Author: Andrew M. Thaler
The answer to the question of whether you can discharge taxes in personal bankruptcy is – it depends. This is a very complicated area of bankruptcy law. Whether a tax will be discharged depends in part on the type of tax, when the tax was incurred and the conduct of the tax payer. While most taxes cannot be discharged in bankruptcy, there are some taxes that can.
First, let’s discuss taxes that are not dischargeable. If sale or payroll taxes are owed, they will not be discharged in a personal chapter 7 bankruptcy. Those taxes are collected by the business/taxpayer for the benefit of the state or federal government. Individuals collect such taxes as a “fiduciary”. A fiduciary is a person or business with the power and obligation to act for another under circumstances which require total trust, good faith and honesty.
First, let’s discuss taxes that are not dischargeable. If sale or payroll taxes are owed, they will not be discharged in a personal chapter 7 bankruptcy. Those taxes are collected by the business/taxpayer for the benefit of the state or federal government. Individuals collect such taxes as a “fiduciary”. A fiduciary is a person or business with the power and obligation to act for another under circumstances which require total trust, good faith and honesty.
By way of example, a shopkeeper is deputized by the governmental to collect sales tax on behalf of the government. The sales tax collected, even though in the shopkeeper’s possession, is never the shopkeeper’s property. The shopkeeper, as either a sole proprietor or officer of a corporation, simply holds the funds in trust for the government. Because there are no controls on the collection and turnover of sales tax as money is collected, business owners strapped for cash very often use that “trust money” as their own. The unauthorized use of the funds constitutes conversion of property that does not belong to the shopkeeper. Shopkeepers will invariably say that they just used funds that they expect to repay when they are required to remit and file their sales tax returns.
In reality it is the exception and not the rule for a shopkeeper to actually segregate sales tax collections each day from other revenue. However, there should be a cash reserve to make sure that there are sufficient funds available to pay sales tax obligations. A failure to pay the tax results in (i) the imposition of high rates of interest, (ii) penalties and, (iii) most importantly, personal responsibility for corporate officers/owners and individuals in control of the company’s finances including signatories on bank accounts. The bottom line is that it is a very bad idea to use trust fund tax money.
The same rules apply to non-payment of withholding taxes from employee salaries. That money belongs to the employee and is deducted from the employee’s paycheck to pay his or her income taxes. Diversion of payroll tax moneys is an unauthorized conversion of property. Like sales tax, payroll tax cannot be discharged in a personal bankruptcy case. At some point the statute of limitations for collecting sales tax and payroll taxes will expire, thereby preventing collection of the tax. However, until such time as time to collect passes, generally 10 years, the debt will remain owing and cannot be discharged by bankruptcy.
There is some good news. Income taxes are treated differently than fiduciary sale and payroll taxes. This is due in part to the fact that the taxes owed are not moneys that the taxpayer collected from others in trust and converted for their own use. Income taxes are due and payable from a person’s earnings, which are not trust funds. For this reason the law allows certain income taxes to be discharged. In short, there is a three year rule, a two year rule and a 240 day rule. For income taxes to be discharged (i) the tax had to be due at least three years before the bankruptcy filing; (ii) a tax return must be filed by the taxpayer at least more than two years before the bankruptcy filing and (iii) the tax claim has to be assessed at least more than 240 days before the bankruptcy filing date.
There are at least two other requirements. The tax return must be non-fraudulent and the taxpayer cannot have engaged in activity deemed willful attempts to defeat or evade the tax. There is a rationale for this rule. If a tax return was filed for taxes that were three years old and the government had at least two years to try and collect the tax by placing a lien on or seize assets, the honest but unfortunate debtor should not be denied a bankruptcy discharge. This is the general rule.
However there is a mine field of issues in this area of law that could result in the income taxes not being discharged. For instance, an extension to file the return extends the start of the applicable waiting period. An agreement to extend the time or the pendency of an offer and compromise will toll and extend these periods. These are just a few situations where the tax may not be discharged. Moreover, there is currently a split among federal circuit courts whether the failure to file a timely tax return (even late by one day) eliminates the ability to discharge the income tax regardless of the two year language. The First, Fifth and Tenth Circuits have held that no discharge will issue. In contrast, the Ninth and Eleventh Circuits have rejected this “one day late” rule instead adopting an interpretation of the law that considers whether the debtor made an “honest and reasonable attempt to satisfy the requirements of tax law.” The Second Circuit, which covers New York, has not weighed in on the issue.
The bottom line is that income taxes are being discharged in New York bankruptcy cases if they meet all the criteria for discharge. You should timely file your tax returns and if faced with income tax debt you cannot afford to pay, consult an experienced bankruptcy professional to guide you through the law in this area.
In reality it is the exception and not the rule for a shopkeeper to actually segregate sales tax collections each day from other revenue. However, there should be a cash reserve to make sure that there are sufficient funds available to pay sales tax obligations. A failure to pay the tax results in (i) the imposition of high rates of interest, (ii) penalties and, (iii) most importantly, personal responsibility for corporate officers/owners and individuals in control of the company’s finances including signatories on bank accounts. The bottom line is that it is a very bad idea to use trust fund tax money.
The same rules apply to non-payment of withholding taxes from employee salaries. That money belongs to the employee and is deducted from the employee’s paycheck to pay his or her income taxes. Diversion of payroll tax moneys is an unauthorized conversion of property. Like sales tax, payroll tax cannot be discharged in a personal bankruptcy case. At some point the statute of limitations for collecting sales tax and payroll taxes will expire, thereby preventing collection of the tax. However, until such time as time to collect passes, generally 10 years, the debt will remain owing and cannot be discharged by bankruptcy.
There is some good news. Income taxes are treated differently than fiduciary sale and payroll taxes. This is due in part to the fact that the taxes owed are not moneys that the taxpayer collected from others in trust and converted for their own use. Income taxes are due and payable from a person’s earnings, which are not trust funds. For this reason the law allows certain income taxes to be discharged. In short, there is a three year rule, a two year rule and a 240 day rule. For income taxes to be discharged (i) the tax had to be due at least three years before the bankruptcy filing; (ii) a tax return must be filed by the taxpayer at least more than two years before the bankruptcy filing and (iii) the tax claim has to be assessed at least more than 240 days before the bankruptcy filing date.
There are at least two other requirements. The tax return must be non-fraudulent and the taxpayer cannot have engaged in activity deemed willful attempts to defeat or evade the tax. There is a rationale for this rule. If a tax return was filed for taxes that were three years old and the government had at least two years to try and collect the tax by placing a lien on or seize assets, the honest but unfortunate debtor should not be denied a bankruptcy discharge. This is the general rule.
However there is a mine field of issues in this area of law that could result in the income taxes not being discharged. For instance, an extension to file the return extends the start of the applicable waiting period. An agreement to extend the time or the pendency of an offer and compromise will toll and extend these periods. These are just a few situations where the tax may not be discharged. Moreover, there is currently a split among federal circuit courts whether the failure to file a timely tax return (even late by one day) eliminates the ability to discharge the income tax regardless of the two year language. The First, Fifth and Tenth Circuits have held that no discharge will issue. In contrast, the Ninth and Eleventh Circuits have rejected this “one day late” rule instead adopting an interpretation of the law that considers whether the debtor made an “honest and reasonable attempt to satisfy the requirements of tax law.” The Second Circuit, which covers New York, has not weighed in on the issue.
The bottom line is that income taxes are being discharged in New York bankruptcy cases if they meet all the criteria for discharge. You should timely file your tax returns and if faced with income tax debt you cannot afford to pay, consult an experienced bankruptcy professional to guide you through the law in this area.
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