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Tax debts and bankruptcy

Treatment of tax debts in a bankruptcy case aims at resolving two Federal policies that are at odd with each other. The government is concerned about collecting the money owed to it. Yet it also wants to help distressed debtors get a fresh financial start after bankruptcy.

Partly due to this conflict, the Bankruptcy Code provisions dealing with tax debt discharge is quite complex. Whether you are able to get your tax debts discharged in bankruptcy depends upon the kind of tax debt that you want to get discharged.

Classification of Tax Claims

Tax claims can be classified as follows:

    • Trust Fund Taxes
      Trust fund taxes are taxes withheld from an employee's wages by their employer and held in trust until paid to the Treasury. If the funds are withheld from your paycheck and your employer has failed to transfer them to the government, then your employer is responsible for the debt. If you have failed, for some reason to have the proper amount of tax removed and file for bankruptcy, then the IRS will have a priority claim against you under the Federal Bankruptcy Code.
        Sales taxes and income tax withholdings are types of Trust fund Taxes.


    • Secured Claims
      These are tax claims secured by a lien on the debtor's assets; that is, the debtor's asset secures the payment of the tax. If the debtor fails to make the required tax payments, then the debtor's asset will be confiscated by the IRS in order to pay their tax debt.
      Usually a claim is secured up to the value of the property.
      For example, if a tax claim for $50,000 is secured by property worth $10,000 then the claim would be divided into:
      a) A secured claim of $10,000, and
      b) Either a priority tax claim or a general unsecured claim of $40,000.
      If the property is subject to any preexisting liens and the total amount of the previous liens exceeds the property's value, then the claim is not secured.
      For example, if the IRS places a tax lien upon a property worth $80,000 that is subject to a preexisting lien of $100,000, then the entire tax lien claim would be either a priority tax claim or a general unsecured claim and not a secured claim.
        But, if the amount of the preexisting lien is less than the value of the property, the IRS will have a secured claim up to the value of the property. The remaining balance of the tax claim would either be a general unsecured claim or a priority tax claim.


    • Administrative Tax Claims
        According to the Federal Bankruptcy Code, any taxes incurred during the pendency of a bankruptcy case on the debtor's bankruptcy estate are administrative taxes. Recently, the Supreme court has recently decided that that under certain circumstances, tax penalties are subject to reasonable subordinate under certain circumstances. Otherwise, Administrative tax claims are treated as first priority claims.


    • Priority Tax Claims
      Priority tax claim status is granted to certain unsecured claims owed to governmental entities.
      Assignment of priority status depends upon the time of assessment of the tax claims. Normally, taxes are assessed after a taxpayer is notified of an alleged deficiency on his tax return and he has had an opportunity to challenge it. The date of assessment is the date when the proposed tax (described in the notice of deficiency) becomes final.
      Here are the three rules to determine priority status of taxes depending upon the time of assessment:


1. The 3 year Rule

      Under this rule, priority status is assigned to a tax if:
      a) it has been assessed for a taxable year that ends before/on the date of bankruptcy filing, and
      b) the return was defaulted on three years prior to the date of filing.
      The due date for the return is vital to determining a tax's priority status.

2. The 240 day Rule

      Under this rule, taxes assessed within 240 days of the petition date are given priority status.
      This is typically applicable when additional taxes are assessed after:
      a) the taxpayer files an amended return, or
      b) the IRS audits the tax return.
      However, there are certain modifications in this 240-day period. If the 240th day prior to the bankruptcy petition falls on a weekend, or legal holiday, then the last business day is considered to be the 240th day. This period is also extended with respect to any time span within an "offer of compromise".

3. The Post-petition Rule

      Certain taxes assessed after the filing of a bankruptcy petition are also assigned priority status. These are taxes whose statute of limitation for additional assessments has not encroached on the date of the bankruptcy filing.
      The following are some of the important priority tax debts:
      a) Certain employment taxes
      b) Certain excise taxes
      c) Certain custom duties
      d) Unsecured property taxes that were last payable (without penalty) maximum one year prior to the bankruptcy filing.


    • General Unsecured Claims and Penalty Claims
      Taxes that are not subject to secured, administrative tax claims, or priority tax claims are General Unsecured taxes.
      These taxes do not qualify for priority tax claim status because they are old claims.
        There is also a kind of tax claim that is secondary to general unsecured claims in certain respects; these are non-pecuniary taxes.


Dischargeability of Taxes

Taxes may be discharged in bankruptcy either through liquidation (as in Chapter 7 Bankruptcy) or reorganization (under Chapter 11 or Chapter 13 Bankruptcy).

Dischargeability Under Chapter 13

Usually Chapter 13 offers limited provision for discharge. But certain tax debts, which are not otherwise dischargeable, may be discharged under Chapter 13.

Under Chapter 13, all the creditors, including taxing authorities, must file a proof of claim with the bankruptcy court. If the priority tax claims are included in the plan, but the taxing authority fails to submit the proof of claim on time or does not submit it at all, then the debtor can object to the claim and may not be required to pay the tax claim at all.

Exceptions to Dischargeability of Tax Claims

There are 3 major exceptions to the discharge of tax debts in bankruptcy. Taxes cannot be discharged if:

  1. The tax is a priority tax claim or it is non-dischargeable. Dischargeability is decided by the status of the tax.
  2. The tax-payer fails to file a tax-return or if the return was filed less than 2 years prior to the filing of bankruptcy.
  3. The debtor files a fraudulent return or deliberately attempts to evade taxes.

Furthermore, federal tax liens are non-dischargeable even if the underlying taxes are discharged. Therefore, secured taxes are essentially non-dischargeable.

For more information on whether your taxes are dischargeable in bankruptcy, you should consult a reputable bankruptcy attorney in your state.

Last Updated on: Mon, 4 Apr 2016

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