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Discharging Tax Debts in Bankruptcy

If you are considering bankruptcy because of tax problems, then you will benefit from reading this article. Most people believe that taxes cannot be discharged in bankruptcy. This myth is not true. There are some technical rules that allow tax debts to be discharged in bankruptcy. If you meet each of the following requirements, then your taxes can be discharged.

The first requirement is that you have filed a legitimate tax return for the year in question. Second, the tax return must have been filed at least two years before you filed for bankruptcy. Third, the tax return was due at least three years before you file for bankruptcy. Finally, the IRS has not assessed your liability for the taxes within 240 days before you filed for bankruptcy.

The following example should make things more clear. Joe filed a tax return in Aug 2003 for the 2002 tax year. In Mar 2005, the IRS audits his 2002 tax return and assesses a tax debt of $10,000. In May 2006, Joe files for bankruptcy. The return was due on April 15, 2003, more than three years before Joe’s filing date. The tax return was filed in Aug 2003, more than two years before Joe’s filing date and the assessment date of Mar 2005 was more than 240 days before the filing date. These taxes can be discharged in bankruptcy.

If you meet all of these requirements, your liability for the taxes should be discharged. Penalties on taxes that are dischargeable are also dischargeable. However, courts are split as to whether you can discharge penalties if the underlying debt is nondischargeable. If you borrow money on your credit card to pay taxes that are not discharged, you cannot eliminate this loan in a chapter 7 bankruptcy.

You cannot discharge debts for income taxes if you did not file a return or you were intentionally avoiding your tax obligations. Returns filed on your behalf by the IRS are not considered returns. Property taxes are not dischargeable unless they were due more than a year prior to your bankruptcy filing. The property taxes remain as a lien against the property and will eventually lead to foreclosure. Trust fund taxes such as payroll taxes cannot be discharged in bankruptcy.

When faced with a tax liability, it is essential to time your bankruptcy. If you do not meet the requirements of discharge, then your only option is to reach an offer in compromise (OIC) with the IRS. Most people are under a misconception that the IRS will settle their debts for pennies on the dollar. The IRS is authorized to settle debts if it determines that there is “doubt as to liability” or “doubt as to collectability” of the debt. The policy behind the OIC program is to compromise debts of those taxpayers who owe more than can be collected in the ten year statute of limitations period.

As you can see, discharging tax debts in bankruptcy is the better alternative for the debtor than entering into a lengthy repayment plan with the IRS.

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The Advantages of Lienstripping in Bankruptcy

In Bankruptcy cases, specifically Chapter 11 and Chapter 13, lienstripping is an effective tool in reducing the payments made to creditors. In Chapter 13, the debtors reorganize their debts into a repayment plan whereas Chapter 11 is for businesses and individuals whose debts exceed the limits in Chapter 13.

Lienstripping is referred to as the debtors’ ability to reduce an undersecured creditor’s claim by valuation of the underlying collateral. This is also known as bifurcation where the undersecured creditor’s claim is divided into secured portion and unsecured portion. The unsecured portion of the lien is stripped away from the collateral and becomes an unsecured claim. For example, if a debtor purchased a commercial building with a mortgage of $500,000 and the current value of the building is $300,000. The creditor’s lien is undersecured and can be bifurcated into $300,000 secured claim and a $200,000 unsecured claim. The debtor is only required to pay back $300,000 over the life of the loan and the remaining $200,000 can by discharged at the end of a successful plan. Under nonbankruptcy laws, the debtor is required to pay the entire amount since lienstripping is unique to bankruptcy cases. Lienstripping is not available in Chapter 7 cases which are used in discharging unsecured debts because liens ride through Chapter 7 cases untouched.

However, there are limitations as to what the debtor can do in valuing claims on the primary residence and vehicles financed within 910 days. Congress in its wisdom has prohibited individuals from modifying loans on their primary residence. If the debtors have one mortgage on their home, they cannot reduce the loan to the value of the house. However, the debtor is allowed to strip away a second mortgage that is not secured by the value of the house. For example, if the debtor has a first mortgage of $300,000 and a second mortgage of $100,000 and the house has a value of $250,000, then the debtor is allowed to strip away the second mortgage. In Chapter 13 cases, Congress applied another limitation to stripping liens on vehicles financed within 910 days of filing bankruptcy. A vehicle that has been financed longer than 910 days can have its lien reduced to the value of the collateral which allows the debtor to make reduced payments based on the current value of the vehicle and not the outstanding balance of the loan. The interest rate can also be reduced to the current market rate and the debtor is not required to pay the contract rate.

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The Advantages of Chapter 11 Bankruptcy

Chapter 11 bankruptcy was originally designed for businesses but individuals may also file under this chapter. Those individuals who exceed the debt limits of chapter 13 bankruptcy are required to file under chapter 11. The current debt limits for chapter 13 is $1,010,650 for secured debts and $336,900 for unsecured debts. The debt limits appear to be low for those individuals who own more than one property whose values have dropped significantly.

There are many advantages of being in chapter 11 as opposed to chapter 13. When individuals file for chapter 7 or chapter 13 bankruptcy, they are subjected to a means test. Those debtors who are above the median income limit for their household size cannot file under chapter 7 and if they file under chapter 13, they are required to make payments in a five year plan. However, the means test does not apply to the individual debtors in chapter 11 cases so they may propose repayment plans that are less than five years and therefore, they will end up paying less of their disposable income to unsecured creditors.

In chapter 11, the debtors can modify their secured debts such as car loans and mortgages. There is a time restriction in chapter 13 cases where the debtor must have financed the vehicle more than two and half years ago before the loan can be reduced to the value of the car. However, in chapter 11 cases there is no time restriction so if you purchased a vehicle a year ago and if the loan is more than the value of the car, you are only required to pay back what the car is worth and not the original balance. In both chapter 11 and 13 cases, the debtors can modify the mortgages on their rental properties. For example, if the value of the property has dropped below the outstanding mortgage, you are only required to pay back the amount based on the current value of the property. The only caveat is that individual debtors are not allowed to modify their primary residence.

Once the values on the secured properties have been established, the debtor will then propose a plan of repayment of the secured and unsecured debts. The plan duration can be controlled by the debtor such as a three year or longer plan. The debtor must submit the plan to the creditors for a vote and if the case is to proceed forward, the debtor must receive at least one vote from the creditors. The remaining creditors that object to the plan can be forced to accept the plan by the court which is called a “cram down.” The advantage of chapter 11 bankruptcy is that the debtor has control over the content of the plan and may propose terms that are to his benefit. However, the advantage of chapter 13 bankruptcy is that you don’t need to solicit the votes of the creditors but you are subjected to a three or five years plan based on your income.