If you run a business and fell behind on payroll taxes, you have probably heard that bankruptcy can wipe out old tax debt. For income taxes, sometimes it can. For trust fund taxes, it cannot. No amount of waiting changes that.
This page explains why, what bankruptcy can still do for you, and where business owners get blindsided.
What makes a tax a "trust fund" tax
When you withhold income tax and the employee's share of Social Security and Medicare from a paycheck, that money belongs to the government the moment you hold it back. You are holding it in trust. The same idea applies to taxes you collect from customers, like certain excise taxes and state sales tax.
When a business does not pay those withheld amounts over, the IRS can go after the people behind the business. Under IRC § 6672(a), any person required to collect, account for, and pay over a tax who willfully fails to do so is liable for a penalty equal to the unpaid amount. That is the Trust Fund Recovery Penalty, or TFRP. It is called a penalty, but it is really the business's trust fund tax, shifted onto you.
Why bankruptcy's timing rules do not apply
Most of the tax-discharge planning you read about depends on clocks: the 3-year rule, the 2-year rule, the 240-day rule. Those clocks come from 11 U.S.C. § 507(a)(8)(A), which deals with taxes on or measured by income.
Trust fund taxes live in a different subsection. Section 507(a)(8)(C) gives priority to "a tax required to be collected or withheld and for which the debtor is liable in whatever capacity." There is no time limit in that sentence. A trust fund tax from fifteen years ago is just as much a priority claim as one from last quarter, as long as it is still collectible.
The words "in whatever capacity" matter. They reach the business that owed the tax and also the responsible person assessed under § 6672. A TFRP assessed against you personally is a § 507(a)(8)(C) claim in your personal bankruptcy.
Chapter 7: not discharged
Under 11 U.S.C. § 523(a)(1)(A), a Chapter 7 discharge does not reach taxes of the kind and for the periods specified in § 507(a)(8). Because § 507(a)(8)(C) has no period, trust fund taxes are excepted from discharge regardless of age. Your credit cards and medical bills can go away. The TFRP stays.
A Chapter 7 can still make sense if clearing every other debt frees up enough cash flow to resolve the TFRP afterward, through the IRS's normal collection alternatives. But walk in knowing the TFRP will be waiting at the exit.
Chapter 13: paid, not discharged
Chapter 13's discharge is broader than Chapter 7's in some areas, but not this one. Section 1328(a)(2) specifically excludes debts "of the kind specified in section 507(a)(8)(C)." So the Chapter 13 discharge does not reach trust fund taxes either.
What Chapter 13 does offer is structure. Under § 1322(a)(2), priority claims must be paid in full through the plan, which can run up to five years. During the case, the automatic stay keeps the IRS from levying while you pay. For a business owner facing a large TFRP and a revenue officer, a court-supervised payment schedule can be a real improvement.
The catch is interest. Because the TFRP is nondischargeable, interest that accrues during the plan is not wiped out at the end, and the IRS manual says any interest balance left when the plan is completed must not be abated (IRM 5.9.17.15.1). See interest on tax debt in bankruptcy for how that works and how § 1322(b)(10) can help.
The employer's share is a different animal
Not every payroll tax is a trust fund tax. The employer's own matching share of Social Security and Medicare is not withheld from anyone. It is the business's own tax.
That share falls under § 507(a)(8)(D), which gives priority to employment taxes on wages earned before the petition only where the return was last due within three years before filing. Older employer-share liabilities can drop to general unsecured status. This matters most to sole proprietors, because a sole proprietor's payroll taxes are personal debts. If you run a corporation or LLC, the employer share is generally the entity's problem, and the TFRP only covers the trust fund portion.
Closing the company does not close the TFRP
A corporation or LLC can file Chapter 7, but it does not get a discharge. Section 727(a)(1) limits the Chapter 7 discharge to individuals. The company's assets get liquidated, the trustee distributes what there is, and the entity simply stops operating.
None of that touches your personal TFRP exposure. If the business's payroll taxes are not paid in full, the IRS can still assess the TFRP against each responsible person. Shutting the doors only removes the one party other than you that could have paid it.
Chapter 11: designating payments to trust fund taxes
When a business reorganizes in Chapter 11 instead of liquidating, a useful tool comes into play. In United States v. Energy Resources Co., 495 U.S. 545 (1990), the Supreme Court held that a bankruptcy court can order the IRS to apply a Chapter 11 debtor's plan payments to trust fund taxes first, if the court concludes that is necessary for the plan to succeed.
Why does that matter to you? Every dollar applied to the trust fund portion reduces the TFRP exposure of the people behind the business. The IRS manual acknowledges the rule and notes that the IRS may challenge whether a designation is truly necessary. It also notes that, under IRS policy, the IRS generally refrains from asserting the TFRP against non-debtor responsible officers while a plan providing for full payment is not in default, absent statute of limitations concerns (IRM 5.9.8.11). For small businesses, see Subchapter V and Chapter 11.
Penalties keep running on collected taxes
IRC § 6658 stops certain failure-to-pay additions while a bankruptcy case is pending. But § 6658(b) carves out liabilities arising from the failure to pay or deposit a tax withheld or collected from others. In other words, Congress gave no break on trust fund taxes here either. Notice a theme?
Florida sales tax belongs in the same bucket
Florida businesses collect sales tax from customers. Unpaid collected sales tax fits the same Bankruptcy Code language: a tax "required to be collected," entitled to priority under § 507(a)(8)(C) with no lookback, and not discharged in Chapter 7 or Chapter 13. If you owe both the IRS and the Florida Department of Revenue for collected taxes, plan for both to survive.
Where bankruptcy can still change the number
A TFRP requires two findings: that you were a responsible person and that you acted willfully. If you think the IRS got either one wrong, or got the amount wrong, the bankruptcy court has authority under 11 U.S.C. § 505 to determine the amount or legality of a tax or penalty, subject to limits. Read section 505: asking the bankruptcy court to decide the tax before you assume the assessment is final.
For more on payroll tax problems outside of bankruptcy, see this overview of IRS payroll tax issues. If your business is behind generally, what to do when a small business owes back taxes is a good starting point.
If you are a business owner looking at a TFRP and wondering whether bankruptcy fits, call my office at (813) 229-7100 and talk to a tax attorney who handles both sides of this. Every case turns on its own transcripts and dates; this page is general information, not legal advice for your situation. The money was never yours to keep, and the Bankruptcy Code remembers that.