Priority of Claims

What is “Priority of Claims” in Taxes?

When we talk about “priority of claims” in the world of taxes, we’re essentially talking about a pecking order for who gets paid first. Imagine a scenario where someone owes money to several different people or entities, but they don’t have enough cash to pay everyone back in full. That’s where priority of claims comes into play. It’s a set of rules that dictates who gets their money first, second, third, and so on. These rules are crucial, especially in situations like bankruptcy, estate settlements, or when a business shuts down and needs to liquidate its assets.

This concept isn’t unique to just taxes; it’s used in many areas of law to sort out who gets paid in these situations. However, tax debts are often treated differently than other types of debts, so it’s important to understand how these rules apply to the IRS and state tax authorities.

Background of Priority of Claims

The idea behind priority of claims is rooted in the need for fairness and order when there aren’t enough assets to go around. If everyone was treated equally, some might miss out on getting anything at all. Thus, legal systems developed a hierarchy based on several factors, including the type of debt, the date the debt originated, and public policy considerations.

Historically, governments have generally been given a high priority when it comes to collecting tax debts. This priority is based on the idea that the government needs to fund vital services and the public good. If taxes were not given a high priority, society would suffer greatly. This principle has been reflected in various legal codes and bankruptcy laws over time.

How Priority of Claims Works in Tax Scenarios

So, how does this actually play out when it comes to taxes? Generally, federal and state tax debts are given a priority over many other kinds of debts. This means that in many cases, the IRS and state tax authorities will be paid before, say, a credit card company or a personal loan lender. However, even within the realm of tax debts, there’s a specific order.

Federal Tax Liens

A crucial factor in determining priority is the existence of a tax lien. If the IRS places a tax lien against your property (due to unpaid taxes), it establishes the government’s legal right to claim your assets. Generally, the IRS’s tax lien will have priority over most other creditors, especially those who came after the tax lien was filed.

The Order of Payment

Here’s a general idea of how the order of payment often works:

• Secured Creditors: These creditors have a specific claim on an asset. For example, a bank holding a mortgage on your house has a secured claim and are often paid first. They will receive the proceeds from the sale of that specific asset.
• Federal Taxes: Unpaid federal taxes usually have priority over most other unsecured debts. However, the exact priority can vary based on the type of tax, when the lien was filed, and whether there are other secured creditors.
• State and Local Taxes: These debts generally have a similar priority level as federal taxes, often coming right after secured creditors and federal tax debts, depending on state law.
• Unsecured Creditors: These creditors don’t have a claim on a specific asset. Credit card companies, medical bills, and other personal loans typically fall into this category. They’re often paid after secured creditors and the government (federal and state taxes).
• Shareholders and Owners: In the case of a business liquidation, shareholders are often the last in line to receive any assets after all other debts have been paid.

Important Considerations

Keep in mind:

• Timing Matters: The timing of a tax lien is critical. A tax lien filed by the IRS before you take out a loan may have priority over that loan, even if you file bankruptcy after taking out the loan.
• State-Specific Laws: While federal tax laws have a general pattern of priority, individual states have their own laws that can alter the priority of state and local taxes. This can get complex, so checking your state’s laws is crucial.
• Bankruptcy: The rules of priority can get especially complicated in bankruptcy. The Bankruptcy Code has its own specific rules that determine the order in which creditors, including tax authorities, are paid. There are specific classifications for tax debts in bankruptcy, like “priority debts” and “unsecured non-priority debts.”
• Negotiations: In some cases, tax authorities may be willing to negotiate payment plans or accept less than the full amount owed. This can happen in situations where collecting the full amount would be very difficult.

Examples of Priority of Claims in Tax Scenarios

Let’s look at some simple examples:

Example 1: Small Business Failure

Let’s say a small business closes down and sells its assets to try and pay off debts. Here’s how it might play out, roughly:

1. Secured Loans: The bank that provided the loan for the business equipment and has a lien on the equipment will get paid off first from the proceeds of selling the equipment.
2. Federal Taxes: After that, any outstanding federal payroll taxes or income taxes will have a high priority claim.
3. State Taxes: State taxes are often next in line.
4. Unsecured Business Debt: Any unsecured business debts, like credit card bills, vendor bills, or loans where specific assets were not collateral will then get paid if there is anything left.

Example 2: Personal Bankruptcy

Imagine an individual files for bankruptcy. They owe:

• A mortgage on their house.
• Unpaid federal income taxes.
• Credit card debt.

1. Mortgage: The mortgage lender has a secured claim, so their mortgage gets paid off from the sale of the house.
2. Federal Taxes: Next in line are usually unpaid federal income taxes. In bankruptcy they are considered a “priority debt”.
3. Credit Card Debt: Credit card debts are unsecured, so the credit card companies get paid after the mortgage and taxes, if there is anything left.

Example 3: Estate Settlement

If someone dies and their estate owes debts, the process is similar:

1. Secured Debt: Secured loans on property are paid first from the sale of the property.
2. Administration Expenses: Expenses of settling the estate (such as legal and accounting fees) are paid next
3. Federal Taxes: Federal tax debts owed by the deceased are often given a priority.
4. State Taxes: State and local taxes are addressed similarly.
5. Other Debts: Other debts, such as medical bills and credit card debt, are paid after taxes.
6. Beneficiaries: Beneficiaries of the will are the last in line to receive anything after all creditors have been paid

Who is Affected by Priority of Claims?

Priority of claims affects a wide range of people and entities:

• Individuals: Anyone who owes taxes or has debts, especially those facing bankruptcy or financial hardship.
• Small Business Owners: Business owners need to understand priority of claims to manage their debts and plan for potential liquidation.
• Estates: The process of settling an estate involves understanding the order of debt payment.
• Creditors: Lenders, vendors, and other parties to whom money is owed must be aware of their position in the order of repayment.

Related Tax Concepts

Understanding priority of claims will often involve considering these related topics:

• Tax Lien: A legal claim by the IRS or state tax authority on your property.
• Bankruptcy: Legal proceedings where debts are reorganized or discharged.
• Insolvency: Being unable to pay your debts when they’re due.
• Secured Debt: Debt backed by specific collateral.
• Unsecured Debt: Debt not backed by specific collateral.

Tips and Strategies

Here are some strategies to navigate the complexities of priority of claims in the context of taxes:

• Stay Current on Taxes: The easiest way to avoid complicated issues with priority of claims is to pay your taxes on time and in full.
• Be Organized: Keep accurate financial records. This can be critical if you need to understand your debt structure.
• Seek Professional Help: Tax law is complex. Consider consulting with a tax professional or bankruptcy attorney if you’re facing tax debts or financial difficulties.
• Negotiate: If you owe back taxes, explore options for payment plans or an “offer in compromise” with tax authorities.
• Understand Your State Laws: States often have unique rules regarding state tax liens.

Common Mistakes and Misconceptions

It’s easy to make a few mistakes in understanding priority of claims:

• Assuming All Debts are Equal: Many people assume all debts are treated the same in bankruptcy or asset liquidation. This is incorrect.
• Ignoring Tax Liens: Failing to understand or address tax liens can have severe consequences, as they often have higher priority.
• Failing to Prioritize Taxes: Putting off dealing with tax debts can lead to serious problems. Tax liens and government penalties can accumulate quickly.
• Not Checking State Laws: State laws vary greatly on the treatment of state tax liens and their priority.
• Thinking Bankruptcy is a Magic Solution: Bankruptcy may help, but doesn’t eliminate every debt, and tax debts often have special classifications.

Understanding priority of claims is vital for anyone who has financial obligations, especially tax debts. It provides a framework for how debts are settled when resources are limited. Staying informed, organized, and seeking professional help when needed can help you avoid serious financial consequences.