The topic of taxes is rarely met with a positive reaction. Generally, as the public, we are aware that taxes exist and that we are required to pay them, but very few actually understand the complexities of taxes and how they are handled in bankruptcy. Let’s leave the complexities of the US tax system to the CPAs and accountants that have spent their time earning an education in this area, and instead focus on understanding the basics of the US tax system. A proper understanding of taxes makes it much more likely for an individual to avoid tax issues, and if they do ever face issues, they will have a better understanding as to what options are available to them in terms of relief. If left unresolved, you tax obligations will only continue to accrue interest and penalties that can wreak havoc on your life.
At Modesto Bankruptcy Attorneys, we have the experience in tax related matters at both the Federal and State level. Our understanding can assist you in preparing for current and future tax obligations, handle current tax issues (such as back taxes, tax liens and audits), negotiate and enter into installment plans, negotiate an offer in compromise and even discharge certain taxes in bankruptcy. The following is not meant as legal advice, and is intended to provide you with a general overview. In order to properly evaluate your tax related issues, it is important to contact an experienced attorney, such as Modesto Bankruptcy Attorneys to seek legal advice.
Overview of the US Tax System
What agencies are responsible for collecting taxes?
In the US, there are multiple tiers of government entities that have the authority to charge and collect taxes. Taxing authorities exist at the Federal, State and Local (county) levels. At the federal level, the United States Internal Revenue Service, more commonly referred to as the IRS, is the agency responsible for collecting taxes on behalf of the federal government. Focusing on California, at the state level, the California Government utilizes three main agencies to collect and handle tax issues.
- The Franchise Tax Board: The Franchise Tax Board, commonly referred to as the FTB, is the agency that is responsible for collecting and handling income taxes from its instate residents as well as out of state residents and/or business if applicable.
- The Employment Development Department: The Employment Development Department, commonly referred to as the EDD, is the agency responsible for handling the collection of payroll taxes due by employees.
- The Board of Equalization: The Board of Equalization is the agency responsible for handling the collection of sales taxes by businesses.
What are the various types federal taxes that are collected?
Taxes are imposed on residents, employees and businesses in the United States in order for the federal government to be able to provide necessary services and benefits. Taxes are used to fund various federal government programs, such as public health and maintaining our highways. Below are some of the most common types of taxes that are imposed at the federal level:
- Income Tax: By far, income tax is the most common tax collected by the federal government. Taxes are imposed and collected from all individuals and businesses who earn money each year. The money can be from employment, investments and business.
- Employment Tax: As an employee, a portion of your wage will be collected by the federal government to fund social welfare programs. Each employee will have a portion of their paycheck withheld to pay for Medicare and Social Security. As an employee, you pay for one half of this tax, and your employer is responsible for paying the other half directly on your behalf. The employer portion does not come from your paycheck.
- Gift Tax: The federal government may impose and collect a tax on certain gifts of money or other assets that are given to others without adequate consideration. For normal gifts to individuals, such as for birthdays, no gift tax is imposed. However, over certain limits a gift tax may apply. In 2020, the federal government allows an annual gift tax exclusion of $15,000 per individual. This means that an individual can gift away up to $15,000 per individual to as many individuals as they desire, and no gift tax will be imposed on the transaction.
- Estate Tax: When a person dies, if they leave an estate that passes to their heirs or beneficiaries that exceeds the allowed exemption limit, the federal government will impose a tax on the deceased's estate. In 2020, the current gift and estate tax exclusion is $11,580,000.00 per individual. If an individual has a total lifetime of gifts and estate value under this limit, no estate tax is imposed and due. Any amount over the limit will be subject to the estate tax. Given such a large exemption limit, the majority of estates will not be subject to the estate tax. However, it is important to note that this exemption limit can change each year, and thus it is important to be aware of it.
What are the various types of state taxes that are collected?
Similar to the federal government, the State of California imposes and collects taxes from residents, employees and businesses to fund government programs for the benefit of its residents. Below are some of the most common types of taxes that are imposed at the state level:
- Income Tax: California collects income tax from those residents who are employed as well as nonresidents and individuals who only reside in the state for part of the year.
- Sales Tax: The California sales tax represents a combination of state, county and local taxes plus a use tax. The tax varies by county, but the minimum base rate is 7.25%. This tax is due on the sale of certain taxable items, and is collected by the seller and then paid to the appropriate state agency.
- Real property taxes: California imposes taxes based on the fair market value of your real property. Property tax is due annually, and is based on a percentage of the fair market value of your home each year. This can increase or decrease each year depending on your home's value. Regardless of the amount, real property taxes will always be imposed and due for any real property for as long as you own it.
What happens if I can’t pay my taxes when they are due?
Income taxes and personal property taxes are collected by both the federal government as well as the state of California annually, usually with a deadline around April 15th. This deadline can change if it falls on a weekend, or if the government decides to extend or change the due date. It is not uncommon for individuals and even businesses finding themselves in a position where they are unable to pay their tax by the deadline. Fortunately, both the IRS and the California Franchise Tax Board offer solutions to those unable to make their tax obligation. These solutions are discussed below:
- Automatic extension: If you find yourself unable to file and pay your taxes by the April 15th deadline, you can request a 6-month extension to file and pay your outstanding taxes. This will give you until October 15th to take care of your tax obligation. To request the extension with the IRS, you are required to submit a form no later than the original April 15th due date. For California, you are given an automatic extension, and are not required to file any form.
- Request an installment plan: If you are in a position where you are unable to pay your federal and state tax obligation, you may be able to request to enter into an installment plan. If approved, this will allow you to pay your tax obligation over time instead of all at once. However, an installment plan is subject to approval and interest may accrue on the unpaid balance, resulting in you owning more than the original amount.
- Offer in Compromise: For those who may find themselves in a financial hardship where an installment plan may not be feasible, an Offer in Compromise may be a solution. An offer in compromise is when the taxing authority agrees to accept a lump-sum payment that is less than the outstanding amount due as satisfaction for the total tax. An offer in compromise is permitted under certain circumstances where an extreme hardship makes it unlikely that you can pay your tax obligation now and in the future.
I failed to pay taxes, will the taxing authorities come after me?
Over the years, we have come across clients who erroneously believe that they could simply ignore paying their tax obligation and that there would be no repercussions. This could not be more far from the truth. In fact, the unpaid taxes will continue to accrue interest and penalties until satisfied. Federal, state and local taxing authorities are well-aware of who owes taxes, and will employ various techniques to make sure they are paid.
- Lien: A taxing authority can place a lien against your real property to secure the repayment of unpaid taxes. A lien serves as a public notice to creditors that another party has a claim against your property. It will stay on your property until it is satisfied. When you try to sell or refinance your home, the lien will need to be satisfied first.
- A levy: This allows a creditor to seize and sell your property to satisfy your unpaid debt. Additionally, they can get a bank levy and take funds from your bank accounts.
- Offset: A taxing authority can offset any debt you own by claiming any current or future refunds that you may receive and applying them to your outstanding balance.
Bankruptcy as a Solution for Tax Relief
When individuals find themselves in financial situations where they are unable to pull themselves out of debt, bankruptcy may be their best option to get their lives back on track. It is not uncommon for those individuals that are currently suffering financial hardships to also be behind on their taxes. Fortunately, filing for bankruptcy may allow an individual to discharge certain tax obligations as well as allow them other payment options to handle their back taxes. Tax debts are treated differently depending on if an individual is filing for Chapter 7 or Chapter 13 bankruptcy.
Can the IRS collect taxes once I declare bankruptcy?
Under certain circumstances, old income tax debts may be able to be discharged through bankruptcy. For those taxes that are unable to be discharged, a repayment plan may be possible with interest rates that are lower than those charged by the IRS installment plans. The IRS’s ability to pursue tax collection efforts once you have filed bankruptcy will depend on if the Automatic Bankruptcy Stay is in place.
The Automatic Bankruptcy Stay and Tax Collection Efforts
As soon as a bankruptcy case is filed, an Automatic Stay goes into effect. This auto stay immediately puts a halt to creditors and their collection efforts, including the IRS. The auto stay will continue in effect until the bankruptcy discharge is issued or the case is dismissed. During this time, the IRS will be unable to file any tax liens or pursue collection efforts such as garnishing your wages or your bank accounts. With the auto stay in place, you are free to determine how your tax debts may be treated.
Which tax liabilities can I discharge in bankruptcy?
Under very specific circumstances, it is possible to discharge certain tax liabilities. In order to qualify to have your tax discharged, an individual will be required to meet all of the following criteria:
- The tax debts must be on gross receipts or wages, such as income.
- The tax must have been owed three years or more prior to the individual filing for bankruptcy.
- You must have filed the tax return for the debt that you are attempting to discharge at least two years or more before filing for bankruptcy. If you file a late return, which means that your extensions are ended and the IRS has filed a substitute return on your behalf, you are considered to have not filed your return, and you cannot discharge the debt.
- The income tax debt must have been assessed by the IRS no less than 240 days before you file your bankruptcy petition.
- Lastly, you must not have committed fraud or willfully attempted to avoid paying your taxes.
If an individual can meet all of the above criteria, it may be possible to discharge their tax liability through bankruptcy. Failure to meet all of the criteria will likely result in the tax being unable to be discharged.
What happens if I am unable to discharge my tax liability through bankruptcy?
Chapter 7 and Chapter 13 bankruptcy treat income tax debt differently. Under Chapter 7 bankruptcy, if the tax debt is not discharged, once the bankruptcy case has been closed, the tax debt remains in place and the IRS can continue to pursue collection efforts. In contrast, under Chapter 13 bankruptcy, a debtor can add their tax debt as part of their repayment plan. This allows the debtor to repay their tax debt over a maximum period of five years and at a lower interest rate than is charged by IRS installment plans.
IRS Tax Liens and bankruptcy
A powerful collection tool that is at the IRS’s disposal is filing a tax lien. A tax lien is a claim or security interest that the IRS is able to place against a particular asset or property. This lien is no different than other liens for debt obligations, such as a mortgage. Your mortgage repayment is secured by a lien against your home. If you default on your payments, the home serves as security of the loan and a lender can foreclose and recoup their loan. Similarly, once the IRS files a tax lien against your property the tax debt now becomes a secured interest, and is no longer subject to discharge through bankruptcy.
How are tax liens treated in Chapter 7 bankruptcy?
The automatic stay that goes into effect upon filing a Chapter 7 petition prevents the IRS from filing a tax lien. If they have not filed a tax lien prior to the Chapter 7 petition, then it may be possible for the tax debt to be discharged. However, if the IRS has filed a tax lien before the Chapter 7 petition has been filed and the automatic stay is in effect, the tax lien is a secured obligation that cannot be discharged under Chapter 7 bankruptcy. Once the case has been closed and the automatic stay has been lifted, the tax lien will continue to stay in effect.
How are tax liens treated in Chapter 13 bankruptcy?
For tax debts that are unable to be discharged, Chapter 13 bankruptcy may allow the debtor to repay the tax lien through a repayment plan. This will result in the lien being satisfied at the end of the repayment period.
Handling tax liens after bankruptcy
For those that are unsuccessful in discharging their tax debt through bankruptcy, they can exercise any of the following options to settle their debt post bankruptcy:
- If feasible, pay the outstanding debt in full
- Present an offer in compromise to determine if the IRS will take a one time payment for less than the outstanding debt as satisfaction for the full amount.
- Enter into an installment plan to pay your obligation over time.
Taxes will always exist and understanding the basics of the US Tax System and the ramifications for failing to pay your tax obligations is vital for an individual’s financial well-being. If you find yourself owing unpaid taxes, contact us at Modesto Bankruptcy Attorneys. We have the experience and knowledge to exercise all possibilities to handle your tax issues. We look towards bankruptcy as a last resort and our attorneys have been successful in resolving tax issues for many clients without the need for filing bankruptcy. However, if bankruptcy is the best solution, our attorneys will be able to achieve the best resolution for you and get your financial health back on track.
We help clients in the following areas: Modesto, Stockton, Turlock, Ceres, Empire, Escalon, Hughson, Lathrop, Linden, Manteca, Oakdale, Patterson, Ripon, Riverbank, Salida, Tracy, Waterford.