Bankruptcy is an often overlooked solution to your income tax problems. Filing at the right time can prevent being backing into a corner.
Bankruptcy As a Solution to Tax Debts
There are lots of reasons people often don’t think of bankruptcy as a sensible way to solve income tax problems.
There’s a misconception that tax debts can’t be legally written off (“discharged”) through bankruptcy, “because it’s the government.” But tax often can be discharged, usually by simply meeting a couple of conditions that are often not difficult to meet.
Even if somebody has heard that older taxes can be discharged, they may know that doesn’t apply to very recent tax debts. So if they owe such recent taxes they inaccurately assume that bankruptcy can’t help them, when in fact it can be the solution to all their financial problems, including the taxes.
The reality is that in countless circumstances—whether your tax problem is relatively small or huge, whether it involves one tax year or multiple years, whether your other debts are modest or monstrous—either Chapter 7 “straight bankruptcy” or Chapter 13 “adjustment of debts” may be the very best way for you to permanently get a handle on your tax debts.
Timing Can Be Crucial
So much about tax debts and bankruptcy is a matter of timing.
Once you recognize that bankruptcy may well be a viable solution for you, the next step is to see how important it is to figure out the best path going forward as soon as possible. That’s because you very likely need a game plan for threading the timing needle as it applies to your personal circumstances. Although sometimes it’s worth waiting to file bankruptcy in order to discharge a tax debt, detrimental events can occur in the meantime that an earlier filing would have prevented. This blog post discusses some of those detrimental events that delaying filing bankruptcy could allow to happen, and how filing earlier would help avoid those problems.
Delay Can Hurt: Tax Levies on Paychecks and Bank Accounts
The most obvious events that a bankruptcy filing would stop are the IRS and/or Oregon Department of Revenue (ODR) grabbing your wages or salary, or the money in your checking or savings accounts. For most purposes these tax creditors are treated just like any other creditors for purposes of the “automatic stay,” the federal law that prevents your creditors from pursuing you or your assets the moment your bankruptcy case is filed.
Besides preventing the embarrassment and financial shock of such a “levy” on your money, there is a good chance that the tax being collected in such a situation could be permanently discharged in bankruptcy. That’s because by the time the IRS/ODR get to the point of using such aggressive collection methods, the tax at issue could well qualify for being discharged. If so, you would be getting hit on a debt that you could avoid paying altogether.
Even if the tax being levied upon does not meet the conditions for discharge, paying a tax by levy is about the worst way to do so. It makes infinitely more sense to do so one of two other ways. First, you could discharge all or most of your other debts (perhaps including some older income taxes) in a Chapter 7 case, and then make agreed reasonable monthly payments directly to the IRS/ODR thereafter. Or second, you could pay the tax even more flexibly through a Chapter 13 case, with payments based on a realistic budget, often paid only after other more urgent debts, while under constant protection from any collection activity by the tax collectors.
Delay Can Hurt: Tax Liens
An income tax debt is usually unsecured, meaning that the IRS/ODR has no lien, no claim on any of your assets. So if a tax meets the conditions for being discharged in bankruptcy, it will be discharged without the taxing authority being able to make any claim on your home or other possessions.
But once the IRS records a tax lien or the ODR records a “distraint warrant” (the state’s version of a tax lien), the situation is greatly changed, often to your very serious detriment.
After the recording of a tax lien, the IRS/ODR’s lien on your house and/or other possessions is a right they have to the equity in your house and in the value of your other possessions, a right that is not affected by the bankruptcy discharge.
Very importantly, a tax lien is superior to the property “exemptions.” Property exemptions protect your assets from your general creditors and from the bankruptcy trustee acting on behalf of those creditors. But exemptions DO NOT protect your assets from tax liens. So, for example, a recorded tax lien attaches to equity in your home without any regard for the otherwise applicable homestead exemption. And if you have any retirement funds, a tax lien usually attaches to those funds, no matter how strongly such funds are protected from almost all other creditors.
So if a tax lien is recorded before you file a bankruptcy case, you will have to pay a tax in full or in part that would otherwise been fully discharged, to prevent the IRS/ODR foreclosing on its lien on your house or on your possessions to satisfy the lien.
The difference is between a tax debt that you do not have to pay at all vs. one that you have to pay in full or in part, just because your bankruptcy was not filed until after the recording of the tax lien or “distraint warrant.”
Delay Can Hurt: Wasted Voluntary Payments
As described in our recent blog post, “Write Off More Income Taxes through Savvy Planning,” there is a science to how you make payments on your taxes to maximize the benefit of your anticipated bankruptcy filing. Simply put, if you are making payments to the IRS/ODR to keep them off your back, you could well be throwing that money down the drain. You need to get together with a bankruptcy attorney highly competent in tax matters to chart a wise plan about all this. That plan would have an anticipated bankruptcy filing date, along with specific guidance on how to deal with your tax creditor(s) until then, including which taxes to pay and when.
The intersection of bankruptcy and income tax is a mine field that even experienced attorney need to tread carefully through. But it’s an arena with huge opportunities for solving your tax debt in a beneficial way. Delaying seeing an attorney and/or delaying filing at the best time will almost certainly hurt those opportunities, potentially costing you thousands or even tens of thousands of dollars.