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How Bankruptcy Handles . . . The Threat of a Recorded Income Tax Lien

The IRS or state recording a tax lien can be very damaging in many ways. Bankruptcy can prevent that damage.



The Effect of a Recorded Tax Lien

The IRS or state tax authority recording of an income tax lien can have hugely bad consequences for you, both outside and inside bankruptcy. Unlike most creditors, these liens can encumber your home, your vehicle and other personal effects, your business assets, all without a lawsuit being filed.

A record of the tax lien goes onto your credit record, accessible not just to other creditors, but also to prospective employers and insurers. It’s likely more damaging than most adverse credit events because it tends to brand you as a tax cheat, even if unfairly so.

And worse than much of what’s on your credit report, the record of your tax lien is part of the public record, accessible to anybody. Any friend or foe, relative or ex-spouse, all can easily find out that you are seriously behind on your taxes. Indeed, in many parts of the country tax liens for both individuals and businesses are published in a local business newspaper.

Tax Liens Can Even Hurt in Bankruptcy

The next two blog posts will explain how Chapter 7 and Chapter 13 handle tax liens that are recorded before the bankruptcy case is filed (and thus are not prevented from being recorded). For now, understand this fact: the recording of a tax lien can often turn a tax debt that could have been completely discharged (legally written off) without paying anything, into one that has to be paid in full, plus additional interest and penalties. So if you are at any risk of a tax lien being recorded against you, it is very important that you get legal advice about the potential benefits of filing bankruptcy, both to stop the tax lien from being recorded and to deal with the tax debts themselves.

Bankruptcy Prevents the Recording of a Tax Lien Either Temporarily or Permanently

The federal law that prevents the recording of a tax lien as soon as you file a bankruptcy case is the same law—the “automatic stay”—that stops virtually all creditor activity against you and your assets at that point.

The “automatic stay” lasts in a Chapter 7 “straight bankruptcy” case usually only about three months. That’s long enough to either discharge most debts or to figure out what to do with those special debts that are not being discharged—such as the vehicle loan you want to keep making payments on or the back child support that needs to be caught up.

Each income tax, as we explained in our last two blog posts, will either meet the conditions for getting discharged or will not. If it is does get discharged, that will happen right before the “automatic stay” expires. After its discharge the debt is legally unenforceable and so there is no longer any tax for a tax lien to be recorded on. Plus it would be completely illegal for the IRS/state to try to do so. Besides the fact that such a lien would be ineffective, the IRS/state would get slapped pretty hard. So they simply don’t file liens on a tax after that tax debt is discharged.

But if you file a Chapter 7 case and owe a tax that does not meet the conditions for discharge, that tax debt will survive after the Chapter 7 case is over and the “automatic stay” has expired. After that a tax lien could possibly be recorded against you on that tax. That’s why people in this situation need to be prepared to quickly enter into a payment plan with the IRS/state to pay off that surviving income tax debt. Or sometimes the tax debt can be reduced and paid off through a formal compromise, or possibly put into an uncollectible status. Often these procedures will prevent a tax lien from being recorded.

However, if you have income tax debts that would not be discharged in a Chapter 7 case, and are too large to pay off in monthly payments and are not eligible for compromise or for being uncollectible, you likely need the much greater protection of a Chapter 13 “adjustment of debts” case. Under Chapter 13 the “automatic stay” generally lasts the entire length of a 3-to-5-year payment plan. The IRS/state cannot record a tax lien throughout that time on any tax that was due as of the time the case was filed. Instead you have that period of protection to pay off the tax, through monthly payments based on your budget and usually without any accruing interest and tax penalties.

In a Nutshell

Bankruptcy prevents the recording of tax liens. Chapter 7 does so and then either entirely discharges the tax, or frees you up so that you can pay off the tax in installments, or can compromise the tax, or get it into an uncollectible status. Otherwise, Chapter 13 protects you and reduces how much you have to pay to pay off the tax. Either way, you can usually prevent a tax lien from being recorded, avoiding all the adverse consequences of that happening.


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