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Write Off More Income Taxes Through Savvy Planning

April 1, 2014

Not only can taxes often be discharged (legally written off) in bankruptcy, by taking the right steps you may be able to discharge more.

Discharging More Taxes

Whether you can discharge an income tax debt depends on whether that debt meets certain conditions. By meeting those conditions before filing bankruptcy, you can discharge taxes that you would otherwise have had to pay.

Most of these conditions require taking some action and waiting a certain amount of time. You may feel that you are not in a position to wait, given pressures from the tax and/or other creditors. But an attorney may be able to buy you more time before you have to file bankruptcy, so that you can discharge more tax debts. And just as importantly, a competent and conscientious attorney can guide you to make good decisions about whether it is worth waiting and to take the right actions in the meantime.

1) Wait the Right Amount of Time Before Filing

Most income tax can be discharged after waiting long enough. Pre-bankruptcy tax strategy turns to a large extent on figuring out with your attorney precisely when each of your tax debts would become dischargeable, and then taking the right steps to hold off on filing bankruptcy until then. Often there are challenges to waiting that long, so you need good guidance in weighing the advantages and disadvantages of waiting vs. not waiting.

2) File Past-Due Tax Returns

Your gut sense may be telling you to avoid filing a tax return if you owe taxes that you have no way of paying. But you cannot discharge a tax until 2 years has passed after you filed the return. Since getting the tax return sent in starts this 2-year clock running, you generally want to send in the return as soon as possible. In the meantime get the advice you need to know how to deal with the IRS and the Oregon Department of Revenue (ODR) during those two years to protect yourself and your assets.

3) Stay in Tax Compliance While Waiting

While you wait, as much as you can don’t add to your tax liability by accruing new income taxes which cannot be discharged when you do file bankruptcy. During the waiting period, have the appropriate amounts withdrawn from your current paychecks. Or if you’re self-employed, as much as you possibly can pay the appropriate estimated quarterly taxes. Make sure your tax payments don’t go to the older taxes—the ones that you are planning to not paying by discharging in your anticipated bankruptcy case—by clearly instructing the IRS/ODR that your tax payments are for the current tax year, not the older one(s). Also stay current on present taxes because that’s usually a good way to keep the IRS/ODR from taking aggressive action against you. That can make it possible to wait longer to file and thus discharge more taxes.

4) Avoid Tax Fraud, Tax Evasion, and Trust Fund Taxes

No matter how long you wait before filing bankruptcy, you can’t discharge taxes associated with fraud, fraudulent tax returns, or tax evasion. So you have to avoid circumstances involving any of these. Otherwise you could put a lot of effort into waiting to file only to have it do no good. If you have reason whatsoever to believe you might be accused of any such behavior, be sure to tell your bankruptcy attorney in your first meeting.

“Trust fund” taxes can also never be discharged. These are taxes that an employer withholds from an employee’s paycheck and must then send to the IRS/ODR. Such tax money is considered to have never belonged to the employer but rather been held “in trust” for the taxing authority. Since they can’t be discharged, if you are responsible for any such “trust fund” taxes, try to pay them when due so you don’t owe any when you file your bankruptcy—or else understand that they would either have to be paid in full through a Chapter 13 case or by you directly after completing a Chapter 7 case.

5) Be Aware of Potential Tax Liens

The recording of an IRS tax lien or ODR “distraint warrant” before your bankruptcy filing creates complications in both Chapter 7 and 13. To overly simply, a tax debt that would otherwise be completely dischargeable may have to be paid in full or in part. So both try to avoid having the taxing authority record a tax lien against you, and take steps to minimize the adverse effect if one is recorded.

You may not have much control over when a tax authority decides to record a tax lien/distraint warrant. But they tend to be triggered by either the passage of a certain amount of time or the raising of certain red flags. Be sure to talk with your attorney or tax accountant about what you may be able to do to prevent raising such red flags.

Also do what you can do to avoid building up equity in possessions or real estate, so that a potential tax lien or distraint warrant would have less to attach to. Be aware that property exemptions, which protect your property from the reach of your general creditors and thus of the bankruptcy trustee, does not protect you from the power of a tax lien/distraint warrant. So any equity you build up while you are waiting to file just risks increasing what you would need to pay to the IRS/ODR on taxes that you might otherwise have been able to discharge altogether.

Get Good Advice and Be Careful

Please be aware that using pre-bankruptcy planning to position yourself in the best possible way to discharge some or all of you tax debts is one of the more sophisticated tasks that bankruptcy attorneys undertake for their clients. The strategies outlined in this blog post are nothing but broad ideas about what may be helpful. But it is truly dangerous to attempt these strategies by yourself without the personal guidance of a very experienced bankruptcy attorney. Consider what we present here as the beginning of the discussion you need to have with your attorney about your own unique situation.