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Your Income Tax Debt Paid through an “Asset Chapter 7 Case”

Have your Chapter 7 trustee pay your income taxes out of the proceeds of sale of assets that you don’t need.

Here’s an unusual way of paying your income tax debt. The circumstances don’t line up very often, but when they do this procedure can work very nicely.

Turning Lemons into Lemonade

Generally, when filing a Chapter 7 “straight bankruptcy” a key goal is to keep everything that you own. You don’t want to surrender anything to the Chapter 7 trustee. Indeed your bankruptcy lawyer will usually be able to protect everything you own through property “exemptions.”

But sometimes you own something or a number of things that aren’t exempt. If so, one of your options may be to file a Chapter 13 case to protect your non-exempt asset(s). Almost always that option takes 3 to 5 years, which may be longer than you want.

If you don’t mind letting go of the non-exempt asset(s), a much quicker option is an “asset Chapter 7 case.” The bankruptcy trustee sells the non-exempt assets and uses the sale proceeds to pay your creditors.

That usually doesn’t benefit you directly. The debts the trustee pays tend to be ones that are being written off (“discharged”) in your Chapter 7 case. So after bankruptcy you’d have no legal obligation to pay them. Paying them something out of your non-exempt assets does not help you financially.

But what if your bankruptcy trustee uses the proceeds of your non-exempt asset(s) to pay income taxes, eliminating or at least reducing what you would otherwise have to pay after your Chapter 7 case is over?

Circumstances in which the Trustee would Pay Your Income Taxes

This works under the combination of two circumstances:

  1. You have an asset not protected by property “exemptions.” You either don’t need it or giving it up is worthwhile considering the other alternatives.

  2. The proceeds from the trustee’s sale of your non-exempt asset would go to pay taxes, taxes which you would otherwise have to pay yourself.

1) Non-Exempt Assets You Don’t Need or Are Worth Giving Up

Most people filing bankruptcy do NOT own any non-exempt—unprotected—assets. But sometimes they do. And in some situations those assets are genuinely not needed or wanted, so giving them to the trustee is easy.

For example, if you recently closed down a business you may still own some of the business assets but have no use for them. Or you may own a boat or an off-road vehicle but because of health reasons no longer want to use them.

Or maybe you own a non-exempt asset which you’d prefer to keep. But you come to realize that surrendering it to the trustee is better for you than any other option. That other option is often filing Chapter 13 to protect the asset. Your bankruptcy lawyer will help you weigh all the advantages and disadvantages of these options.

2) Your Bankruptcy Trustee Pays Your Non-Discharged Income Taxes

Giving the trustee your unnecessary asset(s) makes infinitely more sense if most of the proceeds of sale of the asset(s) proceeds would go to pay your non-dischargeable income taxes. When would that happen?

The Chapter 7 trustee is required by law to pay out the proceeds of sale of the non-exempt assets to the creditors in a very specific order. So whether your taxes get paid depends on what other special debts you have and what you owe on them.

As long as you don’t owe any debts which have a higher “priority” than your income taxes, then the trustee would pay the taxes first. The taxes would be paid in full or as much money as is available. The trustee would pay the taxes before other creditors lower on the list would receive anything.

There are the very few kinds of debts which the trustee pays AHEAD of income taxes. In consumer cases mostly it’s unpaid child and spousal support. (See Section 507(a)(1) of the Bankruptcy Code.)

So if you do not owe back support, then the trustee will pay your taxes (after paying the trustee’s own fees) to the extent funds are available

Conclusion

Again, it’s not common that these two circumstances come together to enable you to pay your income taxes this way. But when they do an “asset Chapter 7 case” can put your assets to very good use.