Your Chapter 7 trustee can use your unneeded assets to pay current-year income taxes if you split the calendar tax year into two: the pre-bankruptcy and post-bankruptcy “short years.”
I’m closing this series on taxes and bankruptcy with three blogs on some relatively sophisticated topics. The tools I discuss do not apply to most cases. But when they do, they can save you a lot of amount of money, and better meet your goals. This first one is a good example.
Let’s first set the scene. If you have substantial income tax liabilities, especially if they are spread over a number of years, Chapter 13 is often the best tool for dealing with them. But a Chapter 13 takes three to five years. Sometimes a Chapter 7 case accomplishes enough so that it’s the better option. If your taxes are old enough and you meet a series of conditions (see my last blog about this), a Chapter 7 case could discharge (legally write off) most or all of your tax debts. But even if Chapter 7 would leave you with a significant nondischargeable tax debt, it might still make more sense as long as you could anticipate a reliable and manageable arrangement for satisfying that one last debt outside of bankruptcy. Getting in and out of bankruptcy in a matter of months instead of up to five years may be worth a lot to you.
The short year election could help just enough to make Chapter 7 a feasible option, and therefore the preferred option. That’s because it can enable more of your nondischargeable taxes to be paid by the Chapter 7 trustee, leaving you owing less taxes at the completion of your bankruptcy case.
As I said in the first sentence of this blog, the short year election allows you to split your tax year into two tax portions, each of which is treated as its own tax year. The first “short year” covers from January 1 of that year to the day immediately before the filing of your Chapter 7 case, and the other “short year” is the rest of the year—from the date of filing your case until December 31.
How can this possibly help? Two ways.
1. It allows any taxes you may owe for the short year before filing the Chapter 7 case to be a “priority” debt in your case, so that it can be paid from assets collected by the Chapter 7 trustee. This turns debt that would have been treated as incurred after the filing of the case, and thus wholly your obligation, into one that may be paid in whole or in part by the trustee. This can reduce or eliminate the current year tax debt, leaving you with either less or none to pay after your bankruptcy case is over.
2. It allows you to apply any loss carry forwards or credit carry forwards from the prior tax year to the income earned during that same pre-bankruptcy short year. The loss carry forwards reduce the tax for that short year, thus reducing any your potential tax debt owed after your case is finished. The credit carry forwards increase the tax for that short year, but that gives the trustee the opportunity to pay it if there are estate assets with which to do so. Each in their own way can increase the possibility that you will have less or no taxes to pay after your case is over.
The context that this works best in is a closed business or some other situation where the debtors have non-exempt assets that they do not mind surrendering to the trustee in return for a discharge of most of or all of the debts. Imagine a spouse who had been trying to run a business, and then had to close it down. The other spouse has a relatively high salary or other income but stopped paying withholdings or quarterly estimated taxes at the beginning of the year because of the lack of income from the other spouse closing down the business. By three-fourths of the way through the year, a substantial amount of tax liability could accrue. They may not be able to simply wait until after the end of the year because of pressure from creditors. The short year election allows the tax debt accrued through three-fourths of the year to be potentially paid by the trustee by liquidating the no longer needed business assets. The trustee may also have funds from other sources, such as preferential payments from a creditor or two.
So, through the benefit of the short year election, in the right circumstances the trustee could pay thousands of dollars of your nondischargeable tax debt by liquidating assets that you no longer need, instead of having this same money just going to your other creditors. And to the extent that the trustee would be getting some of that money through forced reimbursement of creditor’s preference payments, some of your taxes would be indirectly paid by those creditors. Not often that you can get somebody else to pay your taxes.
As I said at the beginning, the short year election is a tool which applies only limited cases, but when it does it can be extremely helpful.
NOTE: This election is available ONLY in asset Chapter 7 cases–not Chapter 13s or no-asset Chapter 7s.