Bankruptcy allows individuals and businesses in financial distress to obtain relief from their debts. “Financial distress,” in this context, typically refers to situations in which one’s income is not enough to continue making required debt payments. The “relief” offered by bankruptcy may involve a discharge of debt after a period of making payments or liquidating assets. Not all debts, however, are eligible for discharge. Discharge of tax debt in bankruptcy is particularly tricky. It depends on the type of taxes owed, and the circumstances in which the debtor accrued the tax debt.
A bankruptcy case is often a difficult process for debtors. This is largely by design. Federal bankruptcy law requires debtors seeking relief to undergo an extensive process of accounting for all of their assets and debts. A court-appointed trustee oversees the debtor’s property, known as the “bankruptcy estate” while the case is pending. The trustee notifies the creditors and holds a meeting to allow them to present their claims. The debtor has to abide by payment schedules created by the trustee.
Three chapters of the Bankruptcy Code form the most common types of bankruptcy cases. Chapter 7 allows for discharge of debts after liquidation of assets. Chapter 11 involves a restructuring of debts and debt payments. Chapter 13 establishes a plan for payment of debts, followed by a discharge of remaining debts. Individuals and families usually file for bankruptcy under either Chapter 7 or 13. Businesses can file under Chapter 7 or 11, but they can only obtain a discharge of debts under Chapter 11.
Creditors may intervene in a case to challenge the eligibility of a debt for discharge. Section 523 of the Bankruptcy Code identifies debts that are not eligible. It is easier to identify taxes that are eligible for discharge than those that are not eligible. Income tax may be eligible for discharge if it meets criteria found in §§ 507(a)(8) and 523(a)(1)(B):
– The tax was due more than three years before the debtor filed for bankruptcy;
– The tax was originally assessed more than 240 days before the bankruptcy filing date; or
– The debtor filed a return for the tax debt at least two years before the bankruptcy filing date.
If the debtor committed any sort of fraud in relation to the tax debt, it will not be subject to discharge. These rules may apply to both federal income tax owed to the IRS and state income taxes.
Payroll taxes, including FICA and Medicare, are never eligible for discharge in bankruptcy. Property taxes are only eligible for discharge if they were incurred more than one year before the bankruptcy filing date. Customs duties are also only dischargeable if they were more than one year old when the debtor filed. Penalties for unpaid taxes are usually not subject to discharge if the underlying tax is not dischargeable.
Discharge of debts occurs at the end of a bankruptcy case. Chapter 7 allows individual debtors to obtain a discharge of any debts that are not addressed in § 523. It does not allow businesses to discharge tax debts. It also does not eliminate tax liens that were recorded prior to the bankruptcy filing. Chapter 11 allows discharge of eligible tax debts by both individuals and businesses. An individual in a Chapter 13 proceeding may obtain discharge of eligible tax debts.
How Can Bankruptcy Clear Tax Debt?
If you’re left wondering how bankruptcy can clear tax debt, you’re far from alone. The rules above are confusing for people who are not financial professionals, tax consultants or bankruptcy attorneys. Basically, clearing tax debt is extremely difficult and complicated, much like the process of doing your own tax return is for most people. However, there is a process that you should think about competing if tax debt is something from which you desperately need relief.
The first step towards figuring out how a bankruptcy can clear tax debt is to complete a full accounting of your tax situation. You may need to order past tax transcripts, produce old tax returns and organize any and all correspondence with the IRS and/or state taxing authorities. From there, you should have a professional consultant review your documents in order to help you understand how a bankruptcy could help clear some if not all of this tax debt. If all of the conditions above are met and you can prove that, it may be wise to proceed.
If not, then you may need to consider the possibility of filing for bankruptcy protection in order to discharge those debts that can be discharged, and then working on paying off those tax debts that remain. There is no way of knowing how your case will play out without a thorough review of your situation, as everyone is different. At that point, you can proceed according to your plan and work towards a financial recovery.
If you have questions about taxes, the tax advisors at Enterprise Consultants Group are available to help you. Please contact us today online or at (800) 575-9284 to discuss your case.