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 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.
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).
"Sam is a wonderful, results-oriented and extremely knowledgeable and talented attorney, who really has 'heart' in working on behalf of his clients, and explains options in a straightforward, respectful manner. He has assisted us with great outcomes which have added to our quality of life. I would not hesitate to recommend Sam for his services as he is an ethical, personable and expert attorney in his field. You will likely not be disappointed with Sam's work ethic, approach and his efforts."
-Aileen Dwight, Licensed Clinical Social Worker & Psychotherapist
Last updated: May 27, 2023
Our best stuff: secrets, tax saving tools, and tax defense strategies from the braintrust at Brotman Law.
These ten big ideas will change the way you think about your taxes and your business.
Find the articles and videos you need to make the right tax decisions in the learning center.
It is not just about what we do, but who we are, why we do it, and how that benefits you.
Meet with us to outline your strategy. No further obligation, 100% money-back guarantee.
According to United States bankruptcy law, an automatic stay is defined as an automatic injunction,...
4 min read
Robert Wood, tax expert and frequent contributor to Forbes.com, wrote that “many would-be former...
12 min read
There is a generous tax benefit that only select taxpayers qualify for. Not well known, it is...
12 min read
We'll answer your most pressing tax law questions in 15 minutes. Please choose a time below that works best for you.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, I must inform you that any U.S. federal tax advice contained in this website is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter contained in this website.