Income-Based Repayment Plans and Bankruptcy
The Smith Law Group is a law firm that does one thing and one thing only: we find ways to assist debtors with student loans in bankruptcy. If you think that sounds like a rather niche corner of law, you would be correct. It is a very narrow practice area, focusing exclusively on interpreting and applying only 98 words of federal law.
We first became interested in this area of law when everyone told us that nothing could be done about student loans in bankruptcy. We heard this from everyone: banks, judges, lawyers, professors, newspapers, lawmakers, and TV pundits. And we were skeptical. There are few problems in law that cannot be addressed by spending every waking minute thinking about them, researching them, and developing creative solutions to address them.
We are working on all sorts of things at SLG. We have developed ways to discharge certain private education loans. We are working on ways to overturn existing precedent regarding when loans can be discharged for “undue hardship.” We are working on ways to help debtors avoid those unconscionable arbitration clauses that so frequently immunize lenders from liability for bad behavior.
Today we want to talk about one solution that we did not create. Instead, this solution has been championed by a number of federal judges across the country. And it has to do with the various income-based repayment plans offered by the Department of Education.
For those who are not familiar with these income-based repayment plans, we encourage you to look into them. They enable borrowers to repay their loans based on a percentage of their income, rather than based on the outstanding principal and interest rate. For example, if you owed $100,000 at 5% interest, the standard repayment plan would require you to pay $1,060 each month for ten years. Under an income-based plan, however, you would only pay 15-20% of your discretionary income no matter how big the balance was.
On the whole, we like these payment plans. They offer a reasonable solution for borrowers who simply cannot afford to repay their student loans on their current income. But there is a catch. Because borrowers are not repaying the loans at a rate sufficient to pay down the debt, the balance will most often continue to get bigger rather than smaller. But if you stay in the plan for the full 20-25 years, whatever is left of the balance is forgiven. Sounds great right?
It is great. But that forgiveness of debt has tax consequences. And taxes, unlike student loans, need to be paid off in one year. So borrowers who complete the plan may end up owing the IRS tens of thousands of dollars in the year they complete their student loan repayment.
A growing number of bankruptcy judges noticed this problem, and devised a very creative solution. Borrowers with high levels of federal student loans who are in bankruptcy can file an adversary proceeding alleging that repayment of the student debt would constitute an “undue hardship.” If the debtor cannot succeed in persuading the court to erase the whole debt, these judges have ordered that if the debtor stays in the income-based repayment plan for the full 20-25 years, whatever debt is left over is discharged in bankruptcy. And unlike forgiveness of debt outside bankruptcy, debt that is discharged in bankruptcy does not have tax consequences. So once the debtor completes the repayment plan, he or she is actually free from debt, and owes the IRS nothing.
We must note that this is not a universal policy, and it is up to the individual judge as to whether he or she will agree to order this form of relief. But it is one of many solutions to the problem student debtors face in bankruptcy. We at SLG will continue to push this solution for borrowers who find themselves with high levels of federal student loans, and insufficient income to repay those loans.