The IRS Trust Fund Recovery Penalty and Chapter 13 Bankruptcy

July 25, 2011

By: David M. Serafin

Under Internal Revenue Code Section 6672, the IRS may impose the Trust Fund Recovery Penalty and hold a small business owner personally liable for an employee’s portion of both withholding and payroll (Social Security/Medicare) taxes unpaid by the business. The IRS must show that the responsible person “willfully” failure to make the payroll deposits on behalf of the employee to impose the Trust Fund Recovery Penalty. Personal liability for payroll taxes (also called FICA or 941 taxes) cannot be discharged in either chapter 7 or chapter 13 personal bankruptcy. But, these taxes can be paid back in chapter 13 bankruptcy over up to 60 months without the accumulation of IRS penalties and interest, starting on the date of the filing of the bankruptcy petition, thereby saving the bankruptcy debtor thousands of dollars.

Absent eligibility to pay back the payroll taxes in a chapter 13 plan, the bankruptcy debtor will likely be exposed to ever increasing penalties and interest which will further hinder his/her financial situation over time. Priority taxes are required to be paid back in full over no longer than 60 months in a chapter 13 personal bankruptcy (corporations are ineligible for chapter 13 bankruptcy). Thus, the question arises whether the debtor is required to include the full amount of payroll taxes owed by the business in the chapter 13 plan or merely the Trust Fund Recovery Penalty for which he/she is personally liable.

For this reason, it is critical for the bankruptcy debtor to have (before incurring the payroll tax liability) incorporated the business AND regularly file an annual Form 1065 (partnership tax return), Form 1120 (C Corporation), or Form 1120S (S Corporation). A sole proprietor who lists business income/deductions on Schedule C of the individual Form 1040 tax return will be on the hook for the entire payroll tax liability. However, the business owner who files a separate corporate or partnership tax return will only be held personally liable for the Trust Fund Recovery Penalty portion.

As the Trust Fund Recovery Penalty assessed against the responsible person sometimes comprises only a small portion of the business’ overall payroll tax liability, the filing status of the business may solely determine whether the Colorado Bankruptcy Court will confirm a feasible chapter 13 plan (an unfeasible plan is one in which the bankruptcy debtor – based on monthly income/expenses or payback of non-dischargeable debt – is not likely to be able to make the payments).