Chapter 7, colloquially known as “straight bankruptcy,” is the “operative” chapter of the Bankruptcy Code that normally governs liquidation of a debtor. Liquidation is a form of relief afforded by bankruptcy laws that involves the collection, liquidation and distribution of the nonexempt property of the debtor and culminates, if the debtor is an individual, in the discharge of the liquidated debtor.
A discharge releases individual debtors from personal liability for most debts and prevents the creditors owed those debts from taking any collection actions against the debtor. However, a bankruptcy does not discharge every financial obligation and Congress has selected certain debts that are not entitled to a discharge. In Chapter 7, debts that are not entitled to discharge are those that are considered “Priority” under Section 507 and those that are per se nondischargeable under Section 523 of the Bankruptcy Code.
Section 507 sets forth the claims and expenses that are granted priority in distribution in a bankruptcy case. Under section 507, there are nine priorities, including certain tax liabilities. Since most tax liabilities are covered under section 507(a)(8) which includes income taxes, property taxes, excise taxes, and employment taxes, it is important to determine whether these taxes are afforded priority status because if so, they are typically non-dischargeable in a chapter 7 bankruptcy and remain the personal liability of the debtor at the conclusion of the bankruptcy case.
Notwithstanding the foregoing, in many instances, tax liabilities are dischargeable in a chapter 7 bankruptcy. This is the case for certain taxes like income taxes, property taxes, excise taxes and employment taxes where the passage of time transforms the tax claim to non-priority status. For example, a tax measured by income or gross receipts (income tax and in some cases, a sales tax – see below) will be a non-priority claim if the tax for which a tax return is required was last due at least three years prior to the filing of the bankruptcy petition. Additionally, the income tax assessed by the taxing agency had to have been made at least 240 days before the commencement of the bankruptcy case.
As it pertains to the dischargeability of state sales taxes in a Chapter 7 bankruptcy, section 507 of the Bankruptcy code does not explicitly set out the rules for a sales tax. That is primarily because the character of a sales tax can be interpreted in more than one way, and based upon that characterization, the sales tax may or may not be rendered non-priority with the passage of time and thus dischargeable in a Chapter 7 case. The characterization of a sales tax can take two routes. It can be a “true” sales tax, one that is imposed on the customer, or alternatively, it can be one that is imposed upon the retailer for the privilege of doing business.
If the sales tax is determined to be a “true” sales tax, one that is imposed on the customer, it is considered a trust fund tax under section 507(a)(8)(C). In this case, when a business collects sales tax from its customers after a purchase, it holds those funds in trust until it is remitted to the appropriate government taxing authority, it is considered trust fund liability. Pursuant to section 507(a)(8)(C), these trust fund taxes are accorded an eighth priority, nondischargeable status irrespective of their age. Therefore, even with a discharge, a chapter 7 debtor will remain personally liable for the full amount of the trust fund liability imposed and this is the case even if the taxpayer-debtor failed to fulfill his statutory duty to collect the taxes since section 507(a) (8)(C) prevents discharge so long as the debtor was required to collect the tax.
On the other hand, if the sales tax is determined to be one that is imposed upon the retailer for the privilege of doing business, it is considered an excise tax. Unlike a trust fund tax that is per se non-dischargeable in chapter 7 as a priority tax regardless of the passage of time, an excise tax is a priority claim that can become non-priority with time and thus become dischargeable.
An excise tax imposed upon the retailer for the privilege of doing business, is dischargeable if the transaction giving rise to the excise tax occurred more than three years prior to the filing of the bankruptcy petition.
If the excise tax does require a return to be filed, if the transaction giving rise to the excise tax occurred more than three years before the bankruptcy AND the required tax return was filed at least two years prior to the bankruptcy filing under section 523(a)(1)(B) – otherwise, the excise tax claim is excepted from discharge altogether.
Lastly, a new issue advanced by some “excise” sales tax states to prevent a discharge is to argue that the sales tax is also a tax measured on gross receipts under 507(a)(8)(A) which would then invoke the 3-year, the 240-day and the not assessed but assessable rules that all must be met to convert the tax claim from priority to non-priority status. Debtors and practitioners should carefully review the laws in each state before considering bankruptcy.
