In acknowledgement of the passing of “tax day”, we thought that we would address the treatment of income taxes in bankruptcy.[i] Many consumers seek bankruptcy assistance because of income tax problems. While income taxes are afforded special protection in bankruptcy, there are some instances where they can be eliminated. Even if they cannot be eliminated, a personal bankruptcy may offer the opportunity for an affordable payment plan. However, before tax issues can be addressed in a bankruptcy, there are certain criteria which must be met.
A consumer cannot file a bankruptcy unless they are up to date in their tax filings. Unfiled tax returns with either the Internal Revenue Service or the Georgia Department of Revenue can be grounds for the dismissal of a bankruptcy case. Not only must the returns be filed, but they must also be accurate. A common mistake made by consumers is to assume that they are not responsible to report self-employment income or “cash” income. Some consumers also forget to report income received as an independent contractor or “1099” employee. The reason for accumulation of much of the income tax debt in cases that we review is that consumers either: 1)failed to file returns as required; 2) filed returns late; and/or 3) filed incomplete or inaccurate returns. Remember that just because taxes are not withheld from your pay does not mean that the income will not be disclosed to the taxing authorities. It is also important to remember that you must file the returns, even if you do not have the money available to pay the income taxes due for those returns. Otherwise, you will generate penalties for not timely filing the returns, which will only increase the eventual amount of the tax debt.
Income taxes can be eliminated (discharged) in a Chapter 7 bankruptcy if they are over 3 years old. However, that time period runs from when the taxes were due, and not when they were filed. For instance, 2010 income tax returns were due on April 18, 2011. For purposes of calculating their age in a subsequent bankruptcy proceeding, those income taxes would not be considered to be over 3 years old – and therefore dischargeable – until April 19, 2014. However, the time period can be extended for many reasons including: 1) the request of an extension of time in which to file the returns; 2) the filing of an amended return; 3) an audit or correction by the taxing authority; 4) negotiation of an offer and compromise; 5) an intervening bankruptcy; 6) filing an inaccurate of fraudulent return; or 6) failure to file the returns when due. Finally, even if the taxes are subject to discharge, any tax liens in place may still survive the bankruptcy. While the taxing authorities would be prevented by the bankruptcy discharge from collecting the debts directly from the consumers (through wage garnishment or refund offsets), the liens would have to be satisfied if the property subject to the liens was ever sold or transferred. Every case is different, and there may be other factors not on this list which may affect the ability of a consumer to discharge their income tax debt. In discussing tax issues with your bankruptcy attorney, make sure that you discuss any issues identified above that may affect the potential discharge of your income tax debt.
Even if income taxes cannot be discharged, either because of their age or other factors, they may be subject to repayment in a Chapter 13 bankruptcy. A Chapter 13 bankruptcy is a court-supervised repayment plan, which allows a consumer to repay their debts over a 3-5 year period. The advantage of paying income taxes in a Chapter 13 case is that it will prevent the accumulation of interest and penalties while the case is pending. This allows the consumer to see an immediate reduction in the amount of tax debt, as opposed to payment plan made direct with the taxing authority, which still allows for the assessment of interest. While tax liens will survive a Chapter 7 bankruptcy, they can be paid in a Chapter 13 case. This means that the consumer would emerge from the Chapter 13 case free of the tax debt and the liens, which many times makes a Chapter 13 case preferable, even if the taxes could be discharged in a Chapter 7 case. However, the consumer in any Chapter 13 case must have adequate monthly income to maintain the Chapter 13 payments, while still managing their ongoing expenses. A high amount of income tax debt, coupled with low or inconsistent monthly income, often prohibits consumers from being able to file a Chapter 13 case.
In summary, an ounce of prevention is worth a pound of cure. Using a tax professional is highly recommended in the filing of tax returns, and absolutely necessary if you own or operate your own business. Likewise, full disclosure of income is essential to avoiding income tax problems. Many times a consumer will overlook income in the filing of a tax return, but will also overlook credits and deductions which would offset the tax consequences of the additional income. This is where the assistance of a tax professional can be invaluable. But if the prevention of tax problems is unsuccessful, keep in mind that there may be some relief available in the bankruptcy courts.
[i] This essay is not intended to offer, suggest or provide any tax advice. Please consult an accountant or other tax professional about any tax advice.