Payroll Tax – Can It Be Discharged in Bankruptcy?

Small business is the lifeblood of our economy. Starting a small business is difficult though. Marketing and management problems, government regulation and taxes all lie in wait to derail the best laid plans. I typically see the small business owner at the end of what is usually a monumental effort gone bad.

The owner now has a number of debts. Business related and personal. He or she often has a debt that can be very difficult to deal with.

Employment tax, or as some call it “payroll tax”.

This is the tax the business owner may have withheld from the employees’ paycheck, matched with some business income and sent in to the IRS (or failed to send in)

When this type of debt exists, the owner will usually talk to a tax professional in hopes that the IRS offer in compromise program (OIC) will be an available remedy.

The OIC can result in a vast reduction of the tax debt, and for some it does, for most…it doesn’t. The OIC usually fails for a number of reasons. I have written about a few here. There are other lawyers and tax professionals who are familiar with the offer in compromise process and who are generally dissatisfied with it as well.

I agree that the OIC must be explored and in some cases it will be successful. But where it isn’t, does the business owner have other options short of paying the debt or moving to a remote island?

1. Long term payment plan – A payment plan that will fluctuate as the business owner’s income fluctuates but will end when the statute of limitations on collection ends ten years from the date of assessment. (give or take a few years – read more here) It can end sooner of course, if the business owner pays the debt off. There are different types of payment plans as well.

2. Bankruptcy

But wait a minute. Bankruptcy can wipe away income tax debt but employment taxes? No way right? Not so fast. Employment tax as mentioned above is divided into two parts:

The employee portion

The employer portion

The employer portion is the part of the tax that includes the obligation to “match” the employee’s 6.2% social security tax and the 1.45% medicare tax. This portion of the employment tax can be discharged in bankruptcy if:

1. There have been more than 3 years between the date the 941 tax return was last due including any extension and the date the bankruptcy filing takes place.

2. There have been more than 2 years between the date the 941 tax return was filed and the date the bankruptcy filing takes place and;

3. The business owner didn’t willfully attempt to evade the tax (a topic for another day)

The employee portion or what is often called the “Trust Fund” is NEVER dischargeable. This portion is withheld by the employer in “trust” and sent in. This part of the debt survives a chapter 7 bankruptcy and must be paid over a period of time in a chapter 13 bankruptcy or directly. It can be settled as mentioned in an OIC, and a payment plan coupled with the statute of limitations on collection will eventually kill it off. (see above as well)

Despite the non – dischargeable nature of the trust fund portion of the employment tax, a bankruptcy may make sense for the business owner with a personal liability for the non trust fund portion. Especially where other debt exists.