Clean up tax debt through bankruptcy? -Forbes | Vette Leader

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You may have heard that bankruptcy won’t help you if you’re up to your eyeballs in tax debts to the IRS. That’s true – most of the time.

The nuanced reality is that filing for bankruptcy can eliminate tax liabilities in some cases. So if you’re struggling with tax arrears that you can’t pay, here’s how to determine if bankruptcy is an option worth considering.

Bankruptcy and tax debt basics

Filing for protection from your creditors under the federal bankruptcy law will generally deter bill collectors from harassing you and relieve you of many of your debts. However, tax liabilities are treated differently than other types.

In bankruptcy jargon, taxes are typically treated as “unpayable senior debt.” This means that they will not be eliminated by bankruptcy and the repayment of the debt will take precedence over the claims of other creditors. Still, there are times when taxes can be considered “collectible debt” that can be eliminated with a bankruptcy filing.

Conditions for exemption from tax liability

The first requirement for a refundable tax liability is that it is actually an income tax liability. This would include unpaid state and federal income taxes, but not, for example, arrears of payroll taxes such as Social Security and Medicare withholdings.

A second condition is that the tax liability must not be too recent – generally less than three years old. More specifically, the original tax return must have been due at least three years prior to the date of filing for bankruptcy.

Next, you must have filed a valid tax return for the debt at least two years prior to filing for bankruptcy. And the return must be submitted on time. If you have requested and received renewals and submitted them by the renewal date, you are considered “on time.” If you filed after the renewal date, the return may not be considered valid and the tax liability may not be recoverable.

In addition to regulations about the age of the debt and the timing of repayment, the IRS must have appraised the debt at least 240 days prior to filing for bankruptcy—in other words, recorded it on the agency’s books. This requirement may also be met if the IRS has not yet rated the debt.

If the IRS assessed the debt and then stopped collecting due to a previous bankruptcy filing or other reason, the usual 240-day time frame could be extended, potentially making debt service more difficult.

Note that bankruptcy will not protect you if you have attempted tax evasion or filed a fraudulent tax return. The rules state that you must have submitted your tax return honestly. Also note that different jurisdictions may have different standards for eliminating tax liabilities through bankruptcy. We’ve gone through the main terms, but local regulations may have other requirements.

Finally, it is important that the tax authority, usually the IRS, has not filed a tax lien on your assets. Once a lien has been placed, filing for bankruptcy will not remove it. This is one of the most common obstacles to bankruptcy tax breaks, so it deserves special attention — and a definition.

At a glance: Prerequisites for exemption from tax liability

In order to be exempt from tax liability through bankruptcy, these requirements must be met:

  • It must be an income tax liability
  • It must be debt that is three years or older
  • You must have filed a valid tax return for the debt two years prior to filing for bankruptcy
  • The IRS must have recorded (or not yet assessed) the debt at least 240 days prior to filing for bankruptcy.
  • You must have submitted your returns honestly – no tax evasion or fraudulent returns
  • The IRS must not have filed a tax lien on your assets

Can you relieve a federal tax lien?

While a tax liability is money you owe to the tax authorities, a tax lien is a legal right to your property. The lien can be placed on all of your property, including bank accounts, personal effects and real estate.

Bankruptcy does not trigger a tax lien. That means the IRS or other taxing agency still has a claim on your property even if the bankruptcy settles your tax liability.

But once you’ve filed for bankruptcy, the IRS can no longer attempt to collect an eligible tax liability, even if a lien exists. This means your bank account cannot be tapped or your wages garnished to collect the tax liability. You can continue to live in a home with a tax lien. However, if you sell the home, the tax lien must be paid off with the proceeds.

Best bankruptcy types for tax debt

The tax liability can be settled by applying for protection with one of the possibilities of the federal bankruptcy code. These include Chapters 7 and 13 for most individuals, Chapter 12 for family farms and fisheries, and Chapter 11, which applies primarily to corporations and larger debts.

Chapter 13 is the most common type of individual bankruptcy filing when it comes to tax liabilities, the IRS says. Chapter 13, known as a reorganization bankruptcy, involves agreements with creditors to pay off debts over a period of three to five years. By comparison, a Chapter 7 bankruptcy wipes out many debts, meaning they never have to be repaid.

A successful Chapter 13 filing waives the debts paid under the plan of reorganization and any debts older than three years at the time of filing. During the payout period, the taxpayer must file timely declarations and pay any new income taxes due.

Depending on the circumstances, interest and penalties may be paid with a Chapter 13 filing. Interest on any tax due is also erased. They are punishable if they are older than three years.

In a Chapter 7 filing, the debtor sells most of the assets and passes the proceeds on to creditors. If there are insufficient or no assets to pay creditors, Chapter 7 still pays the qualifying debts and creditors receive nothing. Chapter 7 tax debts can be paid if they are at least three years old and the taxpayer has filed returns for the most recent four tax periods, the IRS says.

Strategies for tax debt bankruptcy

Patience and timing are essential to eliminating tax debt through bankruptcy. First, an important part of a successful filing is waiting until the tax liability has passed the three-year mark before going to bankruptcy court.

You also need to know what the IRS records show about the timing. Therefore, request copies of your tax account from the agency. The data in these documents will help you know if it’s too early to file for bankruptcy to settle your tax debt.

If a tax lien is making your efforts to eliminate the tax liability through bankruptcy more difficult, make sure the lien is valid. To be valid, the Pfandbriefe must, among other things, clearly identify the taxpayer, the tax year for which the debt is owed and the amount of the assessed debt. The tax authority must also have the lien deposited with the correct entity, which varies by state.

A defective lien may be void and will not stand in the way of bankruptcy.

If chapter 7 doesn’t seem like a viable strategy for eliminating tax debt, chapter 13 can still work. This approach requires you to make payments for three to five years, but offers opportunities to pay off some debt.

Tax Debt Alternatives to Bankruptcy

Bankruptcy isn’t the only way to deal with tax debt. The IRS may be willing to put in place a plan that would allow a taxpayer in default to pay off debts in installments. If tax debt is the primary debt you’re dealing with, an IRS payment plan could be as good an option as Chapter 13 — and save you the legal costs.

If you can’t pay your taxes with an installment plan, you may be able to use the IRS Offer in Compromise program instead. Here’s how it works: You offer to pay the IRS less than the full amount, and if you qualify, the IRS will waive the balance. But understand that once you’ve filed for bankruptcy, you can’t make a compromise offer.

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bottom line

While it’s true that most taxes can’t be eliminated through bankruptcy, some can. Income taxes that were due more than three years ago may be remitted through a Chapter 7 or Chapter 13 filing.

Filing for bankruptcy doesn’t remove liens that tax collectors have placed on your assets, but it does halt further efforts to collect the debt by garnishing your wages or tapping into your bank accounts.

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