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Taxes in Bankruptcy

Bankruptcy can be a powerful tool to resolve tax problems.  Some taxes and penalties are dischargeable. Tax obligations that are not discharged can be paid without ongoing interest or penalties in Chapter 13. The automatic stay stops collection actions by taxing authorities, including garnishment and seizure.  These provisions of the law apply equally to state and federal tax agencies.

Discharge of Taxes.

In general,  unsecured income taxes that were first due more than three years before the bankruptcy was filed, for which a timely and nonfraudulent return was filed, can be fully discharged in full in any chapter of bankruptcy. Taxes that do not fit in the above description are generally not discharged in Bankruptcy.

The following is a description of how taxes are treated:

  • Taxes first due within three years of the bankruptcy and taxes assessed within 240 days of the bankruptcy, or which are unassessed but assessable when the case is filed, are priority claims and are not dischargeable.  Because they are priority claims if the Chapter 7 trustee collects money for the estate, the taxes will generally be paid by the trustee before any payment on unsecured claims (except support).  In Chapter 13, these taxes must be paid in full through the plan without interest, however, the penalties do not need to be fully paid.
  • If a tax return was not filed on time, the taxes for that tax period are not discharged unless the return was filed at least two years before the date the bankruptcy petition is filed.
  • Trust fund taxes are never discharged. A trust fund tax is a tax that is collected by the debtor for the benefit of the taxing authority.  Thus, that portion of the employer's tax returns that was withheld from employees' wages to be sent to the IRS is a trust fund tax.  In some states, sales tax is also considered to be a trust fund tax (the purchaser owes the tax, the seller merely collects it) in others it is considered to be an excise tax (the tax is imposed upon the seller based upon the sale).  For example: California considers sales tax an excise tax, and Wyoming considers it a trust fund tax.  Liability for trust fund taxes is typically imposed upon the employer and a “responsible person” for a corporation, Limited Liability Company, or partnership.  Trust fund taxes or the penalty assessed against a responsible person can be paid through a Chapter 13 plan.

Tax Liens

The IRS frequently files tax liens to assist in the collection of a tax.  These liens attach to the real and personal property of the debtor.   The liens can survive bankruptcy and are not affected by the discharge of the tax itself.   But if the tax was discharged, the lien can not be applied to property that the debtor acquires after the bankruptcy was filed.  In addition, the bankruptcy court will value the lien, as of the date the bankruptcy was filed.  This is a good idea in most cases where the equity in the property that is affected by the tax lien will increase.   A debtor in this situation should discuss this issue with a competent bankruptcy attorney.  If the property will only decrease in value over time then usually it is not worth the time and expense to value the lien.

In Chapter 13,  tax liens are valued and paid off through the plan, usually with some interest.  The value of the lien is equal to the amount of money that would be received by the IRS if the debtors' property were sold.   For instance, if the debtor owned a home worth $300,000 with a mortgage of $275,000, a tax lien could only have a maximum value of $25,000.  To the extent that the lien does not have value, the lien is eliminated and the tax is treated according to its classification as though the lien had never existed.

Tax Liens on retirement plans need to be considered.   While most creditors can not touch retirement plans, the IRS can attach liens to IRAs, 401Ks, and other pension plans.  These liens are not affected by a Chapter 7 bankruptcy.  It may be critical to value the lien or to seek a formal release of the lien.  One may also want to consider Chapter 13 to resolve the lien.  If the tax lien is not released when you face retirement it is possible that the IRS could destroy a retirement budget.

Post Petition Taxes

If a debtor is operating under a plan, whether Chapter 11, 12, or 13.  The debtor must keep taxes and tax returns current.  The failure to keep this current is considered a default in the plan and can jeopardize the bankruptcy.

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