23rd Aug 2013

The interplay between the Internal Revenue Code and the Bankruptcy Code is one of the more complex areas of bankruptcy law and requires that you seek assistance from a Corona Bankruptcy Attorney that understands the rules and can apply them to your particular situation. For simplicity, this article covers only individuals filing bankruptcy, not corporations or other business entities.

What is Covered by the Bankruptcy Stay?

For individuals who file bankruptcy, collection stops on:

  • All 1040 income taxes of the individual debtor, including interest and penalties
  • All liability the individual may have as a “control” person for unpaid employment taxes for a business
  • Stops wage garnishments, bank account levies, and the filing or enforcement of tax liens

An individual bankruptcy does not stop:

  • The IRS from going after corporate or business assets for taxes owed by a business
  • The IRS from taking your refund for a pre-bankruptcy year and applying it to taxes owed for a pre-bankruptcy year

What happens to my taxes in bankruptcy?

Taxes owed at the time of filing bankruptcy are classified in two major ways. First, they are classified as either “dischargeable” or “non-dischargeable” and secondly they are classified as “secured”, “priority unsecured” or “general unsecured” debts. Dischargeable taxes are discharged at the end of your bankruptcy. Non-dischargeable taxes are not discharged. Secured status applies when the IRS has filed a proper tax lien in the county where you reside and/or have property. It attaches to the real estate in the county where the lien is filed, and to most personal property. “Priority” unsecured taxes are entitled to get paid before many other unsecured debts in a bankruptcy case and, in Chapter 13 bankruptcy cases, generally have to be paid in full through the chapter 13 plan. General unsecured tax claims only are paid after all priority claims have been paid and are generally paid along with other general unsecured claims, like credit card debts.

How can I tell if my income taxes are dischargeable in bankruptcy?

The short answer is, this is where you need to consult an experienced Corona Bankruptcy Attorney. Volumes of books have been written trying to sort out the answer to this question.

There are a few general rules, but there are exceptions to the rules that can apply in any particular case. In general, income taxes are dischargeable in bankruptcy if they meet all of these rules:

  • The due date for the return, with any extensions, must have been at least 3 years before filing the bankruptcy
  • The tax return must have been filed at least 2 years before filing the bankruptcy (note under the new McCoy decision in the Fifth Circuit Court of Appeals this rule may be modified to require the tax return to be filed ON TIME, or a special return by agreement with the IRS can be filed. Talk to your bankruptcy attorney about your unfiled tax returns.)
  • The taxes have to have been assessed by the IRS for at least 240 days prior to the bankruptcy filing
  • The tax return is not fraudulent
  • The taxpayer is not guilty of the criminal act of ‘tax evasion’
  • The time periods above can be extended in certain circumstances, such as filing for an offer in compromise or having filed a previous bankruptcy, even if you did not get a discharge in the previous case.

Your bankruptcy attorney will want to obtain a “tax transcript” from the Internal Revenue Service for each year for which you think you may owe taxes. The transcript will reveal the various relevant dates, and the existence of any events that might have extended the timelines.

Secured, Priority, and general Unsecured

The IRS automatically has a tax lien by statute on unpaid taxes. But, to protect their interests and have a secured claim in bankruptcy, the IRS has to file a lien with the county recorder, in the same place where deed records are filed. The lien must be filed in the county where the Debtor resides, in order to have a lien on personal property (such as accounts, furniture, vehicles, etc) and must also be filed in each county where the Debtor owns real estate to attach to the real estate in any particular county.

The IRS lien, when properly filed, attaches to virtually all property, including homestead real estate, retirement accounts, and personal property of all kinds.

When a lien is properly filed, the Bankruptcy Code allows the taxes that are covered by the lien to be considered “secured” up to the value of the property covered by the lien. For example, the Debtor’s property may be worth $10,000, but the lien is for $25,000 in taxes. In that case, the tax debt is secured only to the extent of the $10,000 value of the property and unsecured for the remaining $15,000.

For a tax debt to be “priority”, it must be unsecured and:

For a tax assessed within the 240 days prior to filing the bankruptcy case; or
for a tax year where the return was due within the three years prior to the date of the bankruptcy filing.

Note that the two year rule does not come in to play for determining priority status. Therefore, it is possible for a tax debt to be both non-dischargeable and non-priority.

In general interest accruing on the taxes pre-bankruptcy follows the treatment of the underlying tax. So, if the tax is priority, the accrued unpaid interest will also be priority. However, all penalties are generally treated as non-priority, even if the taxes themselves are priority.

My income taxes in Chapter 13

In Chapter 13 bankruptcy, your plan must pay any secured tax claim and any unsecured priority tax claim, unless the IRS agrees otherwise. The Chapter 13 Plan does not necessarily have to pay anything towared non-priority unsecured taxes, unless your plan is paying unsecured creditors in general.

Taxes that are dischargeable are discharged upon completion of the Chapter 13, including any interest and penalties associated with them. Taxes that are not dischargeable and also not priority are not discharged and wll remain payable after the completion of the Chapter 13 case.

Any income tax refunds you receive after filing the bankruptcy may have to be devoted to your bankruptcy plan. Each bankruptcy district seems to have their own local practice and procedure which sometimes will allow a debtor to keep a portion of their income tax refund, or use the refund for necessary expenses not already accounted for in their budget. This is something you must talk to your attorney about.

Further, any refund for a tax year that is prior to the year you filed your bankruptcy can be taken by the IRS and applied to any taxes owed.

My income taxes in Chapter 7

In general, dischargeable income taxes are discharged while non-dischargeable income taxes are not discharged.

If you have non-exempt assets that your chapter 7 trustee is going to distribute to creditors, then any priority tax claims are likely to be paid at least a portion of what is owed, depending on what money is in the estate and the nature and amount of the other debts that you owe.

Any refund you get for a tax year prior to the year you filed bankruptcy will go to the IRS to pay against prior year’s taxes. For tax refunds for later years, the IRS will seize them only to apply to any non-discharged taxes.

Got tax problems? Get an experienced bankruptcy attorney!

Income taxes and bankruptcy are a tricky area of the law. Lots of nitpicky rules can interfere with a discharge. Talk to experienced Corona Bankruptcy Attorneys about your tax issues and see if bankruptcy can help resolve them. Call us now.

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