October Tax Season: Does Bankruptcy’s “Automatic Stay” Stop Tax Collection, Including Garnishments, Tax Levies and Liens?

With very few limited exceptions the IRS/state must stop all collection activity, from the beginning to the end of your bankruptcy case.

 

The IRS and Your State Tax Authority Are Just Regular Creditors

You’ve no doubt heard that income taxes are treated in special ways in bankruptcy, in ways more favorable for the tax creditors—the IRS and the state tax authorities. For example, a tax debt can’t be “discharged”—legally written off in bankruptcy—unless it meets a series of conditions.

However, for most practical purposes taxes are treated like any other debt in that the IRS and state must stop collecting all past due tax debts as of the moment your bankruptcy case is filed.  They are forbidden to start or continue any activity against you or your property to collect a tax debt.

The Protection You Get

It’s worth being specific about what the IRS and state would normally be able to do but can’t once you file your bankruptcy case. The consequences of some of their collection methods are worse than you might expect. So it can make a lot of sense to file bankruptcy to prevent them from happening.

Garnishment of Paychecks and Bank Accounts

Filing bankruptcy stops the IRS and/or the state from grabbing money out of your checking or savings account, or out of your paycheck.

You might think that, although such garnishments would hurt, since you have to pay it anyway at least this way the tax debt is getting paid. That may not be a sensible way of looking at tax garnishments.

Let’s put aside the huge financial disruption these garnishments would cause, and the fact that as a result your employer and financial institution would find out that you owe back taxes to the government. The fact is that the money grabbed would often be going towards taxes that do not need to be paid.

The main consideration in whether an income tax can be discharged in bankruptcy is how old it is. Often, by the time the tax authorities are garnishing your accounts or paycheck the tax at issue would be able to be discharged in either a Chapter 7 or Chapter 13 bankruptcy case. So not only are such garnishments painful, they may be completely avoidable.

Also, even if the tax has not yet met the conditions for discharge, under Chapter 13 you may well not have to pay some or all of the accrued tax penalties. So to the extent that the money being garnished from you is going to pay a tax penalty, that may be money being wasted as well.

Levy on Your Possessions

The IRS/state have the power to grab most of your assets and possessions in payment of back income taxes. Filing bankruptcy stops such tax levies.

Not only may the tax and/or the penalty being paid through the levy process not need to be paid at all—as described above. But even if the tax being paid is one that you would have to pay, your seized assets would likely be sold by the IRS/state for relatively little—often only a small fraction of what they are worth to you. So, precious little of the tax would get paid through this process.

Furthermore, there is not much of yours that the taxing authorities can’t grab. In contrast, under bankruptcy most people can “exempt,” or protect, all or most of what they own.

So, the IRS/state taking your assets from you to collect on a tax is a very bad way to go because it is a dreadfully inefficient way to pay a tax or tax penalty, uses your assets which could otherwise likely be protected in bankruptcy, and which is going towards a tax or penalty that may not even need to be paid at all.

Recorded Tax Lien

If the above two collection methods sound bad, the recording of a tax lien could in certain situations be the worst. So the fact that filing bankruptcy stops the recording of a tax lien can be extremely beneficial to you.

At first glance tax lien recording sounds relatively mild. A recorded tax lien simply creates a security interest upon your assets in the amount of the tax debt. By taking this action the IRS/state do not seem to be taking anything tangible away from you immediately, unlike with a garnishment or levy.

But the mere recording of a tax lien can make the difference between a tax debt you would not have to pay at all and one that you would have to pay in full.

That’s happens if you have a tax debt that meets the conditions for being discharged in bankruptcy, but you also own property and/or possessions that a tax lien would attach to, and that property/possessions have equity exceeding the amount of the tax debt. The property and possessions could be protected under bankruptcy law—meaning they would not need to be surrendered to pay your creditors—but they would not be protected from a tax lien. So, even though the tax debt could be fully discharged in bankruptcy—written off without paying anything on it—the tax lien attached to your property and possessions would survive the bankruptcy. You’d have to pay the tax in full or at least in part in order to get the IRS/state to release its lien.

However, if you file your bankruptcy case before the IRS/state record a tax lien on the tax that can be discharged, that tax debt would indeed be discharged in that bankruptcy case. That means that you’d usually pay little or nothing on that tax debt.

 

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