%, and entered this amount in the Other Wage Deduction Details of Schedule I, and added it to the actual withholding, adjusted it to a full month value, and entered it into the Means Test”
Additional Tip: This additional tax due should be entered into Schedule E of the petition. The attorney may even have the client contact the IRS and obtain a repayment plan prior to filing
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