In today’s exceptionally hard economic times nearly everyone has thought about bankruptcy, even those with no intention of filing. We all have at least one friend or acquaintance who has filed bankruptcy. Many local businesses as well as quite a few large corporations have filed for bankruptcy protection.

Most of us are also aware that in 2005 the banks and credit card companies successfully lobbied Congress to make it harder for individuals and small business owners to file bankruptcy (yes, these lobbyists represented the same banks – JP Morgan-Chase, Citibank and corporations like AIG and Goldman-Sachs that brought you this new economic crisis in the first place and the same banks have now been bailed out with corporate welfare money) by limiting the amount of income a person can make and still file for Chapter 7. Most people that come to our law office already understand that domestic support, student loans and governmental fines cannot be discharged in bankruptcy. But, what about tax debt? Are taxes dischargeable? The traditional answer is that tax obligations to the state and federal government cannot be discharged. However, like many things in the law, there are exceptions. Depending on the type of taxes, when they were assessed and certain other factors, the tax debt may be dischargeable. Bankruptcy tax dischargeability analysis is not only hard to say but a very tricky area of law and even some bankruptcy lawyers have difficulty accurately determining whether tax debts can be discharged.

During times of massive layoffs and corporate downsizing, many newly unemployed people tap into their 401(k), IRA, or similar tax sheltered retirement vehicle. In some cases the taxes are paid (often as much as 30-40%!) at the time of withdrawal, but when they are not paid at that time, the consequences can be devastating. We have seen clients cash out their 401(k) prematurely, not pay the proper taxes at that time, and find themselves owing the government $50,000 to $100,000 in taxes, penalties, and interest. When a tax debt of that magnitude hits someone without a job and depleted savings, there is really no way to pay the tax debt. Some people will go to their graves owing back taxes and penalties to the IRS. The most important keep in mind thing when significant taxes are owed to the IRS or to the State of California is that there may be some relief.

Some debtors can get tax debt relief through a Chapter 7 bankruptcy. The facts have to be just right for this type of discharge, but it is not impossible. Another really important and powerful weapon against oppressive and overwhelming tax debt is the Chapter 13 bankruptcy plan. In some cases, a person may be able to treat tax debt as general unsecured debt. If this is the case, then only a percentage of the tax debt gets paid, and the balance is discharged. If the taxes are secured (for example by a tax lien) or the taxes are determined to be priority debt (recent taxes for example), there are still ways to reduce the taxes, or at the very least, to pay only the principal amount of the taxes without interest or penalties. The tax arena is filled with laws and loopholes, and this is why both experience and knowledge are necessities when dealing with “back taxes.”

When substantial taxes plus other debts are owed, it is prudent to consult a bankruptcy attorney who clearly understands the tax implications of the Bankruptcy Code.