Taxes that can be discharged in a bankruptcy
It is a common myth that taxes and other IRS debts can never be discharged in a Chapter 7 bankruptcy. Here are the rules that you should know to be able to discharge income tax & IRS debts in a bankruptcy.
Personal Income Tax
Taxes that you owe personally can be discharged if you meet certain rules: the three year rule (3 years since due date or extended due date), the two year rule (2 years since the tax return was filed), and the 240 day rule (240 days since the tax was assessed). There is also a rule against discharging debts from a fraudulent tax return and willful tax evasion. Taxes that do fall under this category (meaning the taxes are less than three years old, or filed less than two years ago, or assessed less than 240 days ago, was filed fraudulently, or the taxpayer was found to be guilty of willful tax evasion), are considered “priority taxes” which are not dischargeable in bankruptcy. Any debt that is considered non-dischargeable in bankruptcy means that you are still responsible for paying this debt whether you file for bankruptcy or not.
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Sales Tax
If you owe sales tax to the CA FTB, whether or not they are dischargeable depends on whether the sales tax is considered an “excise tax” or “trust fund tax.” How the sales taxes are categorized depends on your state. Sales tax is considered a trust fund tax if the tax is assessed on the customer at the time of the sale and the responsibility to collect the tax is on the business owner. The business owner is supposed to collect the tax to turn over to the taxing authority. Trust fund taxes are not dischargeable in bankruptcy.
Sales tax that is the responsibility of the owner for the privilege of doing business in the state is considered an excise tax. California is an “excise tax” state, so that means that the business owners are responsible for the sales tax, not the customer. It may be a little confusing, since almost all the business owners pass on the sales tax to their customers, but the ultimate liability of the sales tax is still on the business owner. Excise taxes are dischargeable in bankruptcy, so that is good news for owners of failed businesses in the state of California.
Payroll Tax
There are two parts to payroll tax: the taxes that are taken out of an employee’s paycheck, and the tax paid by the employer. The taxes that are withheld from an employee’s paycheck (federal income tax, state income tax, medicare social security, and state disability) are “trust fund" taxes. It is the business owner’s fiduciary responsibility to propmtly submit that money to proper taxing authority. The funds taken out of the employee’s paychecks are “held in trust” by the business owner to be turned over to the taxing authority. If the business failed (or even if the business is still continuing), and the funds were used to pay off other debt or expenses other than to turn over to the taxing authority, the taxing authority will not be sympathetic. They only care that the business owner withheld these funds, but used it for other purposes than which it was held for. As with the sales taxes that are considered to be “trust fund taxes” payroll taxes withheld from an employee’s paycheck are considered non-dischargeable in bankruptcy.
The payroll taxes that are paid by the employer are “non-trust fund taxes.” These taxes are dischargeable in bankruptcy.
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