Taxes & Bankruptcy FAQ

When Tax Meets Bankruptcy

Once you understand that bankruptcy can discharge taxes, penalties, and liens, it just raises more questions.

Like most legal questions, the rules on taxes in bankruptcy are many and complex.

Here are a few general answers to tax issues, but make sure you get personalized, sophisticated advice as soon as possible in any tax matter.

What if I can’t pay non dischargeable tax debt over a five year Chapter 13 plan?

The standard rule is that a Chapter 13 plan must pay in full the priority taxes due as of the filing.  Sometimes, that number is simply too large to be paid in the 5 year limit for Chapter 13.

Consider an offer in compromise to the IRS.  The IRS can negotiate with taxpayers (or non payers, as it were) to compromise  tax claims.

The compromise can be based on either doubtful liability (there’s a question about what you really owe ) or doubtful collection(you don’t have resources to pay the tax you owe).
The IRS generally expects you to pay to them whatever income is “excess”  in their view of what it should cost you to live for 50 months or the remainder of the collection statute, whichever is less.

Here’s more on offers in compromise from the IRS on offers.

Check out the IRS standards for allowable housing and living expenses used in evaluating offers.  (If you live in a high cost of living area like the San Francisco Bay Area, you can read and weep, or laugh, as you chose.)

If the taxes in question are non dischargeable because they are relatively recent, consider letting them age before filing bankruptcy.  Income taxes become dischargeable with the passage of time.

Are there tax consequences if my property is foreclosed?

Foreclosure can trigger tax consequences to you.  There are two kinds of tax liability that may arise upon foreclosure:  capital gains tax and cancellation of debt income tax.

Capital gains tax

A foreclosure is treated just like an arm’s length sale for capital gains purposes. Whether there is a gain depends on the tax basis of the property, whether the property is your residence, etc.

Know that the bankruptcy estate in a Chapter 7 and 11 is a separate, tax paying entity, distinct from the individual debtor:

If the property is property of the estate when the foreclosure takes place, the tax consequences should fall to the estate, not the debtor.

This quirk in the law can present some planning possibilities in cases where loss of the property is inevitable.  You may be able to prevent the further insult of having the loss trigger taxes on money you didn’t receive upon the transfer if the foreclosure occurs after, rather than before, bankruptcy.

Cancellation of debt tax

Foreclosures that take place before a bankruptcy filing may generate cancellation of debt income.  IRC 108  Look at the legal ways to avoid paying that tax.

If the foreclosure comes after the filing of a bankruptcy case that leads to a discharge, the personal liability for the debt was discharged in the bankruptcy, not by reason of the foreclosure.

When you get a 1099 for debt forgiveness

Does the IRS have to agree to my Chapter 13 plan?

The IRS is just another creditor in the Chapter 13.

Its objections are limited to the same grounds as any other creditor:  lack of good faith;  lack of feasibility;  best interests of creditors .

Our experience is that the IRS welcomes a Chapter 13 filing since the priority taxes get paid in full with little expenditure of time and energy by the IRS.

What happens to tax liens that survive the Chapter 7 discharge?

If the discharge in the Chapter 7 case eliminates the debtor’s personal liability for the tax year or years for which there is a lien, the lien survives only as a charge on the equity in the property that the debtor owned at the beginning of the case.
The lien survives as it existed at the beginning of the bankruptcy.  It does not attach to assets that you acquire after the bankruptcy case is filed.
Your choices after the discharge are

  • pay the IRS the value of the  equity in assets to which the lien attached at the beginning of the case;
  • do nothing in the expectation that the IRS will not attempt to enforce a lien, if the collateral is of little value or is exempt from levy by law;
  • file a Chapter 13 to pay the lien over time if it attaches to assets of significant value.

Can the bankruptcy court decide tax disputes?

Yes, one of the most useful aspects of bankruptcy is the power of the bankruptcy court to decide disputes between the debtor and a creditor, even if the creditor is the IRS.

In general, the court in a no asset Chapter 7, where there will be no payment on claims of creditors, has no interest in resolving disputes about taxes that will survive the bankruptcy.
But, in Chapter 13, there is always a distribution to creditors and therefore there is a real need for the court to decide disputed claims.   The bankruptcy court may be the quickest and cheapest way to get a fair determination about a tax dispute.


Bankruptcy as a tax tool

Why choose Chapter 13

Employment taxes in bankruptcy

Image courtesy of Pixabay.

About the Author
Northern California bankruptcy lawyer Cathy is a 30+ year veteran of bankruptcy practice in the Silicon Valley. She is known for energetic representation of clients and her command of bankruptcy law.