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Tax Debts Dischargeable in Bankruptcy: 3rd Circuit Breaks it Down

By Tanya Roth, Esq. on July 25, 2012 | Last updated on March 21, 2019

In a recent bankruptcy case before the Third Circuit Court of Appeals, the court zeroed in on the issue of tax debts dischargeable in bankruptcy.

As you may already know, there are dischargeable debts in bankruptcy and non-dischargeable debts. When it comes to tax debts, the distinction isn't always that clear. This case clarifies the distinction between an excise tax and a trust fund tax.

Here's a simplification of the holding: Excise taxes would be dischargeable if they were older than three years on the date the bankruptcy petition was filed. Trust fund taxes, however, would never be dischargeable, regardless of age. (For further details, you can read the opinion here).

The facts are simple: A restaurateur declared bankruptcy and had collected some withheld taxes. Specifically, he collected taxes from customers as sales tax but never turned the funds over to the state of New Jersey.

The thing about taxes is that they aren't always easy to classify. But classification can make a world of difference. In this case, he wanted the taxes classified as "excise taxes" because they would be easier to discharge in bankruptcy. However, the district court classified them as "trust fund taxes."

The IRS defines "trust fund taxes" as those withheld by an employer from an employees wages. "Excise taxes" are those paid when purchases are made on a specific good. The problem in this case was that the sales taxes collected were third party sales taxes, which meant that they weren't sales taxes owed by the debtor to the government.

On the surface, it would look like the distinction would be easy. But the Third Circuit focused on the fact that the simple textbook definitions differed from statutory definitions. This created ambiguity and as a result, the court was forced to look at other circuits as well as at legislative intention.

But legislative intention was unclear. So, the Third Circuit went to the next level and focused on public policy. Bankruptcy policy generally has the effect of allowing the debtor the chance of a fresh start. On the other hand, it's also an easy cop-out for a debtor to declare bankruptcy on unpaid taxes.

In the end, the question boiled down to this: Where these taxes owed by the debtor to the government or were they merely held by the debtor on behalf of a party that owed the tax?

Finding the latter, the Third Circuit ruled that the collected sales taxes were non-dischargeable trust fund taxes.

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