In many cases, taxpayers can potentially use bankruptcy to stop IRS forced collection.
Navigating the murky waters of tax debt can be daunting, especially when the IRS is involved. Fortunately, bankruptcy can be a lifeline for those struggling under the weight of tax obligations. Let’s explore how bankruptcy can provide relief and the different types of bankruptcy available to taxpayers.
Understanding Bankruptcy and Taxes
The Ninth Circuit, which includes California and Nevada, is known for being particularly favorable to debtors. This means that filing for bankruptcy in this circuit can often lead to significant relief from tax debts. Depending on the situation, bankruptcy can either eliminate tax debts entirely or provide the taxpayer with additional time to repay what is owed through a structured plan.
The Automatic Stay: Immediate Relief
One of the most attractive features of bankruptcy is the automatic stay. The moment you file for bankruptcy, the automatic stay goes into effect, immediately halting collection efforts by the IRS and state tax agencies. This means they must release any wage garnishments or bank levies they have placed on you. It’s a powerful tool that provides immediate breathing room for those under financial duress.
Types of Bankruptcy
There are two main types of bankruptcy that can be utilized to manage tax debts: Chapter 7 and Chapters 11, 12, and 13.
Chapter 7: Straight Bankruptcy
Chapter 7 bankruptcy, also known as “straight bankruptcy,” involves the liquidation of assets to pay off debts. For those who qualify, this can mean a complete discharge of income tax debts, assuming certain conditions are met. It’s a powerful tool for wiping the slate clean and getting a fresh start.
To discharge tax debts under Chapter 7, specific criteria must be met:
- Type of Taxes: Only income taxes or non-trust fund payroll or sales taxes can be discharged. Trust fund payroll taxes, trust fund recovery penalties, and fraud penalties cannot be eliminated.
- No Fraud or Evasion: You must not have filed a fraudulent return or willfully attempted to evade taxes.
- Three-Year Rule: The tax returns must have been filed at least three years before the bankruptcy petition date.
- Two-Year Rule: All tax returns must have been filed at least two years before filing the bankruptcy petition. Substitute for Returns (SFRs) do not count; without filing a tax return, taxes cannot be discharged.
- 240-Day Rule: The taxes must have been assessed at least 240 days prior to filing the petition.
Chapters 11, 12, and 13: Repayment Plans
Chapters 11, 12, and 13 offer a different approach. These types of bankruptcy allow for the creation of repayment plans, which can extend over several years. The repayment plans can sometimes result in paying only a fraction of the total debt owed. This option can be particularly beneficial for those who need more time to get their finances in order without the immediate threat of IRS enforcement actions.
Chapter 13 Bankruptcy: Structured Repayment
Chapter 13 bankruptcy, known as a wage earner’s plan, allows individuals with a regular income to develop a plan to repay all or part of their debts over three to five years. This type of bankruptcy can be particularly beneficial for managing tax debt because it stops interest and penalties from accruing on unpaid taxes once the bankruptcy petition is filed.
Key Benefits of Chapter 13 for Tax Debtors:
- Stops Penalties and Interest: Upon filing, penalties and interest on tax debts are frozen.
- Structured Repayment: Allows for manageable payments, potentially at a fraction of the total debt owed.
- Automatic Stay: Immediately stops IRS and state tax collection actions, including wage garnishments and bank levies.
However, the downside of Chapter 13 is that it requires strict adherence to the repayment plan, which can be challenging for those living paycheck-to-paycheck. The default rate for Chapter 13 plans is over 90%, indicating that many filers struggle to complete the plan.
Chapter 11 Bankruptcy: Business Reorganization
Chapter 11 is typically used by businesses that need to restructure their debts to continue operating. This form of bankruptcy allows companies to reorganize their financial affairs under the bankruptcy court’s supervision.
Advantages of Chapter 11 for Businesses:
- Debt Reorganization: Enables businesses to restructure their debts and operations.
- Protection from Creditors: Provides a legal framework to negotiate with creditors while maintaining operations.
However, Chapter 11 can be expensive and time-consuming, often requiring significant legal and administrative costs.
How Bankruptcy Can Help
Filing for bankruptcy not only addresses tax debts but also provides immediate relief from collection efforts. This can stop wage garnishments, bank levies, and other aggressive collection tactics used by the IRS and state tax agencies like the Franchise Tax Board, Employment Development Department, and California Department of Tax and Fee Administration. By halting these actions, bankruptcy gives taxpayers the breathing room they need to develop a manageable repayment plan or achieve debt discharge.
The Downsides of Bankruptcy
While bankruptcy can provide significant relief, it’s not without its downsides. Here are some of the potential drawbacks:
Impact on Credit Score
First and foremost, filing for bankruptcy is quite damaging to your credit. It can result in a significant drop in your credit score, often by 200 points or more. The bankruptcy filing remains on your credit report for up to ten years, which can affect your ability to secure loans, credit cards, and even housing.
Public Record
A bankruptcy filing is a matter of public record. This means that the details of your financial situation are accessible to anyone who wants to look them up. Additionally, while federal and state tax liens on real property survive bankruptcy, they are no longer shown on major credit reports.
Tolling of the Collection Statute
Another downside is that the collection statute on any taxes not discharged is tolled for the duration of the bankruptcy plus an additional 180 days. Normally, the IRS has ten years to collect back taxes, penalties, and interest. However, this period is extended by the time you are in bankruptcy plus six months, giving the IRS more time to pursue collection.
State Taxes and Bankruptcy
State taxes, similar to federal taxes, can be discharged under specific conditions in bankruptcy proceedings. For example, in states like California and Nevada, sales taxes can be discharged if they meet certain criteria. These criteria include the three-year, two-year, and 240-day rules.
The three-year rule requires that the tax return was due at least three years before filing for bankruptcy. The two-year rule mandates that the tax return was filed at least two years before the bankruptcy filing. The 240-day rule stipulates that the taxes were assessed at least 240 days before the filing.
Meeting these conditions can offer significant relief to individuals and businesses facing financial distress. State tax agencies are known for their aggressive collection tactics, often employing stringent measures to recover owed taxes. The ability to discharge these taxes in bankruptcy can provide a much-needed reprieve, allowing debtors to reset their financial situations without the constant pressure from state tax collectors. This provision can be especially beneficial in states with high tax rates and rigorous enforcement practices, helping taxpayers to regain stability and work towards financial recovery.
What Happens to Tax Liens?
When filing for bankruptcy, it’s crucial to understand the distinction between discharging personal liability for tax debts and addressing tax liens. While bankruptcy can eliminate your personal obligation to pay certain tax debts, it does not automatically remove tax liens placed on your property by the IRS or state tax agencies.
Tax liens are legal claims against your property due to unpaid tax debts. These liens remain attached to any equity in your property, even after the underlying tax debt has been discharged through bankruptcy. As a result, the lien continues to encumber the property, meaning that the tax authorities retain a secured interest in the property’s value.
The presence of a tax lien can significantly impact your financial flexibility. For instance, it can limit your ability to sell or refinance the property. Potential buyers or lenders will see the lien and recognize that the tax authorities have a claim on the property’s equity. This can complicate or even halt sales and refinancing efforts, as any proceeds from such transactions would first go towards satisfying the lien before you can access any remaining funds.
Additionally, the process of dealing with tax liens after bankruptcy can be complex. To fully address the lien, you may need to negotiate with the IRS or state tax agency, potentially paying off the lien in full or settling for a reduced amount. Alternatively, you might explore legal avenues to challenge the lien, though this can be time-consuming and require legal assistance.
Bankruptcy and Asset Disclosure
When filing for bankruptcy, transparency is of utmost importance. Full disclosure of all assets is not just a procedural requirement but a legal obligation. Concealing assets can lead to severe consequences that undermine the entire bankruptcy process and jeopardize the debtor’s financial future.
One of the primary roles of the bankruptcy trustee is to oversee and verify the accuracy of the debtor’s financial information. The trustee will meticulously scrutinize your financial transactions, including property transfers, bank account activities, and any other pertinent financial dealings. This scrutiny is intended to ensure that all assets are properly accounted for and that the bankruptcy process is conducted fairly for both the debtor and the creditors.
Failing to disclose assets or attempting to hide them can result in a range of severe penalties. The bankruptcy court has the authority to dismiss your case entirely, which means you would lose the protections provided by bankruptcy, such as the automatic stay that prevents creditors from pursuing collection actions. A dismissal can leave you exposed to continued collection efforts, including wage garnishments, lawsuits, and property seizures.
In addition to the dismissal of your case, the court may impose civil sanctions. These sanctions can include fines and the requirement to pay back creditors from undisclosed assets. The financial burden of these sanctions can be significant, further complicating your efforts to achieve financial stability.
Moreover, asset concealment in bankruptcy is considered a form of fraud. If the trustee or court finds evidence of intentional concealment, you could face criminal charges. Bankruptcy fraud is a federal offense, and convictions can lead to severe penalties, including imprisonment and substantial fines. A criminal record resulting from bankruptcy fraud can have long-lasting effects on your personal and professional life, impacting employment opportunities, creditworthiness, and overall reputation.
To avoid these severe consequences, it is crucial to be completely transparent and forthcoming about all your assets when filing for bankruptcy. This includes disclosing real estate properties, vehicles, bank accounts, retirement accounts, valuable personal property, and any other assets you own. Even assets that you might consider insignificant must be reported to ensure full compliance with bankruptcy laws.
Alternatives to Bankruptcy
Bankruptcy is a significant legal and financial step that can have a profound impact on your credit score and future financial opportunities. Before deciding to file for bankruptcy, it’s important to explore alternative options that might provide relief from your financial difficulties without the long-term consequences associated with bankruptcy. Here are some viable alternatives to consider:
Offer in Compromise
An Offer in Compromise (OIC) is an agreement with the IRS that allows you to settle your tax debt for less than the full amount owed. This option is available if you can demonstrate that paying the full amount would create financial hardship or if there is doubt as to the accuracy or collectibility of the debt. To be eligible, you must provide detailed financial information, including income, expenses, assets, and liabilities. The IRS will evaluate your ability to pay, taking into account your unique circumstances. If approved, an OIC can provide substantial relief and help you resolve your tax issues without the need for bankruptcy.
Installment Agreement
An Installment Agreement is a payment plan that allows you to pay your tax debt over time in smaller, more manageable amounts. This option can be particularly useful if you owe a significant amount but cannot pay it all at once. The IRS offers various types of installment agreements, including short-term and long-term plans, depending on the amount owed and your financial situation. By entering into an installment agreement, you can avoid the immediate financial strain of paying a large lump sum and reduce the risk of enforced collection actions such as wage garnishments or bank levies.
Currently Not Collectible Status (CNC)
Currently Not Collectible (CNC) status is an option for individuals who can demonstrate that paying their tax debt would cause undue financial hardship. If the IRS determines that you cannot afford to pay your taxes and cover your basic living expenses, they may temporarily suspend collection activities. While in CNC status, you are not required to make payments towards your tax debt, and the IRS will not pursue collection actions. However, interest and penalties will continue to accrue on the unpaid balance, and the IRS will periodically review your financial situation to determine if you are able to resume payments.
Home Equity Loan or Line of Credit
If you own a home with significant equity, you might consider taking out a home equity loan or line of credit to pay off your debts. This option allows you to borrow against the equity in your home, often at a lower interest rate than unsecured debt. However, it’s important to carefully consider the risks, as defaulting on a home equity loan can lead to foreclosure.
Each of these alternatives to bankruptcy has its own set of requirements, benefits, and potential drawbacks. It’s important to carefully evaluate your financial situation, consider the implications of each option, and seek professional advice to determine the best course of action for your circumstances. By exploring these alternatives, you can find a solution that helps you manage your debt without the long-term impact on your credit and financial future that bankruptcy entails.
Final Thoughts
Bankruptcy can be a powerful tool for managing overwhelming tax debt, but it’s not without its drawbacks. It’s crucial to understand the specific rules and implications for your tax situation before proceeding. Consulting with a tax professional or bankruptcy attorney can help you navigate this complex process and determine the best course of action for your financial future.
By understanding your options and the potential consequences, you can make an informed decision that best suits your circumstances and helps you achieve financial stability.