Los Angeles Bankruptcy Law Monitor : Los Angeles Bankruptcy Lawyer & Attorney : Christine Wilton Law Firm : Southern California Chapter 13 & Chapter 7 Bankruptcy, Foreclosure

Are you one of those people that gets a large tax refund every year and you pay bills; or take a vacation with it?  You're providing the federal government with a free, no interest loan on YOUR money if you do. MSN posted this article, How to Adjust your Tax Withholdings, which provides a step-by-step guide to show you how to adjust your tax withholdings to put more money each paycheck in your pocket.  Why should you do this you ask? 

Besides the fact that you're loaning your money to the government free of interest and you know they would never reciprocate the sentiment, you're needlessly tying up your money in an account you cannot access but once a year when your big fat refund arrives. Besides, if you need to file bankruptcy, the trustee has the power to take that tax refund to pay creditors.

Taking charge of your money requires a disciplined approach.  Creating a budget  that includes your monthly bills is the first step.  You also need to include those annual bills like insurance and taxes and set up a savings account, making regular monthly deposits to be sure the money is there when the bills arrive.  I know savings rates are low, but it's better than tying up your money for a year and making nothing for handing it over to the feds for a while.

When it comes to filing bankruptcy under Chapter 7, the trustee's job is to look for assets to take from you to pay your creditors.  Any tax return greater than $500.00 can and will be taken by the trustee.  Adjusting your income tax withholding is an easy remedy for you to not only break even at tax time, but leave nothing for the trustee to take to pay creditors.  Consult your tax advisor and your bankruptcy lawyer  to create the best strategy for you.

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Debt settlement requires that you negotiate with creditors to settle debts for less than what you owe. Once an agreement is reached, you pay the agreed amount and your liability for that debt goes away. What these debt settlement companies don’t tell you is that you will also receive a 1099 tax form they filed with the IRS. Now that the debt is gone, you’ve got a tax bill for that settled debt. So, not only have you paid to get rid of the debt, you owe income taxes too.

Too often, hiring a debt settlement company to help you negotiate with creditors can cost in the thousands of dollars. What happens is that they set you up on their payment plan and then the debt settlement company begins taking your money first for their fees and never paying a dime to your creditors until their fees have been paid in full.  Many consumers end up in litigation with their creditors and these companies do nothing to assist consumers until they've been fully paid.

Here’s an example: Say you owe $5000.00 to credit card and you’ve done well and negotiated this debt down to $500.00. You must pay $500.00 to get rid of the debt. At year’s end you will receive a tax bill for $4500.00 and you must pay income tax on that amount; perhaps another 15% depending upon your tax bracket. You’ve paid a total of $1175.00 to settle that account. Simply follow this plan until each credit account has been eliminated and you get the picture.  Add to that cost, the fees for hiring a debt settlement company and you have nothing left.

Bankruptcy, on the other hand, effectively eliminates all debts, without any income tax liability. Usually, you are charged a flat fee for services. Once you’ve received your discharge, your debts are gone forever. Isn't that your goal? So, you pay nothing to your creditors, have no income tax liability and pay one flat fee to file your bankruptcy case and your debts are permanently eliminated.  There's no sense in foregoing a free consultation with a bankruptcy lawyer because you can generally keep your cash and belongings and still eliminate your debts.

Your credit score is the last thing you should be thinking about during any financial crisis. Besides your credit score only measures how well you manage DEBT and isn’t that what you’re working so hard to get out of? We have generally found that most people who file for bankruptcy have their credit score actually increase because the debts are gone. Soon after, you’ll receive offers for credit because the creditors know that you cannot file bankruptcy for another 8 years, making you a prime candidate for high interest credit cards. But why would you want to create debt ever again?
 

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Let's talk about your retirement accounts as they relate to your decision to file for bankruptcy.  There are many varieties and vehicles for retirements savings that include pensions, 401k, 403b, IRA and Roth IRA accounts.  Perhaps there are others that I am not aware of.  As I have said before, DO NOT CASH OUT YOUR RETIREMENT TO PAY YOUR DEBTS.  Your retirement accounts are ONLY for retirement and should NEVER be accessed for any other reason. 

When you file bankruptcy, all of your assets become a part of your estate.  The trustee will have temporary control over that estate and can administer certain assets to pay debts.  However, some assets in your estate, including retirement accounts are exempt from being taken by the trustee. 

One great reason to hire an attorney to assist you in filing bankruptcy is pre-bankruptcy planning.  Your attorney will give you valuable advice before filing your bankruptcy case.  Converting non-exempt assets to exempt assets before filing a bankruptcy is not only non-fraudulent, your attorney has a duty to maximize this type of pre-bankruptcy planning.  Keep in mind the CA IRA has a "reasonably necessary" for retirement limit, in addition to limitations of contributions to only the tax deductible amount for each tax year.

The good news is yes, you can fund that IRA before filing bankruptcy.  Be sure to consult with your personal bankruptcy lawyer to ensure you're taking full advantage of your exemption rights.

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The only reason you should negotiate directly with your creditors, is to avoid bankruptcy.  Remember that working with debt settlement companies is both costly and detrimental to your finances and will likely land you in my office filing for bankruptcy.  If you want to avoid bankruptcy, work directly with your creditors for an agreement on what your debt is worth.  If they even think you're about to file for bankruptcy, they will most likely make some kind of offer.  However, settling debts to avoid bankruptcy comes with a price;  Income Taxes!

Beware that if you settle, or negotiate a debt to avoid bankruptcy, you could end up getting a tax bill.  while the IRS is forgiving settled debt where mortgages are concerned; the California Franchise Tax Board is not because their program has expired.  So, in California, you'll wind up owing state income taxes, if the debt you settled relates to a secured mortgage in a short sale.

But what about your credit cards?  Unsecured debt negotiations and settlements will be taxed by both the state and federal agencies.  So, unless you're prepared to pay taxes on the amount that will be written off by your creditor, then, like Cathy Moran said in her blog, Should I Settle Some Debts Before Bankruptcy, your money could be put to better use, like saving for retirement.

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Generally, taxes are treated the same as other debts in a chapter 7 bankruptcy case.  Taxes may be treated as secured, unsecured, or non-priority unsecured, or some combination.  IRS Code, found in 26 U.S.C. 6321, states that the government is secured if it has recorded a notice of lien.  Taxes that have been recorded as a  lien are a priority and must be paid in bankruptcy and cannot be discharged.  

A colleague of mine,  John Greifendorf, addressed the question, Can I discharge Federal Income Tax in Bankruptcy?  His article is concise and outlines five conditions for discharging what the debtor owes to the IRS and even sets forth and example to follow. 

The Five Conditions are:

1. The due date for filing the tax return was not less than three years ago
2. The tax return was filed at least two years ago
3. The tax assessment is at least 240 days old
4. The tax return was not fraudulent
5. The tax payor is not guilty of tax evasion

If the debtor meets the qualifications, then the tax liability is not a priority and is discharged in bankruptcy; 11 U.S.C. 523(a)(1).  Unsecured taxes that are deemed a priority, fall outside the scope of the conditions discussed by Mr. Greifendorf and cannot be discharged in bankruptcy.

Timing is a critical component in deciding to file for bankruptcy protection and the advice of a bankruptcy attorney will address this issue.  Best practices include filing all tax returns prior to filing a bankruptcy petition with the court.  Seek the advice of a CPA or tax attorney regarding IRS claims. 

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