Tax Claims in Bankruptcy

Originally published by Jason B. Freeman.

Bankruptcies often involve unpaid tax debts.  Generally, tax liabilities may be secured or unsecured for these purposes.  Different rules and outcomes apply to secured and unsecured tax liabilities.  Debtors considering bankruptcy to discharge outstanding tax debts should carefully evaluate the nature of any unpaid taxes prior to seeking bankruptcy relief.

What Is a Secured Claim?

A secured claim is a debt to a creditor who has a lien (security interest) on property of the debtor. If the debtor fails to pay the creditor, the lien gives the creditor the ability to recover the property, sell it at auction, and use the proceeds to pay for the debt.

Home mortgages and car loans are common examples of secured claims. When a homeowner fails to make their mortgage payments, the lender can recover the property with a foreclosure action. Or if a car owner fails to make car payments, the lender can generally legally repossess the car. 

What Is a Secured Tax Claim?

Secured claims are often voluntary. The debtor uses their property as collateral for a loan, and thus is able to leverage their existing assets for other needs. However, secured claims can also be involuntary. For example, tax liabilities to the IRS can give rise to a tax lien against the taxpayer’s property. 

Oftentimes, involuntary secured claims are the result of a tax lien. When the taxing authority follows the procedures required to obtain a tax lien, the debt is classified as a “secured tax claim.”

What Happens to a Secured Tax Claim in Bankruptcy?

Secured tax claims are valuable to the taxing authority because the lien cannot be discharged in bankruptcy. Therefore, if a debtor declares bankruptcy or is otherwise unable to pay the lien off, the government retains the right to recover and auction the property that secures the loan.

However, if the debtor chooses to surrender the property during bankruptcy, to the extent the value of the property is less than the outstanding tax debt, the obligation is treated as a general unsecured debt. Thus, if the government is unable to recover the full loan amount by auctioning the property, the remaining loan amount is discharged in the bankruptcy. 

What Is an Unsecured Tax Claim?

Unsecured tax claims are tax debts that do not have a lien attached. There are two types of unsecured claims: priority and general.

Priority Unsecured Tax Claims

Priority unsecured tax claims are any income, employment, sales or property tax that cannot be discharged in a bankruptcy.

When a debtor declares bankruptcy, all priority claims are paid off before considering general claims. Certain bankruptcy filings require debtors to propose a repayment plan that will fully pay off all priority tax debts. 

General Unsecured Tax Claims

Any unsecured tax claims that do not qualify as priority are treated as general unsecured claims, which are dischargeable in bankruptcy. General tax debts are paid only after all priority and secured tax claims have been paid off.

All general claims are treated equally and receive an equal share of any remaining funds after the payment of secured and priority claims.

Because of the intertwining nature of tax claims, it is imperative that an experienced bankruptcy attorney assist with a bankruptcy filing.

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