Bankruptcy and Taxes

The treatment of taxes in bankruptcy is a complicated topic, but some rules of thumb apply.

Income taxes (federal or state) are generally not dischargeable in bankrputcy unless the returns have been filed, the taxes are old enough (usually 3+ years old) AND there is not a valid tax lien filed in a county where property (with any meaningful value) is held. However, a chapter 13 bankruptcy is an excellent way to pay back income taxes, because all future penalties and interest are stopped upon the filing and completion of a chapter 13 plan — no more chasing a moving target! When you consider that penalties and interest often make up a large portion of the overall tax debt, stopping those from accruing in the future is a substantial benefit.

Income tax returns are filed as normal during bankruptcy, and tax refunds are generally considered “income” in both chapter 7 and chapter 13 that may or may not be kept by the bankrupt debtor.

Sales and Payroll Taxes are almost NEVER dischargeable, as these are taxes collected by the debtor “in trust” for the taxing authority — for example, an employer that withholds taxes from employees’ paychecks. Government agencies are particularly aggressive (understandably so) in collecting these types of ‘trust fund’ taxes, making a chapter 13 particularly attractive as a way to reimburse the taxing authority without causing a shutdown of the business or loss of property.

Property taxes (both on land and personal property) are different from other taxes in that they are linked to the property; taxing authorities here (usually cities, counties, school districts, etc.) typically get an automatic “lien” or security interest against the taxed property to ensure payment. This means that taxes always get paid first, even before mortgages. Assuming that keeping the property is a priority, a chapter 13 bankruptcy can be a way to maintain the property while paying the taxing authority.

In a nutshell, then, while bankruptcy can’t eliminate many taxes, it can provide a way to pay them over time in a more affordable manner, making bankruptcy a worthwhile option for those debtors that have had a temporary setback but have a future ability to pay down the tax debt.