Portland Bankruptcy Law Group

You CAN “discharge” some income taxes, and be relieved of the legal liability for those taxes, in Chapter 7.  But any tax debt you are trying to discharge has to meet a number of strict conditions.  What are those conditions?

There are four main conditions.

But before describing those four, please clearly understand that this whole area—dealing with tax debts in bankruptcy—is a complex one.  We are presenting the information in these blogs to you because the better you’re informed, the more in control of your situation you’ll feel.  But part of being well informed is understanding when you definitely need an attorney’s help.  Meaning that part of our job is to make very clear when you do.  This is definitely one of those areas.

And now, on to those four main conditions for discharging income taxes.

1. Have three years passed since the tax return was due?

Every income tax debt has a due date for the filing of its tax return.  That makes calculating whether or not you’ve met this condition very straightforward.  But remember the important twist here: if you asked for an extension of time—from April 15 to October 15, usually—the three-year period does not begin until the extended due date for filing the tax.

2. Have two years passed since the applicable tax return was actually filed?

It does not help that a tax is old unless at least two years have not passed since the return was in fact filed.  Plus the tax return must have been filed by you, NOT by the IRS or the Oregon Department of Revenue.  Such a “substitute for return”—the common procedure in which the tax authority essentially files a tax return on your behalf based on whatever information it has available—that does not count as a filed return to start this two-year period running. 

3. Have 240 days passed since assessment of the tax?

Assessment is the tax authority’s formal determination of your tax liability, usually through its review and acceptance of your tax return.  In most situations an income tax assessment happens within a few weeks after you file the return.  So this 240-day requirement is meaningless then because that period expires long before the above three-year and two-year ones.  But sometimes the amount of a tax is in dispute because of a tax audit or litigation in Tax Court, which delays the assessment.  By the time the accurate tax amount is assessed, the above three-year or two-year time periods may have passed.  That’s where this condition comes into play, only allowing the tax to be discharged if the bankruptcy case is filed more than 240 days after the date of assessment.  Also, this 240-day period is put on hold while a taxpayer’s “offer in compromise” is pending.  That’s a settlement proposal you make to the tax authority to pay less money or agree to certain payment terms.  The idea is that the time should not expire while the government is considering your offer.

4. Have you filed a fraudulent tax return or intentionally tried to evade the tax?

Even if all the required time periods have passed, if you were dishonest on your tax return—failed to include some of your income, for example–or tried to avoid paying a tax some other way, that tax cannot be written off in bankruptcy.

These four conditions should give you a good idea whether any or all of your income tax debts can be written off in a bankruptcy.  And in some cases applying these four conditions will tell you one way or the other.  But in other cases different considerations can come into play. What if the IRS recorded a tax lien against your home and on your personal possessions?  How would a prior bankruptcy affect these timing rules? What about your appeal of a tax?  What is considered an honest mistake on a tax return instead of an intentional tax evasion?

Bankruptcy can definitely discharge income taxes in the right combination of circumstances, but you need to have an experienced attorney apply all the pertinent rules to your case.

Filing a bankruptcy stops every act by your creditors to determine or to collect their debts against you or your property.  That is, except for those by certain kinds of creditors chasing very specific kinds of debts.  Because this protection from your creditors—called the “automatic stay”—is usually such an effective and anticipated tool against your creditors, it’s very important to know when it doesn’t apply.  The last thing you want is to count on a creditor being stopped only to find out that it isn’t.

Before getting into these exceptions, we emphasize that for most people the automatic stay DOES apply to ALL their creditors.  In those cases the filing of their bankruptcy case DOES put a stop to ALL collection efforts by their creditors.

On the other hand, the kinds of debts NOT covered by the automatic stay are not that rare.  You might have one of them.  They include the following:

1) Criminal: If you owe a criminal fine or restitution, or have to pay probation or other ongoing crime-related fees, a bankruptcy filing does not affect your obligation to pay these.  And if at the time your bankruptcy case is filed, you are in the midst of a criminal proceeding, that will continue, whatever stage it is at– indictment, criminal trial, or sentencing.  This includes not just felonies and misdemeanors, but also lesser matters like traffic infractions that you might not think of as “criminal.”

2) Divorce and family court: Your ex-spouse, or about-to-be ex-spouse, or somebody on his or her behalf, can start or continue a variety of divorce and family court proceedings against you regardless of your bankruptcy filing.  These include legal procedures to establish paternity of a child, determine or change the amount of child or spousal support to be paid, settle child custody or visitation issues, address domestic violence disputes, and even dissolve the marriage.  A divorce case IS stopped by a bankruptcy to the extent that it deals with the division of property between the spouses—meaning the division of BOTH assets and debts.

3) Child or spousal support: If you owe ongoing support, no matter what kind of bankruptcy you file the person to whom you owe it can continue collecting it.  If you owe back support AND file a Chapter 7 case, the person to whom you owe the support CAN STILL continue or start collecting it.  This includes not only collection through wage withholdings and garnishment of bank accounts, but also through seizure of a tax refund and suspension of a driver’s license, an occupational or professional license, or even a hunting or other recreational license.  In contrast, a Chapter 13 filing can stop these aggressive methods of collecting back support.

4) Taxes: Taxing authorities have to stop their collection efforts against you on taxes that you owe at the time your bankruptcy case is filed.  However, your bankruptcy filing does NOT prevent them from starting or finishing a tax audit, sending you a notice that you owe taxes, demanding you to file your tax returns, or assessing your taxes.

These are by no means the only exceptions to the automatic stay, but are the most common.  If you are involved in a court proceeding or are the target of collection efforts by the criminal or taxing authorities, or by an ex-spouse, be sure to tell us when you first contact us.  These special creditors often have an influence on your best legal course of action, so we need to know about them quickly.

If you have an income tax lien in force against you, that usually means that that you have a serious tax problem. The IRS and/or the Oregon Department of Revenue are taking some pretty aggressive enforcement action when they record a tax lien (called a “distraint warrant” by the Department of Revenue). In this blog we focus on taking care of tax liens on your real estate through bankruptcy.

First, a touch of background about tax liens. Simply put, the recording of a tax lien turns an unsecured income tax debt into a secured one. A debt that is not attached to any collateral changes into one that is. A tax lien (in the amount of the income tax/interest/penalties to which the lien applies) generally attaches to everything you own, although that can depend on exactly where the lien is recorded. In Oregon, the tax lien attaches to any real estate you own in the county where the lien is recorded.

When a tax lien is recorded, it does not step ahead of other pre-existing mortgages and liens on your home. Although taxes and their liens can be harder to get rid of in bankruptcy than some other kinds of liens, a tax lien sits on your title in the order that it was recorded. That order is very important when you file a bankruptcy.

Chapter 7

If you owe income taxes from a tax year that is far enough in the past and meets a number of other criteria, those taxes can be discharged (legally written off) along with your other debts. But if that tax debt is secured through a recorded tax lien, that lien continues to exist on the title of your home after your Chapter 7 case is completed and that tax debt is discharged.

What happens to the tax lien after the Chapter 7 bankruptcy is completed depends on whether there is any equity in the home to cover some or all of the value of that tax. The more there’s equity to cover some or all of the tax lien, the more leverage the taxing authority has to require a payment in order for it to release its tax lien. The payoff amount is usually determined through negotiations, turning on the specific facts of the case.  (Note that the homestead exemption does not protect any of the equity from a tax lien.)

If there is absolutely no equity because the value of the property is less than the prior mortgages and liens, then the taxing authority is usually willing to release its lien, perhaps requiring payment of a relatively small “nuisance value” in order to do so.

Chapter 13

Chapter 13 provides what is usually a much more definite mechanism for how much, if any, that you have to pay on a tax lien. In the Chapter 13 Plan we state how much equity in the home we think the tax lien attaches to (after deducting liens with a higher priority), and propose to pay that amount in the 3-to-5 year Plan. If there is no objection—or if the amount is adjusted after objection from the taxing authority—once that amount is paid through the Plan and your case is completed, the rest of the tax is discharged and the lien is released.

And if there is no equity available for the tax lien (because your home is worth less than the amount of the higher priority liens), then in your Plan we propose to pay nothing on the tax lien. That’s because for practical purposes the tax lien attached to nothing, with all available equity exhausted by other earlier liens. So again, at the completion of the case, the underlying tax is discharged, and the IRS/state must release the tax lien even though nothing was paid on it.

The above scenarios involved tax liens where the underlying tax debt is being discharged. In a Chapter 13 case, you can also pay income taxes that can’t be discharged and do so usually under much more favorable terms than outside of bankruptcy or after a Chapter 7 case. If an income tax that can’t be discharge is also secured by a tax lien, then that tax debt must be paid with a relatively modest amount of interest (with the interest rate determined by federal and state tax law). The interest is paid only to the extent covered by the equity in the home (or by any personal property covered by the tax lien). If the tax lien does not attach to any equity, because prior liens total more than the value of the home, then no interest needs to be paid. Either way, at the completion of the case, after the underlying debt has been paid through the Plan, as well as the interest on any secured portion, the tax lien is considered satisfied and is released.

You might have heard that bankruptcy does not help with taxes, and especially not with business taxes.  That’s not true.  This is an area with many myths and misconceptions.  Let’s clear some of them up right now.

Myth: Bankruptcy does not write off some debts, and taxes are one of the categories of debts that it does not write off.

Truth: The first part of this is true: certain select kinds of debts are not written off, or “discharged,” when you file a bankruptcy.  And SOME taxes can’t be discharged, but others CAN.  The question of whether taxes can or can’t be discharged gets complicated because sometimes that depends on the facts.  We’ll dig into this a little bit below.  But very important: even those taxes that can’t be discharged can often be handled much more favorably in a bankruptcy case.  We’ll also show you how below.

Myth: Bankruptcy does not help with employee withholding taxes, the “trust fund” taxes you were supposed to pay to the IRS or the Oregon Department of Revenue after withholding them from your employee’s wages.

Truth: No kind of bankruptcy will discharge this category of taxes.  Admittedly this type of tax is treated quite strictly. After all this is money that, in a sense, was the employees’, for you to hold in trust until paying it over to the taxing authorities on behalf of the employees.  But a Chapter 13 case will give you years to pay off those trust fund taxes, WHILE keeping the tax authorities off your back, usually stopping the interest and penalties from accruing, AND often letting you pay less to your other creditors so that you can focus on paying off this one.  These are HUGE advantages.

Myth: Business taxes can’t be discharged (written-off).

Truth: Depends what you mean by “business taxes.”  If you ran a business as a sole proprietorship (or in a partnership) then the business would not separately pay income taxes—the income would flow through to you as personal income (after deducting the business expenses).  This “business” income tax would or would not be able to be discharged just like any other personal income tax. If you owed for a number of years of unpaid income taxes, a bankruptcy may well be able to discharge a substantial amount of those taxes.  That depends on a series of factors, including whether you’ve filed the tax return for that particular tax, if so how long ago the tax return was filed, when the tax was originally due, whether you tried to get a tax compromise, and whether you tried to evade the taxes.  And similar to what we stated above, if some of your tax debt is not dischargeable and you file a Chapter 13 case, your Plan will usually give you years to pay off those “nondischargeable” “priority” taxes, WHILE protecting you and your assets from the tax authorities, usually stopping the interest and penalties from accruing, AND often letting you pay less (and sometimes nothing) to your other creditors so that you can focus on paying these taxes.  Then when you finish your case and are out of the protection of the bankruptcy court, you will no longer owe any taxes.

CAUTION: This discussion assumes that you own or owned the business as a sole proprietorship or a partnership.  It’s a bit more complicated and some of these answers are different if your business was formed as a corporation or LLC.