Navigating Tax Debt – The Role of Pre-Bankruptcy Planning

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Five pre-bankruptcy steps to help you when navigating tax debt problems.

You can take appropriate action using the bankruptcy rules to navigate your tax debt problems before filing for bankruptcy, so when you do, you have a better chance to discharge (get rid of) your tax debt.

Review the 5 Steps for Tax Debt When Considering Bankruptcy

WAIT out the appropriate lengths of time before filing your bankruptcy case.

Most (but not all) types of income tax become dischargeable after the passing of specific periods. Much of the pre-bankruptcy tax strategy turns on determining with your attorney exactly when your tax debts would become dischargeable and then trying to wait to file bankruptcy until then. Often, because of pressure either from other creditors or from the tax authorities, you can’t wait that long. But, with your attorney’s active guidance, at least you will discharge the maximum amount of taxes possible under your circumstances.

FILE past-due returns to start the clock running on those immediately.

If you owe income taxes for prior years and don’t have the money to pay them, your understandable inclination may be to avoid filing those tax returns as long as possible. But you cannot discharge a tax debt until two years after you file your tax return. So, file the old returns and get the advice you need about appropriately dealing with the IRS/state tax authority during those two years to protect yourself and your assets.

STAY in compliance as much as possible by paying your current taxes.

While waiting to file your bankruptcy case, make sure to withdraw the appropriate amounts from your current paychecks.

Don’t forget to pay the appropriate estimated quarterly taxes if you are self-employed. To prevent the IRS or state from applying your tax payments to older taxes that you plan to discharge, clearly instruct them that your tax payments are for the current tax year rather than any older ones.

Staying current on present taxes can be crucial in preventing aggressive action from the IRS or state, and it may allow you to discharge more taxes.

AVOID tax fraud and evasion, and, whenever possible, “trust fund” taxes.

You cannot discharge any taxes related to fraud, fraudulent tax returns, or tax evasion, no matter how long you wait to file for bankruptcy. If you have questions about these issues, it’s best to consult with a knowledgeable tax accountant and attorney.

Another set of taxes you cannot discharge in bankruptcy is “trust fund” taxes. The employer withholds these taxes from an employee’s paycheck and then sends the amount to the IRS or state. The IRS or state considers this money to have never belonged to the employer, but rather, it was held “in trust” for them.

If you are responsible for any such “trust fund” taxes, it’s important to try to pay them when due. This may mean prioritizing your limited resources to keep these taxes current. Otherwise, you must understand that Chapter 7 will not discharge trust fund taxes, or you must pay those taxes in full as a “priority debt” in Chapter 13.

BE AWARE of tax liens.

You must pay tax liens in full with interest in Chapter 13, and the lien may survive Chapter 7. Therefore, it’s important to try to prevent the taxing authority from placing a tax lien against you. While you may not have complete control over this, it’s advisable to discuss with your tax accountant what steps you can take to avoid a tax lien.

As part of this strategy, you should avoid building up equity in possessions or real estate that the IRS or state can attach a lien to. Even though this equity or property is often “exempt,” meaning that it is beyond the reach of your general creditors and the bankruptcy trustee, it is still subject to a tax lien. So, any equity you accrue runs the risk of increasing the amount you owe to the IRS and state on taxes you might otherwise have been able to discharge completely.

A Big Caution When You Have Tax Debt Before Filing Bankruptcy

Using pre-bankruptcy planning to position yourself in the best possible way to discharge some or all of your tax debts is one of the more sophisticated tasks that bankruptcy attorneys undertake with their clients. Please don’t try these strategies yourself, including the five steps outlined here, without an attorney highly experienced in bankruptcy. You cannot take anything on the website, including the information in the blogs, as legal advice. That’s especially true in this sophisticated area. What is written here should begin the discussion you need to have with your attorney.

To get a fuller understanding of what you have just read, you might want to look through some of our other blogs dealing with this area of practice. If you live in Montana and are considering bankruptcy, we are excited to pick up the conversation.

discharge, income tax, Internal Revenue Service, tax debts, tax liens, tax returns