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As we enter into another tax preparation season we are beginning to get quite a few calls from potential bankruptcy clients who also have tax problems.Income taxes present special problems and issues when it comes to bankruptcy.This article brief summary of this complicated rules that govern taxes for those who file bankruptcy.
As we enter into another tax preparation season we are beginning to get quite a few calls from potential bankruptcy clients who also have tax problems. Income taxes present special problems and issues when it comes to bankruptcy. This article brief summary of this complicated rules that govern taxes for those who file bankruptcy.The Bankruptcy Discharge
In bankruptcy, a "discharge" is the elimination of a debt. The goal of either a chapter 7 or a chapter 13 bankruptcy is obtaining a discharge of your unsecured debts. However, not all unsecured debts are dischargeable. Examples of non-dischargeable debts are student loans, child support and most taxes. However, while most taxes are not dischargeable, in some cases, income taxes are.
Bankruptcy Discharge of Income Taxes
In some instances Bankruptcy can be an effective way of dealing with past due federal and state income tax debt. Under the Bankruptcy Code, whether a tax obligation is dischargeable is determined by when the tax became due. If a bankruptcy debtor owes state or federal income taxes the taxes are dischargeable if the debtor filed their tax return and:
- 3 Year Rule: The tax return was due more than 3 years prior to the bankruptcy filing. (If the debtor obtained an extension, the due date would be the extension deadline); and
- 2 Year Rule: The debtor's income tax return was actually filed more than 2 years prior to the date the debtor files his bankruptcy; and
- 240 Day Rule: The income taxes were assessed by the IRS or Massachusetts DOR more than 240 days prior to the bankruptcy filing; and The debtor did not file a fraudulent return or willfully attempt to evade paying taxes.
If a Bankruptcy debtor meets all of the above criteria, then their income tax debt is dischargeable. However it is important to remember that these rules only apply to individual income taxes. Moreover, in a Chapter 7 Bankruptcy if the underlying tax obligation is dischargeable, the interest and penalties thereon are also dischargeable. However, if the underlying obligation is non- dischargeable, so are all related interest and penalties.
Tax Lien in a Chapter 7 Bankruptcy
If the IRS of Massachusetts DOR has already recorded a lien on your property, then their debt is secured, and in the case of a Chapter 7 bankruptcy, the tax cannot be discharged; even if a debtor meets all of the conditions listed above. However, that lien can only be assessed against the property that the lien is recorded. For example, if you owe the IRS $10,000.00 in taxes and you meet all of the qualification above, and the IRS records the lien against property that is only worth $5,000.00, after your bankruptcy, the IRS cannot record a lien against any other property that you own. Moreover, once the IRS sells the property that their lien is recorded against, the remaining balance that you owe is discharged.
Chapter 13 Bankruptcy
In a Chapter 13 bankruptcy, a bankruptcy debtor makes payments to a bankruptcy trustee for a period of 3 to 5 years. The trustee in turn pays the debtors creditors according to a repayment schedule, or "Chapter 13 Plan". Certain debts are paid in full such as mortgage arrears and certain "priority debts" and general unsecured debts (such as credit cards, personal loans and medical bills) are paid with whatever is left over for a fraction of their value.
In a Chapter 13 Bankruptcy, income taxes are treated as priority debts; meaning that they must be paid before any other debts, and like all priority debts, they must be paid in full through the chapter 13 plan. However in order for an income tax to be considered priority the tax must meet only the 3 year rule and the 240 day rule. If the bankruptcy debtor has any tax debts that fall outside these two rules; that debt is considered a general unsecured debt and the tax debt will be treated the same as the debtor's other unsecured debts and thus be discharged. However, if the bankruptcy debtor does not satisfy these two rules, then the tax debt is considered a priority debt and it must be repaid in full through the Chapter 13 Plan. If the debtor cannot repay 100% of their priority debt through the Chapter 13 bankruptcy, they will have to convert their debt to a Chapter 7 bankruptcy.
Another important consideration for chapter 13 debtors is the accrual of penalties and interest. The filing of a chapter 13 bankruptcy stops the IRS and the Massachusetts DOR from assessing additional penalties and stops the accrual of interest.
Tax Lines in a Chapter 13 Bankruptcy
Another consideration in a chapter 13 is a tax lien. If the IRS of Massachusetts DOR has recorded a tax lien against a debtor's property for unpaid income taxes, that debt becomes secured debt and cannot be discharged; even if the tax would have qualified for discharge under the 2 year and 240 day rules. However, if the amount of the lien exceeds the value of the property which the lien is attached, a debtor may seek relief from the Bankruptcy Judge and have the portion of the lien that exceeds the value of the property striped; something known as a "cram down". The portion of the lien that is stripped then becomes unsecured.
Conclusion
The Bankruptcy rules are complex when it comes to dealing with income taxes and tax issues should not be handled by a pro-se bankruptcy filer or even an inexperienced bankruptcy attorney. If a debtor has income tax issues they should consult with an experienced bankruptcy attorney who is familiar with the bankruptcy rules regarding taxes and the many exceptions.