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The Extraordinary Tools of Bankruptcy: Taking the Bite Out of an Income Tax Lien on Nondischargeable Taxes

Chapter 13 hugely helps minimize the effect of a tax lien on older, dischargeable tax debts. But it also does wonders with newer taxes.


Chapter 7 and Chapter 13 Dealing with a Dischargeable Tax with a Tax Lien

In the last blog post we explained the hugely beneficial way that Chapter 13 “adjustment of debts” can resolve a recorded income tax lien on a tax that could otherwise be discharged (legally written off) in bankruptcy. Although Chapter 7 “straight bankruptcy” can discharge that underlying tax debt, it does not help at all with the surviving tax lien. This can leave the Chapter 7 debtor in the unhappy position of having his or her personal and real property subject to seizure to satisfy the tax lien, while having little leverage against the IRS or state taxing authority for settling the matter.

In contrast, in a Chapter 13 case the debtor has great leverage. And the IRS/state has infinitely less than otherwise. The debtor is protected against the threat of seizure of property throughout the 3-to-5-year payment process. Instead of being at the mercy of the IRS/state, under Chapter 13 the debtor has the bankruptcy court as a readily available and fair decision-maker about how much the lien is worth. The burden is put on the IRS/state to object and disprove the proposed valuation. As a result, tax liens on otherwise dischargeable tax debts can often be paid off in a Chapter 13 case for much less money and through a much calmer process.

A Newer, Nondischargeable Income Tax Debt with a Tax Lien

But what if an income tax that you owe is not old enough and so cannot be discharged, and has a recorded tax lien on it? How do the two bankruptcy options deal with this situation?

(Note that an income tax cannot be discharged if its tax return was due less than 3 years earlier or the return was actually filed less than 2 years earlier. There are some other possible conditions but in most situations these two are the only relevant ones.)

Under Chapter 7

You cannot discharge such newer income tax debts through Chapter 7. If the IRS/state recorded a tax lien before your bankruptcy was filed, that lien would also continue in effect after your Chapter 7 bankruptcy case was completed.

As with older tax debts, you and your assets would be protected from the IRS/state only until the discharge order was entered in the Chapter 7 case, usually about 3 or 4 months after the filing of the case. After that you’d be subject to the IRS’s/state’s collection procedures both under the tax debt and under the lien. Among other collection powers, this means the potential seizure of everything the tax lien attaches to, which is usually everything that you own.

To prevent collection action against you and/or your property after the completion of a Chapter 7 case, you would usually be able to negotiate with the IRS/state to pay off the tax owed and then get the tax lien released. But, just as in the case of a tax lien attached to a dischargeable tax, with a nondischargeable tax you are just as much at a substantial negotiating disadvantage because you have the threat of seizure of your property hanging over your head. And if you have any other debts that survived the Chapter 7 case—such as a home mortgage, a vehicle loan, or child support payments—the IRS/state will not necessarily be considerate about your need to also pay those other obligations.

Under Chapter 13

Just as with dischargeable tax debts, with newer, nondischargeable tax debts you have significant advantages in a Chapter 13 case.

Again, the negotiating disadvantage caused by the threat of seizure of your property is negated because of the continuous protection from such collection action.

However, you are required under Chapter 13 law to pay the nondischargeable tax in full during the course of your case. The existence of a recorded tax lien usually also requires you to pay ongoing interest on the nondischargeable tax. So the total amount of tax and interest to be paid under Chapter 13 and Chapter 7 would likely not be much different.

But what IS different under Chapter 13 is the amount of flexibility you have in paying that amount. Instead of paying pretty much under whatever terms are dictated by the IRS/state, under Chapter 13 how quickly you must pay the tax largely depends on your own budget. If you can afford to pay it off more quickly you can, but you have as much as 5 years if need be. And the order in which the taxes are paid in relation to your other important creditors is largely at your own discretion. You are usually able to make the IRS/state wait their turn in line as you also catch up on a mortgage arrearage, pay down a vehicle debt, or cure a child support arrearage, for example.   

Paying a newer, nondischargeable income tax debt which has a recorded tax lien by paying it through a Chapter 13 case is safer, calmer, and much more flexible than making arrangements to pay it directly with the IRS/state after a Chapter 7 case.


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