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Bankruptcy and Tax Debt LifeBack Tax
Individuals or businesses who owe income taxes to the government may be able to resolve their tax debts when filing for bankruptcy. While most government-related debts tend to be nondischargable under bankruptcy laws, special circumstances may allow back income taxes to be wiped out along with other liabilities during a bankruptcy proceeding. Both federal and state income tax debts may be delayed or potentially discharged during bankruptcy.
In order for income tax to be eliminated in bankruptcy, the tax debt must have been for a tax return that was due at least 3 years ago, its respective tax return must have been filed at least 2 years ago, and their tax liability was assessed at least 240 days before filing for bankruptcy. Tax debt cannot be discharged if the taxpayer never file a tax return themselves, even if the government filed a substitute return. This criteria ensures that the government has an adequate opportunity to collect the taxpayer's debt prior to bankruptcy. Tax debt also cannot be discharged if the taxpayer was found guilty of tax fraud.
Only income tax debt may be cleared through bankruptcy; other tax debts, such as payroll or sales and use tax, cannot be discharged in bankruptcy. Additionally, if the government filed a tax lien to secure the tax debt, the lien may affect whether the tax debt is discharged, depending on the type of bankruptcy.
During bankruptcy, an "automatic stay" is placed on the filing party's creditors, including federal and state governments, preventing them from attempting to collect from the debtor. This stops the IRS or state tax authorities from taking actions such as sending collection notices, filing a tax lien, or levying assets, income, and bank accounts until the bankruptcy is closed. The "automatic stay" rule can provide taxpayers with a small amount of leeway to reorganize their finances for the duration of their bankruptcy case.
Chapter 13 bankruptcy, or a wage earner's plan, allows individual debtors to pay their debts over time while retaining their property. In Chapter 13 bankruptcy, the debtor agrees to partially or fully pay some of their debts, based on their income and whether the debt has legal priority or is a secured claim. These debts are consolidated under a three-to-five year repayment plan managed by a bankruptcy trustee, who distributes payments to the creditors. At the end this payment plan, any remaining unsecured nonpriority debts are discharged. Note that applying for Chapter 13 bankruptcy requires that the individual has filed their tax returns for the past four years
Priority debts, such as taxes owed within the last three years or assessed less than 240 days ago, are granted legal priority and are paid first in a repayment plan. Secure debts, such as tax liens, are limited to the value of the collateral (in the case of a federal tax lien, all of the taxpayer's property), and the remainder of the tax lien is considered unsecured. Recent tax debts, non-income tax debts, and tax liens must be paid in full, and cannot be discharged in Chapter 13 bankruptcy.
Only individual taxpayers (including sole proprietors) may file for Chapter 13 bankruptcy. Partnerships and corporations may instead file for Chapter 11 bankruptcy, or reorganization bankruptcy. Similarly to Chapter 13 bankruptcy, Chapter 11 bankruptcy establishes a repayment plan that allows a business to continue operating while paying its creditors. Individuals may also file under Chapter 11 if they are ineligible for Chapter 13 bankruptcy.
Chapter 7 bankruptcy, or liquidation bankruptcy, is the most common form of bankruptcy. Unlike Chapter 13 bankruptcy, it does not involve a repayment plan. During liquidation, a bankruptcy trustee sells off the debtor's equitable assets, excluding exemptions as defined under state laws. These exemptions are intended to leave the debtor with enough assets to make a living. After selling the debtor's assets, the trustee distributes the proceeds to the creditors, first paying priority debts and secured debts. Afterwards, any remaining dischargable debts are discharged.
When tax debt is discharged in Chapter 7 bankruptcy, the taxpayer is cleared of personal liability, and is no longer obligated to pay their past due taxes. This prevents the government from enforcing collection by taking the taxpayer to court, claiming after-acquired assets, or levying income and bank accounts. However, discharging a tax debt does not remove an associated tax lien that was before the taxpayer petitioned for bankruptcy. A tax lien stays on any assets that it was already attached to, and the taxpayer must pay the lien if they intend to sell those assets. On the other hand, if these assets were not sold during liquidation, they may not be equitable enough for the government to try seizing them.
Chapter 13 bankruptcy is included on credit reports for up to 7 years, while Chapter 7 bankruptcy is included on credit reports for up to 10 years. Due to the impacts on your credit score, bankruptcy may be less preferrable as a tax debt strategy compared to other options, such as entering an installment agreement, applying for an offer in compromise, or requesting uncollectible status. We at LifeBack Tax will be happy to assess your situation, and determine if bankruptcy is the best solution for resolving your tax debts.
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