Give gladly to your Chapter 7 trustee assets that you don’t need, if most of the proceeds from sale of those assets are going to pay your taxes.

We are in a midst of a series of blogs about bankruptcy and income taxes as we approach the April 15 income tax filing deadline. Today we describe a procedure that doesn’t happen very often, but in the right circumstances can work very nicely.

Turning Two “Bad” Events into Your Favor

Most of the time when you file a Chapter 7 “straight bankruptcy,” one of your main goals is to keep everything that you own, and not surrender anything to the Chapter 7 trustee. To that end, your attorney will usually protect everything you own with appropriate property “exemptions.” 

If instead something you own can’t be protected, and so must be surrendered to the Chapter 7 trustee, that’s often considered a “bad” thing because you’re losing something.

And that leads to a second “bad” thing—the trustee selling that “non-exempt” property and using the proceeds to pay your creditors.  That usually does you no good because those creditors which receive payment from the trustee usually are ones that are being written off (“discharged”) in your Chapter 7 case, so you’d have no legal obligation to pay anyway.

But it may well be worth giving up something you own—particularly if it is something not valuable to you in your present circumstances—if doing so would have the consequence of paying some or all of your income tax debt that isn’t being written off in your Chapter 7 case.

Circumstances in which the Trustee would Pay Your Income Taxes

Consider the combination of the following two circumstances:

1)      You own something not protected by the applicable property “exemptions,” which you either don’t need or is worth giving up considering the other alternatives.

2)      The proceeds from the trustee’s sale of your “non-exempt” asset are mostly going to be paid towards taxes which otherwise you would have to pay out of your own pocket.

Let’s look at these two a little more closely.

“Non-Exempt” Assets You Don’t Need or Are Worth Giving Up

Although most people filing bankruptcy do NOT own any “non-exempt”—unprotected—assets, there are many scenarios in which they do. In some of those scenarios, those assets are genuinely not needed or wanted, so giving them to the trustee is easy. For example, a person who used to run a now-closed business, and still owns some of its assets, may have absolutely no use for those business assets. Or a person may own a boat, or an off-road vehicle, or some other recreational vehicle, but because of health reasons can no longer use them.   

More commonly, a person may own a “non-exempt” asset which he or she would prefer to keep, but surrendering it to the trustee is much better than the alternative. That alternative is often filing Chapter 13—the three-to-five year payment plan. In the above example of a boat owned by somebody who can no longer use it, he or she may have a son-in-law who would love to use that boat. But that would probably not be worth the huge extra time and likely expense of going through a Chapter 13 case.

Allowing Your Trustee to Pay Your Non-Discharged Income Taxes

Letting go of your unnecessary or non-vital assets makes sense if most of the proceeds of the trustee’s sale of those assets would go to pay your non-dischargeable income taxes. Under what circumstances would that happen?

The Chapter 7 trustee is required by law to pay out the proceeds of sale of the “non-exempt” assets to the creditors in a very specific order. If you don’t owe any debts which have a higher “priority” than your income taxes, then the taxes will be paid in full, or as much money as is available, ahead of other creditors lower in order on the list.

The kinds of debts which are AHEAD of income taxes on this priority list include:

• Child and spousal support arrearage
• Wages, salaries, commissions, and employee benefits earned by your employees (if any) during the 180 days before filing or before the end of the business, up to $10,000
• Contributions to employee benefit plans, with certain limitations

If you know that you do not owe any of these higher “priority” debts, then the trustee will pay your taxes (after paying the trustee’s own fees), to the extent funds are available, assuming the tax creditor files a “proof of claim” on time specifying the tax debt.

As you can imagine, each step of this process must be carefully analyzed by your attorney to see if it is feasible, and if so then it must be planned and implemented by your attorney. Again, it will only work in very specific circumstances. But when the stars are aligned appropriately, this can be a great way to get your taxes paid.