Bankruptcy by Example: The Advantages of Filing a Chapter 7 Bankruptcy to Prevent a Recorded Tax Lien

The more complicated Chapter 13 option is often better for tax debts, but here’s how a simple Chapter 7 case can solve a big tax problem.

Dischargeable Taxes under Chapter 7

In a Chapter 7 case if you have an income tax debt that is old enough and otherwise meets the conditions of discharge, and no tax lien has been recorded on it, that tax is simply discharged—legally written off so that the IRS or Oregon Department of Revenue (ODR) can never collect on it. The IRS and ODR are forbidden under federal law from ever trying to pursue you for that tax debt in exactly the same way that any creditor can never collect on a debt that’s been discharged in bankruptcy.

There are essentially two conditions to meet for successfully discharging an income tax debt. First, the tax return for that tax must have been legally due to be filed with the IRS/ODR—including any extensions—more than 3 years before the date that the Chapter 7 case was filed at the Bankruptcy Court (regardless when that tax return was in fact filed). Second, that tax return must have been actually filed with the IRS/ODR more than 2 years before the date that the Chapter 7 case was filed. (There are a couple of other possible conditions, but they don’t apply to most people.)

So if these conditions are met, the tax is discharged under Chapter 7, and usually quite quickly, only about 3 or 4 months after your case is filed.

The Effect of a Tax Lien

However, if the IRS or ODR recorded a tax lien at any time before your bankruptcy is filed—even just a very short time before—that recording would create a lien in the amount of the tax owed. That lien would be on everything the recording covers. In Oregon that means a lien on either all of your real estate within the county where the lien is recorded, or on all of your personal property (non-real estate). Or the tax lien can cover both types of property if the IRS and/or ODR records liens on both.

The prior recording of a tax lien can make all the difference. It can change a debt that gets completely discharged into one that you have to pay, in part or in full.

That’s because, like most other liens, tax liens are not wiped out by bankruptcy.

Take the more familiar example of a vehicle loan, where the lender holds a lien on the vehicle’s title. You can discharge the debt on the loan in a Chapter 7 case, but that does not take the lender off the title. So if you want to keep the vehicle you have to pay the debt.

Tax liens are similar. The lien on your property created by a recorded tax lien is not gotten rid of by a bankruptcy case. So if you have a debt that meets the conditions for being completely discharged in a Chapter 7 case, but the IRS/ODR have recorded a tax lien on that tax, that tax lien on your real estate, on your personal property, or on both would continue to exist after the completion of your bankruptcy case.

At that point you or your attorney would need to negotiate with the IRS and/or ODR about how much you would have to pay to get them to release their lien(s). The amount that you would pay would depend on the value of whatever you own that the lien is attached to (without deducting a homestead exemption or any other property exemptions of bankruptcy because they don’t apply to tax liens).

The “Automatic Stay” Preventing Tax Liens

As long as the IRS or ODR has not recorded a tax lien before your Chapter 7 case is filed, it cannot do so during your case. That’s because, like all other creditors, they are prevented from taking any steps to collect on a pre-existing debt, such as recording a lien, through the “automatic stay.”

So if you owe a tax that can be discharged in bankruptcy, then at the completion of your Chapter 7 case you would have no debt against which the IRS/ODR can record a tax lien once the case is over. The tax debt and the tax lien would both be gone.

Two Contrary Examples—1st, No Recorded Tax Liens

Lauren owes $7,600 to the IRS and $2,900 to the ODR for 2010 income taxes—a total of $10,500. She’d filed her 2010 tax returns on time, without extensions. Neither the IRS nor ODR have recorded a tax lien.

She also owes $50,000 in a combination of medical debts and credit cards.

She owns very little other than a vehicle that she depends on to get to work and to take her 10-year old son to school. It is worth $10,000, and was given to her through the death of her grandmother a year before.

Lauren meets with an experienced Oregon bankruptcy attorney who advises her that her 2010 income tax debts can be discharged in bankruptcy, as can as the rest of her debts. She also learns that, because of a change in Oregon law last year, and because she doesn’t own or have equity in a home, she can protect the full value of her vehicle if she would file bankruptcy.

So with the help of her attorney she files a Chapter 7 case, the $10,500 in income taxes owed to the IRS and ODR, and the $50,000 of other debts, are all discharged within a few months. Her vehicle is fully protected. She is debt-free.

2nd, Recorded Tax Liens

Dan has the exact same situation as Lauren except that he didn’t meet with a bankruptcy attorney until after both the IRS and ODR had recorded tax liens against all of his personal property, which includes his $10,000 vehicle.

His attorney tells him the bad news that the taxes that Dan could have discharged in full without those recorded tax liens now hasve to be paid in full if he wants to keep the vehicle.

Instead of filing a Chapter 7 case and owing nothing, Dan has two choices.

He can discharge his $50,000 of other debts under Chapter 7 and then arrange to make payments to the IRS and ODR to eventually pay off the $10,500 he owes. More interest and penalties would be added the whole time until the tax debts are paid in full. In the meantime the tax lien would continue sitting on his vehicle (and on all his other personal property), and on his credit record, potentially for years.

Second, Dan could file a 3-to-5-year Chapter 13 “adjustment of debts” case, with a similar result but with more flexibility in payment terms on the tax debts and more protection from the IRS/ODR during the payment process.

Either way he’d have to pay the $10,500.

Conclusion

The difference between Lauren and Dan—between filing a Chapter 7 case before tax liens are recorded and after they are—is the difference between not having to pay any of the tax and having to pay it all.

Different facts could result in less stark of a difference. But the lesson is clear: if you owe income taxes of any significant amount, see a competent bankruptcy attorney to find out your options, and to avoid ending up being in Dan’s situation.