What Happens to Income Taxes in Bankruptcy
Sept. 26, 2016
The two rather unpleasant-sounding topics—taxes and bankruptcy—can actually turn into a pretty good combination.
If you got an extension to file 2016 tax returns, it’s now only three weeks until the extended October 17 deadline. So it’s a good time to look at the many kinds of relief that bankruptcy can provide with tax debts.
Today we’ll list and briefly describe these many kinds of relief. And then in the next several blog posts we’ll explain each one. Any single one of these could help you tremendously. If you have large and/or complicated tax debts, a combination of these kinds of relief could permanently fix a seemingly hopeless situation.
Here are the major ways bankruptcy can help you with your income tax debts.
A Chapter 7 “straight bankruptcy” can discharge (permanently write off) certain income tax debts. They must meet a set of conditions, mostly related to how old the tax is.
If you owe an income tax debt that does not meet those conditions and can’t be discharged, Chapter 7 can still usually discharge all or most of your other debts. As a result you will then more likely have the means enter into a sensible installment payment plan with the IRS and/or other tax authority to pay off the taxes.
If you owe an income tax debt that cannot be discharged, and have an “asset” Chapter 7 case (in which you surrender some of your assets to the bankruptcy trustee) the trustee may well pay the tax debt out of the proceeds of the sale of those assets.
If you owe income tax debt that can’t be discharged, and especially if that debt is large, paying those taxes through Chapter 13 can be much cheaper, easier and safer than dealing directly with the IRS or state tax agency.
A Chapter 13 is often a cheaper way to pay income taxes that can’t be discharged because usually no more interest and penalties are added after the case is filed. Plus often you don’t have to pay part or all of the previously accrued penalties.
A Chapter 13 is often an easier way to pay nondischargeable taxes because the payments are often lower and much more flexible than what the taxing authorities would require.
A Chapter 13 is a much safer way to pay such taxes because you are continuously protected from the taxing authorities’ collection actions. Avoiding tax liens, wage and bank account levies and such is especially valuable when your circumstances change and you need to adjust the payment terms.
A tax refund is an asset that belongs to you as of the first day of the tax year, regardless that it is not yet in your possession. So the bankruptcy trustee has a right to whatever part of the anticipated refund is not “exempt”—not protected. There are usually ways to protect your refunds so talk with your bankruptcy lawyer about how to do so for you.
The “automatic stay” legally stops all your creditors from trying to collect their debts once you file bankruptcy. It applies to the IRS and all tax authorities mostly in the same way as it does to all your other creditors. There are some sensible exceptions—they can demand that you file your tax returns, tell you how much you owe, and do an audit to figure the amount you owe. But otherwise you’re protected from tax collections.
If you own a sole proprietorship business that you want to keep operating, and the business and/or you are significantly behind on your tax obligations, Chapter 13 can be a very good tool for staying in business while resolving your tax problems.
If you have closed or are about to close your business and owe a lot of taxes from it, whether you file a Chapter 7 or 13 depends on how much and exactly what kind of taxes you owe, in addition to other non-tax factors.
If you expect to owe a significant amount of income taxes for the current tax year, it can make sense to file a partial-year tax return at the time you file bankruptcy, especially if you are filing a Chapter 13 case, so that the taxes owed for the partial year up until then can be paid through your bankruptcy case.
When the circumstances otherwise allow, you can increase the taxes that bankruptcy will discharge and can reduce the taxes that you must pay by applying the following strategy during the months or even possibly a few years before filing bankruptcy:
wait out the period(s) of time while the tax is not dischargeable, so that enough time passes so that you will be able to discharge that tax;
stay current on current-year tax obligations since you can’t discharge recent taxes anyway;
file any past-due tax returns because they cannot be discharged until at least 2 years after filing, so that you may be able to discharge those taxes; and
avoid committing tax fraud and evasion, and owing withholding taxes, because those can never be discharged.