Submitted by Attorney Pernell McGuire
In today’s economy more and more small business owners are being forced to seek protection from creditors by filing bankruptcy. In many cases, the small business owner has tax liability for payroll taxes and wants to know how a bankruptcy can help them. In certain circumstances, bankruptcy can help deal with payroll taxes by either eliminating them altogether or providing more favorable repayment terms then if the business owner is left to deal with the IRS on their own. Payroll or employment taxes are comprised of two parts:
- the employer portion, and
- the employee portion.
Employer Portion of Payroll Taxes is Dischargeable – Sometimes.
The employer portion of the payroll tax is the tax which the employer owes directly to the IRS. The employer portion includes the employer’s obligation to match the employee’s 6.2% social security tax and the 1.45% Medicare tax.
For sole proprietors, the employer portion of the employment tax can be discharged in bankruptcy if:
- there are more than three years between the date the 941 tax return was last due, including extensions, and the date that the bankruptcy was filed;
- there are more than two years between the date the 941 tax return was filed and the date the bankruptcy case was filed; and
- the employer did not willfully evade payment of the tax.
Employee (Trust Fund) Portion of Payroll Taxes is Never Dischargeable.
The employer is required to withhold the employee portion aka “trust fund” portion from the employee’s pay check and remit it to the Internal Revenue Service (IRS).
The employee portion of the tax is referred to as a trust fund tax because the employer is collecting the employee paid portion of the payroll tax from the employee in the capacity of a trustee for the IRS.
The employee paid portion of the payroll tax includes the 6.2% Social Security tax and the 1.45% Medicare tax.
Trust fund taxes are never dischargeable in Chapter 7 bankruptcy. Thus, if the business owner files chapter 7, he or she will still have to deal with the IRS to resolve the tax liability. In that case, interest and penalties on the outstanding tax liability will continue to accrue. Under such circumstances, the business owner should strongly consider filing chapter 13 to deal with the tax liability.
Under Chapter 13, the business owner submits a plan to repay its tax (and other) debt over a there to five year period of time. The tax debt must be repaid in full over the term of the plan. However, the tax debt does not continue to accrue interest or penalties – only the tax existing as of the date of filing the bankruptcy must be repaid. Further, the tax debt has priority over any other unsecured debt and thus, gets paid before any other unsecured debts.
There is no escape from trust fund recovery taxes. However, trust fund taxes will become uncollectible if the 10 year statute of limitations expires without the IRS filing suit, regardless of whether the taxpayer files bankruptcy or not.
Any business owner facing significant tax liability should consider visiting with an experienced bankruptcy attorney to determine whether bankruptcy can provide the necessary relief.