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

The IRS views payroll taxes withheld from the wages of employees as a “trust fund tax.” The reason is that the money is collected from employees by the employer for remittance to the federal government, but the taxes never belonged to the employer. Federal law states that the money is held in a trust for the U.S. Treasury Department. Under most circumstances, bankruptcy does not absolve you of the responsibility of paying the trust fund recovery penalty (TFRP). Six aspects of the TFRP can make it difficult or impossible to get rid of:

• It counts as a tax;
• gets priority status;
• loses its Chapter 13 super discharge protection;
• is not dependent on the outcome of the company’s bankruptcy;
• blame for the lapse cannot be shifted;
• and borrowing to pay it does not escape the debt.

Trust fund taxes include both withholding of federal income taxes for the employee and payment of the employee’s share of FICA tax. The employer’s FICA tax is not part of the employee’s payroll, and is not considered a trust fund tax. In United States vs. Sotelo, the U.S. Supreme Court ruled in 1978, by a 5-4 vote, that the TFRP is essentially a federal tax. The Court majority held that the label of “penalty” does not change the fundamental nature of the TFRP. Also, the TFRP equals the full amount of the unpaid trust fund taxes, not a portion of them or a small additional amount.

Priority Tax

Under 11 U.S.C. § 507(a)(8), the TFRP is considered a priority tax under bankruptcy law. This is consistent with the notion that money paid to the employer for remittance of payroll taxes belongs to the government. Section 507(a)(8)(C) of the code states that this trust fund recovery tax must be paid regardless of when it came due. Trust fund penalties are not dischargeable in a personal bankruptcy case, under Section 523(a)(1)(A) of the bankruptcy code, whether or not the IRS files a claim in the case.

Chapter 13 was once the route to discharge the TFRP. For cases filed before October 17, 2005, a “Superdischarge” was available under Chapter 13. That is no longer true, however, for owners or officers of a business who qualify as “responsible persons.” Instead, these responsible individuals must deal with the penalty as they would any other nondischargeable tax.

Personal Liability Is Common for Back Payroll Taxes

Despite the “corporate shield,” the IRS looks through the company to the responsible owner. Even if the company is itself in bankruptcy, the IRS is still coming after the individual owner. If only the company files, the stay against the IRS generally does not prevent the IRS from assessing and collecting the TFRP against people who do not file a personal bankruptcy, like the manager, shareholder, or director.

One exception does exist. IRS has adopted a policy to hold off on its 100% penalty for unpaid trust fund taxes if the taxes are being paid in full through a Chapter 11 bankruptcy plan and the plan is not in default. A bankruptcy court may also order IRS to take its payments from the company under the plan first toward the trust fund taxes, if needed for the plan to work.

Nor can you shift the blame. IRS and the courts use a very broad reading of who is a “responsible person.” The courts have defined a responsible person as an individual or individuals who have significant, though not necessarily exclusive, control over the decisions that affect which creditors are paid. A responsible person may be an officer, employee, shareholder, or even a payroll provider.

The embezzlement of funds by another person is no excuse for failure to pay the taxes. It does not matter that someone else at the company was just as responsible as you are, or that the company is working out an installment plan with the IRS. The IRS will likely treat your paying other creditors while payroll taxes go unpaid as evidence that your failure to pay was willful. However, this will not automatically trigger the trust fund recovery penalty. But there is a remedy if you paid more than your share: you can sue the other person who was responsible, but only in a separate lawsuit.

Debt Incurred to Pay a Nondischargeable Tax

Because many owners end up paying trust fund taxes with borrowed money, their TFRP liability often prevents them from getting out of other debts in bankruptcy. This happens because the bankruptcy code generally makes debt incurred to pay a nondischargeable tax itself nondischargeable, so that any business-related loan you used to pay the trust fund taxes is usually nondischargeable. If you used a credit card or other personal loan, that debt may survive your discharge in bankruptcy. The Cook case illustrates how the courts view the trust fund taxes as ultimately the taxpayer’s liability. The owner charged the taxes owed by the company to his own personal American Express card, which was not the company’s account. The court refused to discharge this debt in his personal bankruptcy, saying he would still owe it to the IRS regardless. Notice that this is so even though the IRS had not assessed a trust fund penalty against the owner.

There is an exception for the unusual case where a bank repeatedly honored company overdrafts, as in Van Dyn Hoven. Some of the checks overdrew to cover trust fund taxes, but the bank honored them and then rolled the overdrafts into notes personally guaranteed by the company’s sole shareholder. A district court let the owner’s personal guarantee of the notes be discharged. This was because the borrowing was within the course of normal business conduct for the company: the taxes were paid from the operating account. And there was no evidence he had known that borrowed funds were being used to pay the taxes, or that he had applied for the loan to pay them. The court defined ‘incurred to pay a tax’ as used in Section 523 as money borrowed for the purpose of paying taxes. In addition, the bank was aware of the company’s business and kept regular watch on its account. This may well have been different if the owner had applied for a loan to pay the taxes, or had used a personal credit card.

Don’t put off paying payroll taxes and hope that bankruptcy will erase your liability for them. Usually it won’t. If the IRS has proposed the trust fund recovery penalty, you have 60 days to appeal from the date of the letter. If you don’t respond, it can assess the penalty and then file a tax lien or levy against your personal property. The IRS generally has three years to assess the penalty and up to 10 years to collect it. Every case turns on its own facts, so it pays to evaluate your situation at the earliest sign of trouble.