Sam Brotman, JD, LLM, MBA December 16, 2013 4 min read

Discharging Taxes in Bankruptcy - Part One

When the debtor files a petition for bankruptcy relief, this action immediately affects the collection of taxes. Debtors should first familiarize themselves with preferred tax resolution methods specific to innocent spouse relief, a request for abatement of penalties, an installment agreement, or an offer in compromise (OIC). “Using administrative tax resolution methods instead of bankruptcy may help clients avoid having a ‘black mark’ on their credit history. However, a federal tax lien listed on the debtor’s credit report may damage his or her credit rating as much as a bankruptcy notation” (JournalofAccountancy.com, “Discharging Taxes in Bankruptcy,” 8/15/2013). When the standard options are not sufficient, petitioning for bankruptcy relief may be appropriate.

There are rules[1] that govern the discharging of taxes in bankruptcy. A tax claim may be characterized as a trust fund tax, a secured claim, an administrative tax claim, a priority tax claim, a general unsecured claim, or a penalty claim. In other words, a “debtor’s ability to discharge any tax debt is based upon the classification of that particular tax debt” (Armknecht, “Discharging Tax Debts in Bankruptcy,” 8/15/2013). The rules are specific to how taxes are assessed by both claim status and category.

For this reason, trust fund taxes are defined as “money withheld from an employee’s wages (income tax, social security, and Medicare taxes) by an employer and held in trust until paid to the Treasury” (IRS.gov, “Trust Fund Taxes,” 9/12/2013). When an employer pays an employee, the employer does not pay to the employee all the money the employee has earned. Instead, the employer has the responsibility of withholding taxes from the employee’s paychecks. The income tax and the employees’ share of FICA (social security and Medicare) are withheld from the employees’ paychecks and are paid to Treasury through a federal deposit (IRS.gov, “Trust Fund Taxes,” 9/12/2013). An employer’s tax deposit is considered a current expense. Congress has imposed penalties for an employer’s failure to deposit employment taxes.[2]

In addition, trust fund taxes are also specific to those obligations that fall under the categories of sales taxes. The collected taxes are held in trust by the debtor. The funds are sent to the appropriate taxing authority. “Such amounts held in trust are simply not [the] property of the debtor or of the bankruptcy estate” (Armknecht). The debtor will be required to submit funds to the appropriate taxing authority when there is a priority of tax claim pursuant to 11 U.S.C. 507(a)(8)(C).

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[1] Rules that govern the discharging of taxes in bankruptcy fall under Section 507 of the U.S. Code (11 U.S.C. 507 – Section 507: Priorities).

[2] For more information about trust fund taxes and the employer’s responsibility, review Publication 15, Circular E, Employer’s Tax Guide.

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
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