Bankruptcy and Payroll Taxes: 6 Reasons the Trust Fund Penalty Survives Discharge

Of all the debts a failing business leaves behind, the one most likely to follow its owner out of bankruptcy is the money withheld from employees' paychecks and never sent to the Treasury. The Internal Revenue Code calls the owner's exposure a penalty, the Bankruptcy Code treats it as a tax, and the combination has held up in each chapter a business owner is likely to file.

The penalty comes from 26 U.S.C. Section 6672(a), which makes "any person required to collect, truthfully account for, and pay over" a tax, who "willfully fails" to do so, liable for "a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over." It reaches the income and Social Security taxes withheld from employees' pay, the trust fund taxes, and not the employer's own matching share. Six features of the law keep it alive past a discharge.

1. The Company's Bankruptcy Is Not the Owner's

A corporation or LLC that files Chapter 7 receives no discharge at all, because Section 727(a)(1) grants one only to individuals. A company that confirms a Chapter 11 plan may be discharged, but Section 524(e) says that "discharge of a debt of the debtor does not affect the liability of any other entity on" that debt.

The trust fund penalty was never the company's debt to begin with. As the Supreme Court described it in United States v. Energy Resources Co., 495 U.S. 545 (1990), Section 6672 "authorizes the Government to collect an equivalent sum directly from the employer's officers or employees who are responsible for collecting the tax." It is a separate liability of a separate person, and the automatic stay that protects the company does not, by its own terms, reach that person.

You file the company and then you get the letter anyway.

2. The Code Gives the Tax Priority in Whatever Capacity It Is Owed

Section 507(a)(8)(C) grants eighth priority to "a tax required to be collected or withheld and for which the debtor is liable in whatever capacity." The last three words fit this situation exactly: the owner is not the employer, and did not owe the tax as an employer, but is liable for it as the responsible person, and the Code does not care which capacity produced the liability.

Notice what the subparagraph leaves out. The income tax priorities in Section 507(a)(8)(A) turn on returns last due within three years before the petition or assessments within 240 days of it. Subparagraph (C) sets no such period, so, for bankruptcy purposes, there is no waiting out the trust fund penalty the way an owner might wait out an old income tax year.

3. Section 523 Carries the Priority Into Nondischargeability

Under 11 U.S.C. Section 523(a)(1)(A), a discharge does not release an individual from a tax "of the kind and for the periods specified in section 507(a)(3) or 507(a)(8) of this title, whether or not a claim for such tax was filed or allowed." Because the penalty is a 507(a)(8)(C) tax, it is excepted from the Chapter 7 discharge of an individual owner, and Section 1141(d)(2) applies the same exception to an individual's Chapter 11 discharge.

The phrase "whether or not a claim for such tax was filed" is the part that matters to an owner who hoped the IRS would miss the claims deadline. Missing it changes nothing.

4. Even the Broader Chapter 13 Discharge Names It

The Chapter 13 discharge for completing a plan is broader than the Chapter 7 discharge and excepts fewer debts, which is why owners sometimes look to it for help with tax problems. Section 1328(a)(2) closes that door for this penalty by excepting any debt "of the kind specified in section 507(a)(8)(C)." The plan can pay the penalty over time. Completing the plan does not erase what is left.

5. The Label Penalty Did Not Persuade the Supreme Court

In May 1978, before the current Code took effect, the Supreme Court decided United States v. Sotelo, 436 U.S. 268, and held that an officer's Section 6672 liability for withheld taxes, though the statute calls it a penalty, is "not dischargeable in bankruptcy." The argument that a penalty is something other than a tax had an appealing logic (the present Code, in Section 523(a)(7), does allow certain tax penalties to be discharged, including those imposed for events more than three years before the petition, so the distinction is not imaginary), and the Court rejected it for this liability, which Section 6672 measures dollar for dollar by the tax that was withheld and never paid over.

Sotelo interpreted the old Bankruptcy Act. The present route runs through Sections 507(a)(8)(C) and 523(a)(1)(A), which reach the same result in their own words, and it is the present route a lawyer will rely on.

6. Willfulness Requires No Bad Motive, So the Hard Choices Do Not Excuse It

The IRS treats a responsible person as willful who "either intentionally disregarded the law or was plainly indifferent to its requirements (no evil intent or bad motive is required)," and gives paying other business expenses instead of the withheld taxes as an example. The owner who kept the lights on, paid the landlord, and let the merchant cash advance debits clear while the payroll deposits went unmade has not, in that description, found a defense. The owner has, if we are to call it what the agency calls it, supplied the evidence.

Two procedural points soften the picture a little. Section 6672(b) bars the penalty unless the IRS first sends written notice that the person will be subject to it, at least 60 days before notice and demand, which gives the owner a window to contest responsibility before assessment. And in Energy Resources, the Supreme Court held that a bankruptcy court may order the IRS to treat a Chapter 11 debtor's tax payments as trust fund payments where that designation "is necessary for the success of a reorganization plan," which can reduce the unpaid trust fund balance on which an owner's penalty rests. Section 1129(a)(9)(C) lets a plan pay priority taxes in installments over up to five years from the order for relief. None of these discharges the owner's liability; they only change how much of it is left.

Where Delancey Street's Work Stops

No settlement company can negotiate away a trust fund penalty; that is a matter between the owner and the IRS, handled by a tax professional or counsel. Delancey Street, which negotiates merchant cash advance debt, is not a law firm; representation before the IRS or a bankruptcy court is outside its work. Where daily advance debits are what pushed the payroll deposits aside, Delancey Street offers a free and confidential initial review of the advance debt, bringing in independently licensed attorneys for legal questions. An owner already facing a proposed trust fund assessment should put the tax representative first in line.

The money in question belonged to the employees from the moment it was withheld. Every rule above follows from the law's refusal to forget that.