“Tax Bankruptcy” puts together two words that people do not normally associate. People are surprised to learn that taxes can often be effectively dealt with in bankruptcy and sometimes even wiped out. Putting taxes into a bankruptcy can be very complicated. Not only are there dozens of types of taxes, but then each type of tax comes with a list of criteria, pages long, for any given option in or out of bankruptcy. If navigated properly, the labyrinth of bankruptcy/tax laws may offer relief depending on the specific facts of the case.
Tax Classifications in Bankruptcy
For the purposes of this information, all references to a “tax” refers to income taxes. Most other types of taxes, like corporate taxes, sales taxes, etc. have similar classifications, but they do differ in several respects, including how and when they take on a certain classification. A taxpayer should contact a knowledgeable tax or bankruptcy attorney for an evaluation.
The different classifications for taxes in bankruptcy can be a little confusing because in some instances, a certain tax debt can be two classes at once. For instance, for bankruptcy purposes, a tax debt can be both general, unsecured and priority.
A tax debt can also be considered either secured or unsecured; and, mind-bogglingly, secured and unsecured–at the same time. Is this confusing? Of course it is. Tax problems would be really easy if things were simple.
This category of tax debt applies to taxes for which a Federal Tax lien has been properly filed. Further, the taxpayer must own property with equity available to the IRS. A tax lien, when filed, “attaches” to property owned by the taxpayer in a similar way that a mortgage “attaches” to a piece of real estate.
For example, if a taxpayer owes $10k on a tax debt for which a lien is filed, and the taxpayer has $50k in equity in their home, the taxes are “fully secured” by the home equity. To flip the number, if a taxpayer owes $50k and only has $10k in available assets, the taxes are secured to the extent of the $10k and unsecured for $40k. This is a scenario where a tax debt takes on two classifications at once.
Priority taxes are those that meet any of the following criteria:
- The return was due in the last three years,
- The tax was assessed within the past 240 days, or
- The tax is not yet assessed but is still assessable.
The last one here refers to the Audit Statute Expiration Date being open.
For instance, if a taxpayer files a Chapter 13 bankruptcy, thinks they owe no taxes for the most recent tax year, then the IRS audits the most recent return and assesses a tax, these taxes could be considered priority taxes.
Unsecured (Non-Priority) Taxes
Taxes are considered unsecured when no tax lien has been properly filed. Like the example above, a single tax debt can have both a secured and unsecured portion, if a lien is filed, and depending on how much property the taxpayer owns. To go a little deeper, Unsecured taxes can be split into two categories–dischargeable and non-dischargeable.
This classification includes tax liability on the following: tax returns which have not been filed; taxes that were filed late; or for tax returns that were filed fraudulently or in a willful attempt to evade taxes.
Dischargeable Tax Debts
This is the type of tax debt we like because it means that the taxes are unsecured and are dischargeable in bankruptcy. They have to meet the following five tests:
- A tax return was filed on time (including extensions).
- The return was filed greater than two years ago.
- The return was due greater than three years ago.
- The tax owed was assessed greater than 240 days ago.
- The taxpayer did not commit fraud or willful evasion.
If a tax debt meets every one of these tests, then it is may be dischargeable in bankruptcy. Each tax year is typically tested separately, as the timing for these tests obviously change for each tax year.
Letting the Taxes Age
Wait to Become Dischargeable
“Letting the taxes age” refers to attempting to wait the period of time necessary for the taxes to become dischargeable. Notice from above that a Priority tax most commonly is a “newer” tax from a tax return that was filed somewhat recently. For instance, if a taxpayer files a tax return on time by April 15th of any given tax year, the tax debt is considered “Priority” until it meets the tests above and then changes class to become an unsecured, dischargeable debt.
A taxpayer cannot simply lay idle and expect the IRS to ignore the tax debt owed for three years, however. A taxpayer must contact a tax attorney and have the tax attorney advise on the best wait to wait it out, if that is a possibility. A common way to wait it out is to enter into an Installment Agreement.
Wait for the Collection Statute Expiration Date to Expire
The Collection Statute Expiration Date is 10 years from when the tax is assessed. If a taxpayer is close to this expiration date, sometimes it is prudent to just wait until the Statute runs. This would mean that the tax debt would no longer be collectible by the IRS.
An Installment Agreement is one way to accomplish this, although a taxpayer must be careful as to what type of Installment Agreement they request. A Partial Pay Installment Agreement may actually extend the statutory collection period, which essentially defeats the purpose.
Various time periods can be suspended or “tolled” if certain events occur. The primary time periods of concern are the dischargeability date (which actually contains three separate time periods), the Collection Statute Expiration Date, and the Audit Statute Expiration Date. Tolling events are in the top-10 of most complicated parts of a bankruptcy discharge analysis. A few examples of tolling events include:
- Prior Bankruptcy
- Request for Due Process Hearing
- Extension to File Tax Return
- Audit, amended return, or additional assessment
- Substitute for Return
- Agreed tolling, signed OIC, or stipulation, etc.
Treatment of Different Tax Classes in Bankruptcy
Taxes secured by property are not dischargeable in a Chapter 7 bankruptcy. This means that the lien survives the discharge. Typically, a taxpayer can make an Offer-in-Compromise or submit a request for an Installment Agreement after the bankruptcy in order to deal with this debt.
Taxes that are considered Priority are not dischargeable in a Chapter 7. They, like secured taxes, survive the discharge and must be addressed after the bankruptcy case closes. These taxes can be addressed by way of an Installment Agreement or Offer-in-Compromise.
As mentioned above, this class of taxes contains two categories, dischargeable and non-dischargeable (subject to 5 “tests” above.) The dischargeable category are fully dischargeable. This means that the bankruptcy wipes them out! Non-dischargeable, unsecured, non-priority taxes are actually somewhat rare in that the circumstances that would make a tax debt have such a classification are quite narrow.
Taxes deemed secured must be paid in a Chapter 13 proceeding to the extent of the security. Interest is paid at the IRS rate. Using a Chapter 13 to pay secured taxes can be advisable in many scenarios. If a taxpayer is unable to afford the payment required to pay the tax in full during the pendency of the case, then there may be other options, depending on the taxpayer’s unique circumstances.
Taxes that are Priority must be paid in full in a Chapter 13, regardless of amount. Depending on the circumstances, the Priority debt may just be too large to pay back during the pendency of a Chapter 13. Therefore, other options may need to be considered. If the amount is affordable, a Chapter 13 can be a great way to pay Priority taxes.
Taxes that are consider unsecured, non-priority will receive the same treatment as any other unsecured, non-priority debt (e.g. credit card, medical bill.) If they are in the dischargeable category, they will be eligible for discharge at the end of the case. If the Chapter 13 case pays some unsecured debt back, then the taxes will receive a pro-rata share.
Bankruptcy may be a good solution to many types of tax debts and with proper planning, can offer great relief. Time is usually needed to implement a strategy to minimize tax liability, but knowing that there is a way out gives a taxpayer a deep sense of relief and confidence.
Your Next Step to Debt Relief
If you are struggling with debt, consult with an attorney who can give you guidance on options available to you. Each case is different and consultation with an attorney knowledgeable about the law as it applies to your particular circumstances is an important first step in resolving debt.
Read More About Taxes
- Collection of Delinquent Property Taxes on Your Home
- Discharging Income Taxes in Bankruptcy
- Effect of Tax Lien on Payment of Taxes in Chapter 13 Bankruptcy
- Loss of Home for Delinquent Property Taxes
- Non-bankruptcy Options for Tax Debt
- Property Tax Relief for Disabled & Elderly
- Special Relief for Veterans on Property Taxes
- Understanding Property Taxes (Ad Valorem Taxes)
Read More About Bankruptcy and Debt Relief
Chapter 7 – Usually the cheapest and fastest type of bankruptcy, Chapter 7 can wipe out credit cards, medical bills, and loans.
Chapter 13 – Does everything that Chapter 7 does, but with the added benefit of being able to help catch up on past due mortgages, car payments, and taxes.
Taxes – If you owe money to the IRS, there may be several different options for you, including some non-bankruptcy options.
Student Loans – There are many solutions to student loan issues, including getting a better payment plan, curing a default, and even loan forgiveness.
Debt Lawsuit Defense – When a creditor sues you over a debt, you can respond with a defense, which may allow you to win the lawsuit.
Loan Modifications – A special agreement between you and your mortgage lender might help you with a past due mortgage loan.
Debt Library – More in-depth articles on some of the more detailed areas of bankruptcy and debt relief.