Although we are technically coming out of the recession and bankruptcy filings are on the decline, a significant number of Crystal Lake and McHenry County residents are considering bankruptcy. A major contributing factor to bankruptcy is tax debt and penalties due to the IRS or State of Illinois. This blog post will attempt to explain for the most common types of tax debt whether you can discharge taxes in bankruptcy.
The most common forms of tax debt.
Personal bankruptcy filers and small business filers generally face three types of tax debt or quasi-tax debt when considering bankruptcy:
- Individual or family income tax liability. This is relatively straightforward and is what most people think of when wondering whether you can discharge your taxes in a bankruptcy. This is debt owed to the Internal Revenue Service or the Illinois Department of Revenue.
- Unpaid payroll tax, unpaid sales taxes, or related trust fund liability. This can be a problem for small business employers that had employees at one point.
Individual income tax liability can be discharged in bankruptcy, usually after 3 years after the return was due.
Regular unpaid income tax debt, owing to either the IRS or the Illinois Department of Revenue, can be discharged if all of the following are true:
- It has been at least 3 years since the tax return that caused the income tax liability was due (and this includes any extensions).
- The return actually must have been filed more than 2 years ago. This usually only applies if you filed your returns late.
- There have been at least 240 days since an IRS adjustment or audit adjustment took place or there was an amended return. If you make an Offer in Compromise, this time frame is extended during the time that the OIC is under consideration plus 30 days. See 11 U.S.C. §507(a)(8)(A)(ii)(I).
Trust fund tax liability generally cannot be discharged in bankruptcy.
Federal law requires employers to withhold from the pay of and hold “in trust” for the benefit of its employees the employee’s share of federal income and social security taxes. See 26 U.S.C §3102, 26 U.S.C. §3402. Because of the requirement that these taxes be held in trust for the benefit of the employee and the federal government, they are commonly referred to as “trust fund taxes.” There are similar payroll taxes, sales taxes, and excise taxes to be remitted to the State of Illinois that are considered to be trust fund taxes.
Unpaid trust fund taxes cannot be discharged in the company’s bankruptcy filing. See 11 U.S.C. §523(a)(1)(A); 11 U.S.C. §507(a)(8)(C). This generally is not that big of a concern if the company is liquidating under Chapter 7 of the Bankruptcy Code because the company is essentially dead anyhow. However, this is a big problem for the owners of the company who were responsible for the collection and holding of these trust fund taxes.
The employer, officer, or member of the company who are deemed “responsible” for “willful” failure to collect and remit trust fund taxes will have personal liability for the unpaid trust fund taxes. See 26 U.S.C. §6672 (federal taxes); 35 ILCS 735/3-7(a) (Illinois taxes). Additionally, they will likely face a 100% penalty in addition to the unpaid tax liability.
For the individual owners and employers of the defunct company who are held responsible for the company’s failure to remit trust fund taxes, their personal liability for the taxes and for the penalty imposed for failure to pay the taxes is non-dischargable in bankruptcy. See 11 U.S.C. §523(a)(1)(A); 11 U.S.C. §507(a)(8)(C). This debt must be paid in full.
If you think your small business may fail, speak to your bankruptcy attorney well in advance of the doors closing.
Because of the harsh penalty for failing to pay tax authorities certain taxes, small business owners should consult with a knowledgeable bankruptcy attorney before closing up shop. Winding up the company the right way can save you significant tax liability and penalties.