Discharging Taxes in Bankruptcy

Question: I owe $40,000 in back taxes. Can these be discharged in bankruptcy? Also, I have applied for an extension on filing my 2008 tax return. Should I file the return before filing bankruptcy, or does it matter?

Answer: On your bankruptcy petition, creditors are listed as holding secured claims, unsecured priority claims, and unsecured nonpriority claims. Whether or not your taxes can be discharged will depend on where they must be listed and under which chapter you file. A creditor’s claim is a debt that you are alleged to owe.

Secured claims must be paid in their entirety. These claims would include taxes for which a lien has been placed on your real property. If, however, the lien impairs an exemption to which you are otherwise entitled your attorney may be able to avoid the lien,

Unsecured priority claims must be paid in their entirety under Chapter 7. These debts are dischargeable under a Chapter 13 full compliance discharge. A full compliance discharge occurs when you complete all plan payments, even if your Chapter 13 plan calls for less than 100% payment of priority claims. A full compliance discharge eliminates debts incurred to pay nondischargeable federal, state or local taxes. 11 USC § 523(a)(14). Government fines, penalties and forfeitures are also dischargeable under a full compliance discharge, excluding criminal fines under § 1328(a)(3).

Unsecured nonpriority claims must be paid at least to the value of your nonexempt property. In a Chapter 7 liquidation bankruptcy some of your assets will be exempt from being sold to pay your creditors. For example, there is presently a $525 exemption for each item of personal property. If you have a sofa that is worth $400 the sofa will be exempt. If the sofa is worth $900 then $525 will be exempt property and $375 will be nonexempt property. Unless, there is another statute to exempt the full value of the sofa at least $375 must be paid to creditors. The court is not concerned with whether you sell your sofa to acquire this amount or find the money elsewhere. The value of all your nonexempt property is what you will be required to pay your unsecured creditors under Chapter 7.

Creditors holding unsecured nonpriority claims in Chapter 13 must be paid at least the amount that they would have received in Chapter 7. This is called the Best Interests of the Creditor test. The amount that unsecured creditors will actually receive depends upon the percentage (also called the dividend) confirmed in the Chapter 13 plan.

Taxes are normally paid as priority claims, unless:

1) The income tax or sales tax is over three years old and meets certain other conditions, including no recent offer and compromise agreement with the taxing authority . § 507(a)(8)(A).

2) The property tax, whether or not assessed, was due over one year prior to the bankruptcy filing.

If the tax is not a priority claim then it will be paid the same dividend as other unsecured creditors.

Conclusion: If the $40,000 you owe in back taxes is over three years old, this amount can be listed as an unsecured debt and discharged in any chapter. If the debt is less than three years old, the amount must be paid in full in Chapter 7, but can be discharged under a Chapter 13 full compliance discharge.

In most cases you should file your tax return before you file bankruptcy. The tax is due when you file. Prepetition taxes can be placed on your petition and paid over time through a Chapter 13 plan. Postpetition debt is only payable through a Chapter 13 plan if the taxing authority files a proof of claim. If no claim is filed, the debt is not discharged even if you receive a full compliance discharge.

The law now requires that where a tax return was required, a Chapter 13 Debtor must file tax returns for each of the four years prior to the bankruptcy filing. If you can not provide copies of the returns by the first day your Meeting of Creditors is scheduled, the law requires that your case be dismissed. § 1308.

Disclaimer: Handling taxes in bankruptcy can be a complicated process. Sometimes the advice of a tax professional will be required. This article is meant to give a brief overview of when taxes can be discharged in Chapter 7 and Chapter 13 bankruptcy filings. No attorney-client relationship is formed or intended.