Monday, March 07, 2005

Discharging Tax Debts Through Bankruptcy

Disclaimer: The information contained in this article is provided for general information purposes only and is not intended to be a legal opinion, legal advice or a complete discussion of the issues related to the area of consumer bankruptcy. Every individual's factual situation is different and you should seek independent legal advice from an attorney familiar with the laws of your state regarding specific information.

Discharging Tax Debts Through Bankruptcy

People can get into tax debt for many reasons: divorce, health problems, poor business planning, etc. Whatever the reasons for your tax problems, it may be possible to eliminate some or all of your tax debt with proper planning and filing for bankruptcy.

If the IRS or state tax agency is being uncooperative during a collection negotiation or has begun enforcement proceedings such as a wage garnishment or bank account seizure, the client should consider seeking protection granted by the Bankruptcy Code. The Bankruptcy Code provides that upon the filing of a bankruptcy petition, an Automatic Stay is entered prohibiting the continuation of litigation or efforts to collect any debt without the express approval of the Bankruptcy Court.

Automatic Stay

Filing any type of bankruptcy will preclude the IRS or other tax agency from continuing to levy upon wages or other assets of the taxpayer. The IRS can be ordered to return property seized prior to bankruptcy. Therefore, if the IRS seizes an asset, the taxpayer can still seek help from the Bankruptcy Court to stop a sale and get the property back in a Chapter 13 case.

Types of Bankruptcy

The taxpayer has several types of bankruptcy proceedings to choose from. A Chapter 13 provides for repayment of the individual taxpayer's debt in whole or in part over a 3 to 5 year period. A Chapter 7 Bankruptcy provides for the gathering and liquidation of taxpayer's nonexempt assets and for the discharge of his or her dischargeable debts.

Chapter 13 Repayment Plan

Only individuals may use Chapter 13 of the Bankruptcy Code. Chapter 13 is not limited to wage earners. Instead the debtor may have regular income from any source; welfare, Social Security, unemployment compensation, pension, a business, investments, etc., so long as it is regular and stable enough to allow the debtor to meet obligations under the plan. Chapter 13, however, is limited to small debtors. A debtor's unsecured debt may not exceed $250,000 and secured debts may not exceed $750,000. The filing of a Chapter 13 petition, like the filing of a petition under any other chapter of the code, automatically stays all efforts to collect debts from the individual other than through the bankruptcy proceeding. The stay applies to the efforts of the Internal Revenue Service.

Debtors Retain Assets

Under Chapter 13 a debtor will usually remain in possession and control of the assets. If the debtor has a business, the debtor may operate that business without interference from the trustee or by any creditor. A trustee is appointed to serve as a disbursing agent. Payments pursuant to the plan are made to the trustee who receives a percentage fee (usually 8-10%) for disbursing the funds to the various claiming creditors. Payments must begin within thirty days of the petition. Only the debtor may prepare a Chapter 13 plan. The plan must provide for full payment to all secured creditors to the extent of their secured interest and priority creditors (e.g., most taxes due the Internal Revenue Service). Nonpriority taxes may be partially paid as unsecured debts and will be discharged upon successful completion of the plan. The plan may provide for less that full payment of unsecured, nonpriority debts including many tax penalties. Ordinarily, the plan should provide for repayment within three years. However, the court may, in extraordinary circumstances, approve up to five years for repayment.

There is no requirement for a vote by the creditors to approve the plan. If the court believes that the plan is fair and equitable to all the parties and that the debtor has the ability to meet the payments pursuant to the plan, it will approve it. The only exception to this is that secured creditors may object to the plan. However, if one or more secured creditors object, the court may still approve if it is satisfied that the plan permits the creditor to repay its lien and if the plan offers the nonassenting secured creditor payment with a present value at least equal to the value of the creditor's secured interest.

The approval of the Internal Revenue Service is not required for a plan. Because approval is not required, a Chapter 13 bankruptcy gives an individual taxpayer the ability to force a payment plan upon the Internal Revenue Service over its objection. Instead of having to deal with an unreasonable Revenue Officer, the taxpayer presents his or her other case to a Federal Bankruptcy Judge who has the ability to force the IRS to accept extended payments. All of this makes a Chapter 13 Bankruptcy particularly attractive when the taxpayer has sufficient income to allow repayment of the IRS tax liability within five years. The major disadvantages of Chapter 13 are the adverse effect upon the taxpayer's credit rating and the administration fee taken by the trustee for collecting the plan payments. On the other hand, in most cases, the taxpayer may avoid paying interest to the IRS.

Partial Payment of Liabilities

A Chapter 13 plan may provide for partial payment of dischargeable taxes. For example, if the taxpayer had limited assets and income, the plan might provide for a payment of 10% of dischargeable taxes.

Chapter 7 Bankruptcy

Chapter 7 is also known as a "straight" bankruptcy. Such a proceeding may be commenced by the filing of a voluntary petition by the debtor or by the filing of an involuntary petition by a group of the debtor's creditors. The taxpayer is required to file a schedule of all of his or her assets and liabilities with the court. Within 20 to 40 days after the filing of the bankruptcy petition, the taxpayer will be required to appear before a trustee to be examined regarding his or her assets and liabilities. The trustee will liquidate all of the taxpayer's property which is not exempted by state or federal statutes, as applicable.

Subsequent to the first meeting, the court will enter a discharge of the taxpayer's debt. All debts which are not specifically excluded by statute will be discharged by this order. The Bankruptcy Code provides that the following taxes are not dischargeable:

  • Any tax entitled to priority under Section 507 of the Bankruptcy Code;
  • Any tax for which a required return was not filed or which a late return was filed if that late return was filed within two years of the Chapter 7 petition;
  • Any tax for which the debtor filed a fraudulent return or which the debtor otherwise tried to willfully evade. (Note: such a liability might be dischargeable in Chapter 13.)
Priority Taxes

The Bankruptcy Code gives the following types of federal, state and local taxes priority:

  • Income taxes which are less than three years old, computed from the date the return was due, not the end of the tax year. Any income or gross receipts tax assessed within 240 days before the petition was filed are nondischargeable. The 240 day period is extended if the taxpayer makes an offer of settlement within 240 days after assessment of such tax. The key here is the date the tax was assessed and not the date of the return. In addition, any tax assessable after the date of the petition is not dischargeable;
  • Any withholding tax (Trust Fund Taxes) for which the debtor is liable in any capacity. Thus, whether the debtor is liable for trust fund taxes as an employer or, pursuant to IRC § 6672, as a responsible officer of a corporation, the tax liability is not dischargeable regardless of the age of the debt;
  • Other employment related taxes if within three years of the filing date;
  • Excise taxes which are less than three years old;
  • Certain customs duties; and
  • Any pecuniary loss penalty on any of the foregoing.
Dischargeable Taxes

As a result of Bankruptcy Code Sections 523 and 507 the following taxes are dischargeable:

  • Tax penalties for nonfiling, late payment, late deposit, fraud penalties and late estimated payments if the taxes to which they relate are dischargeable.
  • Income taxes which are: Over three years old; Have been filed at least two years prior to the petition; and/or Have been assessed as an audit deficiency for at least 240 days.
  • Estate and gift taxes which are over three years old.

Adverse Effects of Bankruptcy

Because of the adverse effects upon a taxpayer's credit rating, many people should consider bankruptcy as a last resort. An extensive analysis of the taxpayer's risks, (i.e., the property which he might be required to liquidate and which liabilities would be discharged) should be undertaken prior to the initiation of any bankruptcy proceeding.

Post-Bankruptcy Actions

Once a discharge has been entered by the Bankruptcy Court, submit a written request to Special Procedures Branch that the IRS abate the tax. The Service will abate the liability by preparing a Form 3870. Some have found that the IRS is very inefficient in preparing post-bankruptcy abatements. Some debtors have had levies made on their wages or bank accounts after a bankruptcy. Your attorney must aggressively pursue abatement. If all else fails, the client may request that the Bankruptcy Court hold the IRS in contempt of court.


Although bankruptcy is not a cure-all, it may be a viable alternative to dealing with unreasonable Revenue Officers. In the proper circumstances, bankruptcy can be used to:
Reduce tax liability; and/or

  • Eliminate tax liability; and/or
  • Reduce tax liability; and/or
  • Secure an extended plan for payment of the tax liabilities; and/or
  • Litigate tax controversies.

Prior to the initiation of any of these proceedings, however, the attorney and client should thoroughly research the applicable bankruptcy statutes and, of course, the client should be fully advised of the adverse effects of a bankruptcy on his credit rating. We are a bankruptcy and debt relief agency. We help people file for bankruptcy.

If you have any questions, please call us at (619) 448-2129 or e-mail us to set up an appointment.

About the Author
Carl H. Starrett II has been a licensed attorney since 1993 and is a member in good standing with the California State Bar and the San Diego County Bar Association. Mr. Starrett practices in the areas of bankruptcy, business litigation, construction, corporate planning and debt collection.


Anonymous said...

Question for you: if a married couple files jointly with a large IRS debt and then divorces, and the husband agrees to take the debt as part of the settlement agreement but then later files Chapter 7 bankruptcy and gets the IRS debt discharged, is the wife still liable for that IRS debt or is it discharged from her as well?

Carl Starrett said...

Assuming that it is truly a dischargeable tax debt, the wife would not automatically receive a discharge of the debt. However, the husband may not be completely off the hook because the former wife might have a nondischargeable reimbursement claim if the former wife had to pay the tax debt.

It sounds like the husband assumed liability for the tax debt under a maritial settlement agreement. Section 523(a)(15) of the Bankruptcy Code sets forth restrictions on the dischargeability of debts assumed from marital dissolution proceedings. The former wife should consult with an experienced bankruptcy attorney to discuss the facts of her case to see if she has a valid reimbursement claim.

Anonymous said...

Thanks. Maybe I can clarify some, as this is my own situation.

We divorced at the end of 2001. In April 2001 we filed married, jointly, posting a very large IRS debt. Our California Marriage Settlement Agreement stipulated that in lieu of paying me alimony or spousal support, my exhusband would pay the IRS debt. I personally have not made any voluntary payments towards the debt, though I have in the past lost several federal tax returns to it. The IRS chose not to honor the MSA, however, and since then I have been receiving balance due notices. My ex, however, had been paying the debt on installments, and $35k remained at the time he filed for Chapter 7 at the end of 2004. He claimes he received a discharge notice for the debt from the IRS that was addressed to both of us, but I haven't received anything myself other than another balance due notice. I'm waiting for him to send me a copy of the discharge notice but in the meantime I'm quite worried that I'm liable for this debt. I don't expect to be reimbursed for anything and don't intend to pursue reimbursement - I just don't want to get stuck with anything.

Thanks for your advice!

Carl Starrett said...

The MSA is essentially a contract between you and your ex husband. I do not believe An MSA can alter the creditor's rights, it only governs the relationship between the former spouses.

You have been stuck paying the debt to the extent the IRS has taken your tax refunds. You might be able to reopen the divorce case and obtain a modification to the MSA that compensate you for those losses.

Anonymous said...

Here's my situation: My ex-husband and I divorced over three years ago. As part of the settlement we were supposed to share the IRS debt. He wasn't paying any of the bill, but I was sending in checks. He then filed Chapter 13 bankruptcy. After he filed, the IRS no longer withheld any of my refunds, etc. I have had no contact with him over these years, and I believed that the IRS debt was part of the past. However, now he has filed a lawsuit against me claiming I was completely uncooperative in repaying the debt. I have my cancelled checks to show that I had been paying. He's suing me for more than the original debt. What are my rights?

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tax debt help said...

This becomes a more serious matter when you personal details are sagged for IRS recovery process and before the recovery you have to face many problems.

Tax Loan said...

The settlement process, often called an offer in compromise, underwent a massive change with the passage of the Tax Increase Prevention and Reconciliation Act of 2005. Starting July 16, 2006, the new rules go into affect and they are a bear. The biggest issue is you now must pay 20 percent of your offer amount to even have the settlement offer considered!

Anonymous said...

My HR informed me today that they received a writ of wage garnishment from a company I never heard of nor had any knowledge of whom they are. What should be my first step of action to straighten this out and most importantly who should I contact first to stop the garnishment? Please help kindly!!