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Discharging Tax Debt Under Chapter 7

Houston Tax Attorney

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Discharging Tax Debt Under Chapter 7

A common misconception is that federal taxes cannot be discharged through bankruptcy. This is false, and unfortunately even many bankruptcy attorneys do not understand tax issues in bankruptcy cases. A Chapter 7 filing can be a very powerful tool in obtaining relief for past due taxes.

What is Chapter 7 Bankruptcy?

A petition filed under Chapter 7 of the Bankruptcy Code is used to discharge debt through liquidation of assets. However, exempt and excluded assets are retained by the debtor. Examples of exempt assets include your homestead up to 1 acre, personal property ($30-60K), life insurance, pensions for state and local employees, tools of trade, earned but unpaid wages, and unpaid commissions up to 75%.

What does Filing a Chapter 7 do to Taxes?

Filing a bankruptcy petition gives rise to an automatic stay which immediately halts IRS collections. The IRS cannot file additional liens, send notices requesting payments, issue a summons, or levy your assets for any tax debt that arose prior to the bankruptcy petition. The automatic stay continues through the remainder of the bankruptcy process.

However, filing bankruptcy freezes the collections statute. If any of the tax debt is nearing statute expiration, you would not want to do anything that could freeze the collections statute. All tax returns must be filed prior to filing a bankruptcy petition. Additionally, failure to file tax returns or obtain an extension for returns that are due after the bankruptcy petition will result in the dismissal of your case.

Will my Tax Debt be Discharged Through a Chapter 7?

It depends on what types of tax claims are present. Tax claims will fall under one or more of the following categories, listed from highest to lowest priority:

  1. Secured tax claims
  2. Unsecured tax claims
    1. Administrative taxes that accrue while the bankruptcy case is proceeding
    2. Gap taxes
    3. Unsecured tax claims that meet the criteria to be priority claims
    4. General unsecured (i.e., nonpriority) taxes

Secured Tax Claims

If the IRS has recorded a Notice of Federal Tax Lien, those taxes are considered secured tax claims. The underlying debt against the individual may be discharged, but the tax lien will stay on the property until it is sold, at which point the debt will be paid through the sales proceeds.

Priority Claims

Taxes that are priority claims are not dischargeable in a Chapter 7 to the extent not paid out of the assets. Such claims include:

  1. Trust fund recovery penalties
  2. “Three-year Rule” taxes: Income taxes for which the due date of the return, including extensions, is within three years before the date of bankruptcy filing
  3. “240-day Rule” taxes: Income taxes assessed within 240 days of the date of bankruptcy filing
  4. “Two-year Rule” taxes: Income taxes related to a late return filed within 2 years of bankruptcy

General Unsecured Taxes

Unsecured taxes will be fully discharged.

Example

Bob owes taxes for 2010, 2011, and 2012, owing $25,00 for each year. All returns were timely filed prior to their October 15 extensions. Bob owns a home worth $500,000 with an equity of $300,000. IRS has filed a tax lien for 2010, but not the other years. If Bob files a Chapter 7 bankruptcy, the 2011 and 2012 taxes would be completely discharged since they meet the 3-240-2 rules and are nonrpriority tax claims. The 2012 is discharged against Bob personally, but a lien will remain on the property for $25,000 because it is a secured tax claim. The IRS legally could choose to enforce the lien by foreclosing on your home after the bankruptcy. However, this is not something that is commonly done, and almost never where the equity is less than $100,000.

Should I File a Chapter 7?

If you’re considering filing a Chapter 7 to discharge federal tax debt, you need to speak to a tax attorney first to determine whether that is an option for discharging the debt. Some of the factors that need to be considered include:

  • Whether you primarily owe tax debt, or if you also have significant consumer debt. If you have consumer debt, you may be subject to the means test.
  • The dates the returns were filed and taxes were assessed
  • Whether any tax liens have been filed
  • What types of assets and amount of equity in assets you currently own
  • Whether there are any trust fund recovery penalties assessed

This is yet another reason why hiring a tax attorney versus a CPA or enrolled agent for tax disputes is important. A CPA or enrolled agent cannot provide tax court or bankruptcy court representation, and may not even suggest to you all the options available in resolving your tax matter.

Won’t a Chapter 7 Hurt my Credit Score?

Bankruptcy should always be a last resort and it will significantly lower your credit score for 10 years. However, the effect on your credit score should not dissuade you from considering a Chapter 7. Most clients with tax debt already have low credit scores caused by IRS liens. Liens remain on your credit report for 7 years, or until the tax has been fully paid and the lien is withdrawn. You will have a difficult time buying a house or qualifying for a loan anyway with a tax lien on your credit report.