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Filing timely tax returns is key if you wish to discharge tax debt in bankruptcy.

It is possible to discharge income tax debt in bankruptcy, however, not all taxes are eligible and timing plays a very important role. If you’re anticipating tax troubles on the horizon, it is always best to go ahead and file a tax return. Failure to do so can result in the IRS preparing a “Substitute for Return” and wildly overestimating your tax bill. If the Substitute for Return becomes final and the taxes are formally assessed, you just lost your ability to discharge your tax debts in bankruptcy. Section 523 of the bankruptcy code provides as follows:

(a) A discharge under section 727 . . . of this title does not discharge an individual debtor from any debt —(1) for a tax or a customs duty — . . .(B) with respect to which a return, or equivalent report or notice, if required —(i) was not filed or given. . . .

This provision serves as a warning to debtors: failure to file a tax return will not only cause you to incur penalties and fees, it can jeopardize your rights in bankruptcy.

In Re Smythe

A decision out of the United States Bankruptcy Court in Tacoma, Washington, In Re Smythe, holds that debtors who fail to file a tax return before the IRS issues an assessment have just lost their ability to discharge assessed taxes in bankruptcy. The facts of the Smythe case are fairly straightforward: the Smythes filed for chapter 7 bankruptcy seeking to discharge income tax debts for 1999-2004. The IRS conceded that the 03′ and 04’taxes could be eliminated, but argued that the taxes for 99′-02 were non-dischargeable because assessments were made before the debtors filed 1040s. The IRS argued that it was their assessment, not the subsequent filing of the 1040, that created the tax debt. The IRS assessed debt was one in which no return was filed or given, therefore the debts were non-dischargeable under section 523. The Court agreed with the IRS argument:

Given the plain language reading of “debt” in the Bankruptcy Code and the holding inWogoman, the Court agrees with the I.R.S.’s argument. When the I.R.S. made tax assessments against the Debtors, the Debtors’ tax obligations became enforceable and the I.R.S. could pursue its claims; therefore, the assessments created “debt[s]” as defined in the Bankruptcy Code. Although the Debtors subsequently filed Forms 1040, the tax debts had already been established by the I.R.S. assessments. The tax debts, therefore, are debts “for which no return was filed,” and are nondischargeable under § 523(a)(1)(B)(i)

The Bottom Line

Even if you can afford to pay your tax bill, failing to file a tax return is not a good idea. In addition to the penalties that the IRS charges for late payment, they also charge additional penalties for late filing. Not to mention the fact that technically, failing to file a tax return is a crime. there isn’t a worse creditor to own money to them the government, letting tax problems faster can not only increase penalties but jeopardize your ability to shed these debts through bankruptcy.

Federal Tax Liens can’t be discharged. If the IRS recorded a tax lien on your property before you file for bankruptcy. You’ll have to pay off the tax lien, which you may be able to do in Chapter 13.

Get in tax trouble and the penalties often grow huge.

What starts as a manageable problem can soon tower over you.

Breathe deep;  there is a solution.

Chapter 13 bankruptcy can cut tax penalties down to size.

All tax penalties discharged in 13

Old or new, large or small, Chapter 13 discharges all unsecured tax penalties.

In contrast, Chapter 7 discharges some tax penalties.

Also dischargeable in Chapter 7 are penalties where the transaction or event that triggered the tax occurred more than three years before filing, whether or not the tax itself is dischargeable.  523(a)(7)(B).

That’s good, but if you are eligible, Chapter 13 is better.  All penalties are discharged.

Who can file Chapter 13

Chapter 13 is available to individuals (no corporations or LLC’s), with regular income, whose debts total less than the caps for secured and unsecured claims.

You know if you are a real person and whether you have regular income, so the thing that needs analysis is the allocation of your debts between those that are unsecured (the creditor has no lien on your assets) versus the debts for which there is a lien.

To be a secured claim in bankruptcy, that lien has to attach to an asset that has market value greater than any liens senior to it.

Tax liens don’t go to the head of the line just because they are debts owed to the government.  They fall in line behind any other lien holder who perfected their lien before.

Recent taxes must be paid

Chapter 13 plans are written by the person who has filed the bankruptcy case.  The Bankruptcy Code requires, however, that recent income taxes be paid in full through the plan.

Note that it is the TAX and the INTEREST on that tax that have to be paid during the life of the Chapter 13.

Penalties get treated just like personal loans, medical bills, and credit card debt:  what that class of creditors gets in the Chapter 13 is driven by the means test and the best interests of creditors test.   In most Chapter 13 plans, that’s little, or nothing.

Chapter 13 cuts those penalties down to size.

Tax liens whittled down

The discussion above deals with unsecured taxes and tax penalties.  The rules change when a tax lien is filed.

At its simplest, a Chapter 7 discharge eliminates the IRS’s ability to levy your bank account or garnish your wages for taxes that have been discharged.

However, the Chapter 7 discharge doesn’t alter any tax lien recorded before the bankruptcy, even if the taxes themselves are discharged.

If the tax liability is discharged, any lien in place will not attach to assets you acquire after your bankruptcy is filed.

Chapter 13 does alter tax liens.  (See why I’m a fan of 13?)

Chapter 13 treats as a secured claim only that part of a lien that attaches to real value in the taxpayer’s assets.

Put bluntly, if you don’t have any assets, then the lien is worthless and will be voided at the conclusion of your Chapter 13 plan.

Oh, technically,  the tax lien may attach to your household goods, all right.  But those things have very little market value.

Pay the resale value of your pots and pans through the Chapter 13 plan, and the lien is deemed satisfied.

If you can’t cut a deal with the IRS that eliminates the tax penalties as part of an offer in compromise or payment plan, you have bankruptcy options for tax penalties.