Paying Your 2012 Income Taxes on the Backs of Your Other Creditors

If you expect to owe 2012 income taxes, and you file bankruptcy after Dec. 31, that tax can be “included” in your case.  

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An income tax debt that you owe for the 2012 tax year presents both some challenges and opportunities if you file bankruptcy in early 2013. The challenges are practical ones. You have a debt that you wish you didn’t have, it can’t be written off (discharged) in bankruptcy, and you may well not know how much it is because you haven’t prepared the tax return yet. So it can be a frustrating and scary uncertainty.

The interplay between taxes and bankruptcy can be complicated, but let this inspire you: in the right circumstances your 2012 income tax debt can be—believe it or not–paid in full essentially without costing you anything. That’s because under bankruptcy law in many circumstances recent tax debts are paid in place of your other creditors, leaving less or nothing for those other creditors. If effect you are paying a tax debt which you would have to pay out of your own pocket after bankruptcy with an asset which would otherwise go to debts which you would be written off in your case. This can happen in both Chapter 7 and Chapter 13, much more likely under that latter. This blog shows how your taxes can be paid in an “asset” Chapter 7 case, and the next blog shows the more common Chapter 13 situation.

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Payment of 2012 Income Taxes in an “Asset” Chapter 7 Case

Most Chapter 7 cases are “no asset” ones. This means that the bankruptcy trustee takes nothing from you because everything you have is exempt or else not worth the trustee’s effort to collect. So none of your creditors—including the IRS—are paid anything through your Chapter 7 case itself.  In that situation, you would have to make arrangements to pay any 2012 income tax with the IRS (and/or any state tax agency, if applicable).

On the other hand, an “asset” Chapter 7 case is one in which you own something that is NOT exempt and IS worth for the trustee to collect, sell, and distribute its proceeds to the creditors. Some of the time that may not be the result that you’d want—most debtors are hoping to keep everything they own and not have any of their assets go to their creditors. But in other situations, surrendering a particular asset or two may in fact be a very good strategy.

The Example

Consider this. You own something that you truly do not need. A boat that has become more expensive and more work to own than you’d expected. Or business equipment from a business you’ve given up on. And you owe some 2012 income taxes. In a Chapter 7 case, if you do not claim an exemption on those assets and your bankruptcy trustee believes the boat or the business equipment are worth collecting from you and selling, then the 2012 taxes are among the first debts that the trustee will pay out of the proceeds. Although most of your creditors are paid pro rata—equally, based solely on the relative amount of their debts—the “priority debts” are paid ahead of your other creditors. So, assuming you do not have any debts that are even higher on the priority list (see Section 507 of the Bankruptcy Code), your 2012 IRS/state income tax will be paid in full before the trustee pays anything to any of your other creditors. As a result you would no longer have this tax to pay after your Chapter 7 case is completed.

Notice what would happen in this scenario if you did NOT owe this 2012 tax debt. The trustee would simply pay that same money towards all your other debts, all or most of which would likely be discharged in your bankruptcy case. So here you are using an asset that you don’t need in order to pay a debt that you would have had to pay after your bankruptcy. You are not using that asset to pay other debts that you would simply have been written off in the bankruptcy. You are putting your unnecessary asset to very good use when you pay off the 2012 taxes.

Caution

For this to work as described takes just the right conditions, with more twists and turns than can be fully explained here. So definitely discuss all this thoroughly with your bankruptcy attorney.

But if you do owe 2012 (or any other recent) income tax, and have some non-exempt assets that might be worth giving up, this procedure is worth a closer look. It may be particularly helpful if you are on the fence trying to decide between filing a Chapter 7 and 13. Compared with spending three years or more trying to preserve an asset and/or to pay some income taxes under Chapter 13, paying some (or all) of your taxes with that asset through Chapter 7 may well be the much more sensible option.

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