Bankruptcy

Does Bankruptcy Clear State Tax Debt?

Find out what will happen to state tax in bankruptcy.

State tax debts can sometimes be cleared (discharged) by filing for bankruptcy. It depends on the type of tax debt that is owed. Many of the same rules apply to state income tax debt and tax debt owed to the Internal Revenue Service (IRS). However, tax liability resulting from business ownership, such as sales, withholding, and franchise tax, which have specific rules that vary between states, and you’ll want to speak with an experienced attorney about your particular case.

Wiping Out State Tax in Bankruptcy

State taxes follow the same rules for dischargeability as federal income taxes. For instance, whether you can get rid of them will depend on when:

  • the taxes came due
  • you filed your return, and
  • the taxing agency assessed the tax.

If the state income tax that you owe meets the rules for federal income tax discharge, then the state income tax can be discharged too.

(To find out the details, read Does Bankruptcy Wipe Out Tax Debt?)

State Taxes That Won’t Go Away in Bankruptcy

Some state taxes never get discharged in bankruptcy. For instance, you’ll remain responsible for paying:

  • income taxes less than three years old
  • income taxes on a return filed less than two years before the bankruptcy
  • fraudulently reported income taxes
  • sales, payroll, and other business-related tax.

Business taxes (such as sales and payroll taxes) are known as “trust fund” taxes. A business must collect them and hold them in trust for the taxing authority.

If you operate as a sole proprietorship, you’re automatically personally liable for sales and payroll taxes. If you have an interest in a corporation, partnership, or limited liability company, you’ll be personally responsible for any tax the business doesn’t pay.

Taxing authorities tend to aggressively collect trust fund taxes (the period will depend on the state, and it’s usually quite long). If you owe trust fund taxes, you should seek advice from an experienced attorney on how best to proceed.

How a Chapter 13 Bankruptcy Can Help

If your state tax obligation won’t go away, a Chapter 13 bankruptcy will let you spread the payments over three to five years. You’ll have the added benefit of potentially paying less on other debt, such as credit card balances, leaving you a larger percentage of your income to pay off the tax. Understand, however, that tax debt can be complicated. Before you explore this route, you’ll want to get an assessment with a bankruptcy attorney.

Questions for Your Attorney

  • How much time does the state have to collect the tax that I owe?
  • Can I discharge my state tax?
  • Would filing a Chapter 13 bankruptcy make sense in my case?
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