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How to Pay Some or All of Your Income Tax Debt Through Your Chapter 7 Trustee

March 14, 2014

Sometimes it’s OK to give your non-exempt assets to your Chapter 7 trustee, when the proceeds from those assets are going to pay your taxes.

If you owe relatively recent income taxes, and are in the relatively uncommon situation that you have some assets that are not protected by the available property exemptions, you can neatly turn these two bad events to your advantage.

When All Your Assets Are Not Fully Protected

It’s generally good that, when you file a Chapter 7 “straight bankruptcy,” everything you own is protected through property exemptions. That way you don’t need to surrender any of your possessions to your bankruptcy trustee.

Because of a change in Oregon law effective July 2013, more people can file bankruptcy without being concerned about having to surrender anything to the trustee. That’s because that law for the first time allowed people filing bankruptcy in this state to use not just the Oregon set of exemptions but also the federal one contained in the Bankruptcy Code. That effectively increased the amount of property that a person could protect, especially for those who don’t own a home or have equity in it.

But there are still situations in which neither the Oregon set of exemptions not the federal one protects everything. Often there are other ways to shelter such non-exempt assets, including by filing a 3-to-5-year Chapter 13 “adjustment of debts,” which also often happens to be a good mechanism for dealing with income taxes. But, depending on all details of your situation, it may be simpler, much quicker, and ultimately wiser to file an “asset” Chapter 7 straight bankruptcy—one in which the Chapter 7 trustee has some non-exempt assets to administer—and thereby have the trustee pay some or all of your income taxes for you.

When the Chapter 7 Trustee Would Pay Your Income Taxes

For this to happen requires the combination of the following two circumstances:

1) You own some non-exempt asset(s), preferably one(s) you either don’t need or is (are) worth surrendering, considering the disadvantages of any other options.

2) The anticipated proceeds from the trustee’s sale of your non-exempt asset(s) would mostly go towards your income taxes, specifically more recent taxes which would not be discharged (legally written off) in your Chapter 7 case.

Let’s get a better understanding of these two circumstances.

1) Non-Exempt Assets Worth Surrendering

Most people filing bankruptcy don’t have any non-exempt—unprotected—assets, but because both the Oregon and federal exemptions have rather arbitrary quirks and limits, there are situations in which the protections are inadequate.

In some of those situations, the unprotected assets may genuinely not be needed or wanted, so giving them to the trustee is easy. For example, if you owned a recently-closed business, and still have some of its assets, you may well have no further need of those business assets. Or you may own a boat or some kind of recreational vehicle, but now because of health or other reasons you can no longer use them. In these situations you may even welcome having the trustee take such assets out of your hands to avoid the hassle of selling them yourself—especially if doing so would end up doing you some good.

Those situations are pretty rare. More likely, you own a non-exempt asset which you’d rather keep, but you decide that surrendering it to the trustee is much better than your other options. Often your other main option is filing a much more complicated and lengthy Chapter 13 case. Consider the above example of the boat or recreational vehicle but now instead assume it’s something you’d be able to use and would prefer to keep. When looking at the two options, you may well decide that the benefits of keeping the boat or vehicle through a Chapter 13 case are not worth its significant extra time and expense.

2) Paying the Proceeds to Your Non-Discharged Income Taxes

Some, generally older, income taxes can simply be discharged in a Chapter 7 case, so that you would no longer owe them once your Chapter 7 is done—they are completely written off without paying anything on them. In most circumstances the bankruptcy trustee would pay nothing on those taxes. What you instead care about are those, generally newer, income taxes that can’t be discharged in your Chapter 7 case. You want the trustee to pay the proceeds of your surrendered assets towards THOSE income taxes.

When would that happen?

The Chapter 7 trustee is required by law to pay out the proceeds of sale of your non-exempt assets to your creditors in a very specific order. Certain special kinds of debts called “priority” debts are paid in full before anything goes to your “general” debts. Also, among the “priority” debts, those higher on the priority list are paid in full before those lower on the list receive anything.

So, if you don’t have any debts which are higher on the priority list than your income taxes, then the money that the trustee is distributing to your creditors will go to your taxes until paid in full, or as much money as is available.

If you DO have a debt or two that are higher on the priority list, then those would be paid in full first, before anything is paid on your taxes. The kinds of debts which come before income taxes on this priority list include:

  • Child and spousal support arrearage

  • Wages, salaries, commissions, and employee benefits earned by any employees (if applicable) during the 180 days before filing or before the end of the business, up to $11,725.

  • Contributions to employee benefit plans, with certain limitations

So, when all these conditions are met with the result that you can expect that the proceeds of your non-exempt assets would mostly go to taxes that you would have to pay anyway, talk to your attorney about the potential benefits of filing an “asset” Chapter 7 case instead of a Chapter 13 case.