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The first few weeks of April means that many–if not most–Americans are thinking about their state and federal tax obligations. Some taxpayers are fortunate enough to receive a federal or state income tax refund. However, others may find themselves facing a hefty tax bill due to their withholding election or for other reasons. One reason why taxpayers often face large, unexpected tax bills is because they are self-employed and fail to account for self-employment taxes and other expenses. In other cases, tax mistakes from previous years may catch-up with the taxpayer due to an IRS or FTB audit. Penalties and interest imposed can create large and unmanageable tax obligations.  

Some people have the mistaken notion that taxes can never be discharged through bankruptcy. This is an unfortunate (and mistaken) assumption to have because bankruptcy relief is often available to address tax liens and other tax problems. However, the intersection of tax law and the U.S. Bankruptcy Code is complex. Taxpayers should not typically attempt a tax-motivated bankruptcy without first consulting with an experienced Sacramento bankruptcy attorney who has both tax and bankruptcy knowledge.

Are Taxes Dischargeable in Bankruptcy?

The bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was a comprehensive reform of the U.S. Bankruptcy Code that tightened up the Code in many ways. One may be aware that the typical forms of consumer bankruptcy are Chapter 7 and Chapter 13 bankruptcy. While there used to be a difference in the dischargeability of taxes between Chapters 7 and 13, that distinction largely disappeared with the reform. Today, the main factors that control whether bankruptcy can discharge or wipe away your tax debt is the age of the tax debt and how it arose.

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While certain types of taxes are typically dischargeable, others are not. For instance, employment taxes and certain sales taxes are not dischargeable. That is to say, there is a general presumption against taxes known as “trust fund” taxes. These taxes are collected by individuals and business owners and held “in trust” for the government. By contrast, income taxes and other non-trust fund taxes are potentially dischargeable.

Typically, old tax debts are dischargeable, provided that they meet certain characteristics. Typically an income tax debt is dischargeable when the tax return giving rise to the underlying tax debt was filed at least two years prior to the intended bankruptcy filing, and the return was supposed to be filed at least three years prior to the filing. In addition, the tax return must have actually been filed, and the liability must have been assessed a minimum of 240 days before the filing. Finally, the taxpayer is only eligible for discharge if (s)he did not engage in fraud or evasion. Thus, older income taxes are typically discharged while more recent tax debts do not have that ability.

Bankruptcy and Tax Liens

If you are considering filing bankruptcy to handle tax liens, the news is generally less positive. A tax lien is a security interest that is used to improve the IRS’s ability to collect on a tax debt. Essentially, when the IRS records a tax debt against your property, it is a way for the agency to transform the debt into a secured debt. However, notice is required before the IRS can record the lien. If you’ve received an IRS notice or letter, it is prudent to consult with a tax attorney to see if anything can be done before the lien is recorded.

To start, if the IRS has not yet recorded liens against your property the automatic stay can stop the IRS from doing so and force it to engage in the bankruptcy process. If your tax debt is eligible for discharge, as described above, you may end up being able to wipe away significant amounts of your debt.

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However, if the lien was recorded prior to your bankruptcy filing, it is generally non-dischargeable under Chapter 7 bankruptcy. Chapter 7 bankruptcy is well-suited in dealing with unsecured debts like credit card bills, but it is still less effective or ineffective at eliminating secured debts. In many cases, the taxpayer will need to handle the tax lien following the close of the bankruptcy case. The IRS may be willing to negotiate a payment plan or provide for an offer-in-compromise with the taxpayer. As an alternative, the taxpayer can also explore the possibility of using Chapter 13 bankruptcy to pay the tax lien over a three-to-five-year payment plan.

Discuss Options with a Sacramento Bankruptcy Lawyer

The Sacramento bankruptcy lawyers of The Bankruptcy Group can help Sacramento, Roseville, Folsom, and other local taxpayers better understand their bankruptcy options when facing a large tax debt. If you are considering a tax-motivated bankruptcy, call 1-800-920-5351 today or contact us online.