How Bankruptcy Handles Withholding Taxes Owed on Behalf of an Employee
Feb. 20, 2015
Employee withholding taxes can’t be written off in bankruptcy. But still, either Chapter 7 or 13 may provide your best solution.
Withholding Taxes Are Special
If you have a business, or recently had one, with one or more employees, and you or your business withdrew money from the employees’ paycheck but did not send that withheld money on to the IRS or other appropriate state or local tax agency, most likely that tax agency is chasing you hard for payment of that money. They do not take kindly to not getting paid what are often referred to as “trust fund taxes.” The income taxes, social security and Medicare taxes that you withheld from your employee(s) paycheck are said to be held in trust by you on behalf of your employees. So if you don’t turn this money over to the tax agency(ies), they can get very aggressive in trying to collect it out of you, much more so than with personal or business income taxes.
Here is how the IRS sees it:
When you pay your employees, you do not pay them all the money they earned. As their employer, you have the added responsibility of withholding taxes from their paychecks. The income tax and employees’ share of FICA (social security and Medicare) that you withhold from your employees’ paychecks are part of their wages you pay to the Treasury instead of to your employees. Your employees trust that you pay the withholding to the Treasury by making Federal Tax Deposits. That is why they are called trust fund taxes.
Through this withholding, your employees pay their contributions toward retirement benefits (social security and Medicare) and the income taxes reported on their tax returns. The withheld part of these taxes is your employees’ money, and the matching portion is their retirement benefit.
Employment tax deposits are a current expense. Postponing paying them is not the same as making a late payment on your phone bill or to a supplier. Congress has established large penalties for delays in turning over your employment taxes to the Treasury.
The Collection of Withholding Taxes Is “Stayed” by Filing Bankruptcy
If you are personally liable for unpaid withholding taxes and are being chased hard, the “automatic stay” that goes into effect upon the filing of a personal bankruptcy will stop that collection action against you just as it would as to virtually all actions by all creditors. So filing bankruptcy will stop the seizure of your bank accounts, garnishment of your wages or receivables, tax liens on your vehicle(s) and real estate, and pretty much anything else that the tax agencies can otherwise do against you.
A Chapter 7 “straight bankruptcy” filing will stop collection action immediately, but usually only for the three, four months. A Chapter 13 “adjustment of debts” filing will also be effective immediately, and will usually be effective for three to five years. More about these options in a moment.
Careful about Business vs. Personal Tax Obligations
When operating a business you need to be careful about who owes the withholding tax, you or the business. If you operate the business as a sole proprietorship (essentially under your own name or under a dba, but not in corporate form), than usually you are directly obligated on any business debts, including employee withholding taxes.
Even if the business is in a corporate form (or is a limited liability company), if you have the responsibility to pay the business’ obligations you are very likely personally liable on the withholding taxes. That may true if you a management or decision-making role and yet have no ownership in the business!
Be aware that if you are personally liable for a corporation’s employee withholding taxes, your bankruptcy filing will stop collection action against YOU and your assets but NOT against the corporation or its assets. Nor will your bankruptcy filing protect any other possibly liable individuals. That is, the protection of the “automatic stay” applies to you and your assets, but not that of any legally distinct business entity or of any co-obligor.
Withholding Taxes Can’t Be Discharged in Bankruptcy
If you file a Chapter 7 bankruptcy case, any withholding taxes you owe will not get legally written off (“discharged”). Older personal income taxes that meet certain conditions CAN get discharged, but employee withholding taxes can NEVER get discharged in bankruptcy.
However, since usually most or all of your other debts will get discharged, after the Chapter 7 case is finished you might then have the means to enter into a payment plan with the IRS/state/local tax agency to pay off the withholding taxes. But again, the tax agency will likely be more aggressive about getting paid quickly than with a simple income tax debt. So this may not be a sensible option, especially if the amount of withholding taxes is relatively large.
Chapter 13 May Be the Best Option
A Chapter 13 payment plan also cannot discharge any tax withholding debt. But what it can do is protect you and your assets while you pay off that withholding debt over time, based on what you can actually afford to pay. Your withholding tax debt is handled together with all your other debts, which may well include regular income taxes. Indeed under Chapter 13 you don’t necessarily have to pay the withholding taxes first—sometimes even more urgent debts like child support or vehicle loan or mortgage arrearages are paid ahead of or at the same time as the withholding and other tax debts. At the end of the case the tax withholding debt will be paid in full, most or all of your unpaid debts are then discharged, and you are debt free (except for long-term debt like a mortgage or student loan).
As strong as the tax agencies’ tools are for their collection of unpaid employee withholding tax debts, both Chapter 7 and 13 will stop those collection actions, at least against your own income and assets. Chapter 7 will stop those actions only long enough to discharge your other debts so that you can perhaps enter into an arrangement to pay the withholding tax debt under reasonable terms. But more often you will need the much longer protection provided under Chapter 13, where you have up to five years to pay the withholding tax debt, under very flexible terms.