Contrary to popular myth, bankruptcy does not discharge every financial obligation. Congress has identified a few debts that, in fairness, should not be discharged in a bankruptcy case. Some of these debts are enumerated in Section 523 of the Bankruptcy Code, including debts for fraud or embezzlement, domestic support obligations, and student loans. Some of these debts are never dischargeable, and some may be discharged under certain conditions.
One type of debt that is excepted from discharge by the Bankruptcy Code is when the debtor is liable for “a tax required to be collected or withheld and for which the debtor is liable in whatever capacity.” 11 U.S.C. §507(a)(8)(C). This type of tax is commonly called a “trust fund tax,” which is a tax that is either paid to or withheld by a person or business and kept “in trust” to be paid over to the government. Examples include income taxes and Social Security (FICA) taxes withheld from the paychecks of employees, and sales taxes collected by vendors from their customers. Trust fund taxes do not include the employer’s matching Social Security (FICA) taxes, employment, or sales taxes not actually collected, but are due as the result of an audit, or related penalties and interest.
Even when a company or corporation protects its officers and shareholders with limited liability from business debts, a taxing authority (like the IRS) can still “pierce the corporate veil” to determine which individual (or individuals) was responsible for collecting, keeping, and paying over taxes, called a “responsible party.” A trust fund recovery penalty may be assessed against a responsible party, which is also not dischargeable in bankruptcy. The only way for a responsible party to resolve a trust fund tax debt without payment is to wait for the ten year statute of limitations to expire.
Because trust fund tax debts are not dischargeable in bankruptcy, a responsible party unable to pay the tax debt should consider a Chapter 13 bankruptcy filing. During a Chapter 13 case, the individual submits a plan to repay the tax debt in full over three to five years. A benefit of bankruptcy is that the trust fund tax does not continue to accrue interest or penalties during the repayment period. After the debtor has paid the taxes according to the bankruptcy plan, the debt to the taxing authority is forever and completely extinguished.