Paying Your 2013 Income Taxes on the Backs of Your Other Creditors

Posted by Kevin on April 16, 2014 under Bankruptcy Blog | Comments are off for this article

An income tax debt that you owe for the 2013 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, however, under the right circumstances your 2013 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. 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 2013 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 2013 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.

The Example

Consider this. You own a boat that has become more expensive and more work to own than you’d expected.  In a Chapter 7 case, if you do not claim an exemption on the boat and your bankruptcy trustee believes the boat is worth collecting from you and selling, then the 2013 taxes are among the first debts that the trustee will pay out of the proceeds.   Why?  Because the taxes are what is called “priority debts”.  Although most of your creditors are paid pro rata—equally, based solely on the relative amount of their debts— “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 2013 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.

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.