The rule that Uncle Sam comes first, in bankruptcy, can be a life saver, even if the debtor is going to lose everything in the process.
I was brainstorming with a colleague about his client who was about to suffer a huge judgment in state court. There were virtually no other creditors that made bankruptcy otherwise appropriate and the judgment might well be non dischargeable. There was a paid-for house well over the homestead exemption and stock investments to boot. We were trying to figure out what benefit might flow from filing bankruptcy.
What tipped the scales in my mind toward bankruptcy as opposed to letting the creditor collect under state law? The capital gains taxes.
The ugly fact about state law collection actions is that the creditor can force a sheriff’s sale of the property, the creditor gets the net sale proceeds, less any exemptions, and the debtor gets the tax bill. Not a very appealing outcome.
Contrast that to a bankruptcy liquidation: the trustee sells the asset, pays any taxes triggered by the sale, and THEN the creditor gets paid the balance.
Taxes incurred by the estate are an expense of administration. §503(b)(1)(B) The bankruptcy estate takes the asset with the debtor’s tax basis and with any tax attributes, such as the principal residence exclusion.
In the case I was considering, it looked like there might be $500,000 in gain on the sale of the house, $250,000 of it taxable. If the combined state and federal rate on that gain is 25%, the tax would be $62,500.
At a sheriff’s sale, the creditor gets all the non exempt cash and the debtor gets a $62,500 tax bill, having been stripped of the assets from which the tax might be paid. In bankruptcy, the trustee picks up the tax bill.
The debtor in this scenario may emerge from bankruptcy flat broke, but there won’t be a tax insult to add to his injuries.
Image courtesy of mediaspin.com.