Tax and Bankruptcy
Bankruptcy is that legal process which can solve all your major problems relating to debts including tax debts and can take the burden off your shoulders. It can bring your life back on track in addition to giving you an opportunity to start afresh and rebuild yourself.
Bankruptcy begins with filing a petition in Bankruptcy Court. Personal Bankruptcy can be filed under 2 Chapters and that are Chapter 7 (Straight) Bankruptcy or Chapter 13 (Re-organizational Plans) Bankruptcy. When you are going through tough times, one of these might just be the answer to your problems.
Requirements needed for either of the Chapters is different, so the Chapter you qualify for depends upon your financial condition and nature of debts at the time of filing Bankruptcy.
Chapter 7 Bankruptcy and Taxes
Chapter 7 Bankruptcy deals with liquidation of assets and is filed by those having no regular income or if they have, there income is less than the ‘median’ income or have debts which are in most parts unsecured. In this, Court appoints a trustee to sell the non-exempt property and discharge your ‘dischargeable’ liabilities, in dischargeable debts, he will first satisfy the secured debts and than the unsecured ones. Tax debts come under dischargeable category only if they satisfy the following.
Requirements for discharging tax debt.
- The 3-Year Rule: The tax return on which the tax debt arises must have been due at least 3 years before you file for bankruptcy.
- The 2-Year Rule: The tax return was filed at least 2 years before the bankruptcy (having the IRS file for a substitute doesn’t count).
- The 240-Day Rule: The taxes were assessed by the IRS at least 240 days before filing AND FOR STATE TAXES IN CALIFORNIA THE PERIOD IS EXTENDED TO 300 DAYS.
- Lack of Fraud or Willful Evasion: There was not a fraudulent tax return or willful attempt to evade paying taxes.
- Income Taxes Only: Taxes other than income such as payroll taxes and other penalties are by law excluded from bankruptcy discharge.
CALIFORNIA REQUIRES FILING OF AN AMENDED RETURN AFTER AN IRS AUDIT ASSESSMENT. THE 3-YEAR QUALIFICATION FOR BANKRUPTCY IS MEASURED FROM THE DATE WHEN THIS AMENDED RETURN WAS DUE AND THE 2-YEAR RULE WHEN IT WAS FILED.
There are some non-dischargeable debts which are not satisfied by the sales proceed like alimony, child support and taxes which do not meet the pre-requisites mentioned above and trust fund taxes. Also if a tax lien was recorded before bankruptcy was filed, it remains even after bankruptcy has been discharged but only to the extent of taxpayer’s equity when the lien is on exempt property.
Chapter 13 Bankruptcy and Taxes
Chapter 13 Bankruptcy is filed only by those who have regular and above state median income which could be wages or pension payment or social security. In this, debts are repaid through installments approved by Court over a period of 3 to 5 years. The biggest advantage of filing under this Chapter is that you can retain all of your property. Another major benefit of Chapter 13 Bankruptcy for the debtors is that it allows you to lower the amount you owe on most secured debts (called a “cram down”). But, for taxes to be crammed down, it must meet all the following conditions.
Requirements for discharging tax debt
Taxes should be Income taxes and the returns were due more than 3 years before filing and taxes were assessed by the IRS at least 240 days before filing and IRS must not have recorded a tax lien.
However, if the taxes are income taxes but either the returns were due for less than 3 years or taxes were assessed within 240 days than such taxes become priority taxes and trust fund taxes have to be paid in full, though Chapter 13 stops any penalties and interests over it, after Bankruptcy has been filed. But, if you drop out of Chapter 13 penalties and interests on tax debt are revived retrospectively.
If you have filed Bankruptcy, IRS becomes like any other creditor and has to follow Court’s decision.
Unfiled taxes may be given a fraction of a dollar as actual filing of returns more than 2 years ago is not a requirement here.
Additional options in Bankruptcy
Bankruptcy is by far the best way to deal with tax debts as you may even file Bankruptcy under another Chapter after you have completed first one to discharge any of debts including tax debts that may be left.
Advantages of Bankruptcy
No matter which Chapter you file in, the immediate effect of it is ‘automatic stay’ which is legal prohibition imposed on all your creditors including the IRS to stop all credit recovering techniques against you. Only in rare cases of proven fraud is this stay lifted, otherwise you stay protected against creditors for as long as bankruptcy proceedings are underway.
You can file bankruptcy even if tax liens have been filed against you. It is more advantageous to file for bankruptcy when you have tax lien along with many other debts pending against you because a tax lien is shown in credit report for 15 years whereas in case of a chapter 7 bankruptcy, the tax liens that were included in the filing will be erased from the credit report much earlier than the record for the bankruptcy itself. For Chapter 13 bankruptcy, the tax liens will be removed the same time as the bankruptcy which is 7 years from the date of filing.
It is better to act quickly because if tax liens are filed, IRS gets a claim against your property including the property that you acquire after lien has been filed.
For more information about solving your tax debt through bankruptcy, contact our bankruptcy lawyers today.