How Chapter 7 bankruptcy can help you with an IRS tax debt

by Howard S. Levy, Esq. on August 26, 2012

in Bankruptcy - Chapter 13, Bankruptcy - Chapter 7, Bankruptcy and the IRS, Cincinnati

Chapter 7 is for you if you do not have any money left at the end of the month to repay your creditors.  It is designed to give you a fresh start from honest mistakes you made in your finances – too much credit card debt, medical bills, a failed business and yes, unpaid taxes.  If you qualify for the Chapter 7, when your case is over, these debts will be discharged – meaning that creditors can no longer involuntarily collect them from you.

A Chapter 7 is known as a liquidating bankruptcy.  If you have property with equity, you could lose that property to a bankruptcy trustee, who will sell it and pay the proceeds to your creditors.  Equity is the cash that would result from a sale of your property.  Most Chapter 7 bankruptcies are known as no asset cases because there is not enough equity in your property to result in any meaningful payment to creditors.

Most people filing a Chapter 7 do not lose any property because of laws that protect it. These laws are known as exemptions, and are intended to ensure that you come out of Chapter 7 with property that is essential for day-to-day living.  For example, Ohio law protects up to $3,225 of equity in a car, $20,200 of equity in your house and $10,775 in household goods. There are also protections for money in your bank account, jewelry and retirement accounts. A Chapter 7 generally lasts between 4-6 months.  The bankruptcy filing lists all of your assets and their garage sale value, your monthly income and living expenses, and your creditors. There is a meeting with a bankruptcy trustee about 5 weeks after you file, where you will be asked questions under oath about your property and financial affairs, primarily to verify that you have been honest in what you have listed in your filing.  This takes about 10 minutes, on average.  Creditors can also attend this meeting and ask you questions, but this is fairly uncommon.

If you have been honest, are truly experiencing a hardship in repaying your creditors, and have no assets of value past exemptions, you should pass through the meeting successfully. The bankruptcy trustee works for the Department of Justice, and is appointed to ensure you qualify for the benefits of a fresh start, to ensure that your creditors are treated fairly, and, in situations where there are assets of value, to work to recover them from you. After the meeting with the bankruptcy trustee, the trustee and creditors have 60 days to object to your bankruptcy.  Again, this is the exception for honest people who cannot afford to repay their debts.  After the 60 days expires, the court is then able to issue your discharge, and your case is then closed and over.

With that background, let’s address the impact your Chapter 7 bankruptcy could have on the IRS. Taxes can be eliminated in a Chapter 7 bankruptcy.  There are a few rules to keep in mind, though:

  1. You must have filed a tax return (estimated filings by the IRS, known as substitute for returns, rarely count);
  2. Your return must have been filed 2 years before the bankruptcy;
  3. Your return must have been due to be filed 3 years before the bankruptcy (including extensions);
  4. The IRS must have put the money you owe on their books 240 days before the bankruptcy (usually in audit situations);
  5. You must owe income taxes.  Trust fund taxes are cannot be eliminated in a Chapter 7.
  6. There cannot be fraud involved in your tax return.  Taxes due from fraud cannot be eliminated in bankruptcy.

Eliminating taxes in bankruptcy, then, is mainly an issue of timing – filing the bankruptcy when the taxes are old enough to be eligible for a discharge. Taxes are given a priority in the bankruptcy code that requires a few more hurdles than, say, credit cards, which are not given a priority.  You could file bankruptcy today and eliminate credit cards.  Taxes, due to the nature of being a debt owed to the government, require a little more planning and footwork.

A benefit to using a Chapter 7 on the IRS is that you are relying on bankruptcy law and timing issues, not the good graces of the IRS to give you a fresh start from an offer in compromise. Also, a compromise can take at least a year to be reviewed by the IRS; Chapter 7 takes half that time. If the IRS filed a tax lien before your bankruptcy, they do not have to take it off after the bankruptcy is over.

Bankruptcy eliminates the IRS’ ability to collect the debt – take your wages, bank accounts, etc.  It does not force the IRS to remove a tax lien, although in no assets cases the IRS may release the lien as it has no value.  If there is a lien and the IRS does not release it, it is good for 10 years, and in most cases will just sit, not enforced (as you have no property to enforce it against) and then expire. Chapter 7 can be a powerful tool for you to eliminate debt without repayment, including the IRS, and get a fresh start in your finances.

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