People often think of taxes simply as money owed to the government and don’t put anymore thought into the unpleasant topic. There are many different kinds of taxes, most of which fall into a few basic categories: taxes on income, taxes on property, and taxes on goods and services. The government is creative on ways it can collect revenue and have found ways to exact a fee from most every aspect of our lives. For someone contemplating bankruptcy, what kind of tax one may owe, when it was first due, whether a return was filed, or when a return was filed, all make a big difference in how the tax is treated.
Everyone is familiar with income taxes. One earns income and generally there is a portion that must be paid to the government, whether that be the state, the federal government, or local municipality in some cases. Business owners will also be familiar with sales taxes and payroll taxes. There are also estate taxes, inheritance taxes, gift taxes, capital gain taxes, excise taxes, and the so called sin taxes which are imposed on products like tobacco and alcohol, and luxury taxes which are imposed on expensive vehicle or jewelry.
In my bankruptcy practice I represent many small business owners. In those states that assess a sales tax, businesses that sell direct to consumers are required to withhold a portion of the sale proceeds and pay that amount to the state. Employers are also required to withhold a portion of an employee’s wages and transfer the withholding to the state. Sales taxes and payroll taxes are two of the most problematic areas for business owners.
Sales taxes and payroll taxes are required to be held in trust for the government and paid quarterly. To be held in trust means that the funds don’t belong to the business and must be reserved solely for the benefit of the government. These taxes are often referred to as “trust fund taxes”. Small business owners, often juggling expenses and struggling with inconsistent revenue, often times fail to segregate the trust fund taxes. As a result when it comes time to make the required necessary quarterly payment to the government, those funds are no longer available. It’s actually rare for me to meet a small business owner that properly segregated the trust fund taxes and paid it timely to the government.
In addition to the obvious problem in that the tax was not paid and interest and penalties are accruing, because these are trust fund taxes, any person that is responsible for the remittance of the sales or payroll tax is also personally liable for the debt. That’s right, it may be a business obligation but now it has just become a personal obligation too.
Now to the point of my blog. Let’s limit the discussion here to only the most common kinds of taxes I see in my practice: income and trust fund taxes (sales and payroll). Contrary to popular belief some taxes do go away in bankruptcy depending on certain criteria. Let’s break it down a bit more.
In a bankruptcy context, taxes are categorized as secured, priority, and general unsecured. The IRS becomes secured by filing a Notice of Federal Tax Lien and each state have similar noticing requirements dictated by statute. Once a notice of lien is properly filed, the taxing authority may collect from property one claims as exempt in a bankruptcy case. This is property that one asked to keep instead of turning over to the trustee to pay creditors. The type and value of the property one is allowed to keep is determine by law. The tax debt may also be collected from property that was part of the bankruptcy case, but was returned when the trustee determined it had insufficient value to pay creditors, and the trustee abandoned, or removed it, from the bankruptcy case. These two types of property are referred to as “exempt” or “abandoned” property.
The tax lien remains attached to the exempt and abandoned property owned when the bankruptcy case began. The tax lien is generally not limited to the value of the assets at the beginning of the bankruptcy case. Once the tax lien attached to property, it attaches to any appreciation in the value of the property. Similarly, if the value of the property decreases, the lien only attached to the decrease value. If the property was of a kind that one added funds to after the bankruptcy case began, such as a bank account, the tax lien will only attach to the bank account value that existed as of the beginning of the bankruptcy case.
Priority income taxes are those taxes that were returns where the due date of the return, counting extensions, is within three years of the bankruptcy filing date; or assessed within 240-days of the filing date; or trust fund taxes, no matter the age. Priority taxes do not go away in bankruptcy. However, the repayment may be structured over a five-year period. Often times the ability to control the timing of repayment is reason enough to file for bankruptcy protection, notwithstanding the fact that the tax will still have to be repaid.
Except for taxes on returns that have not been filed, taxes on returns filed late within two years of the filing date; taxes on fraudulent returns; or, taxes for years where the taxpayer willfully attempts in any manner to evade or defeat taxes that are due, a tax claim that is neither secured or priority is dischargeable in bankruptcy – meaning it goes away.
This is only an overview of a complicated are of law with many traps for the unwary. I hope that you will find this information informative and useful. You should contact your attorney to obtain advice with respect to any particular issue or problem.
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