This article originally appeared in the Spidel California Tax Newsletter
It is not uncommon for an entrepreneur or an officer of a closely held corporation to be assessed a personal liability for California sales taxes. An individual doing busi ness as a sole proprietor in California is personally liable for any un paid sales tax, and in the case of a dissolved or abandoned corpora tion any responsible officer who willfully failed to pay over the tax may be personally liable.
If he or she can’t pay it, bankruptcy may be a remedy; the California sales tax, including interest and penalties, is dischargeable in Chapter 7 bankruptcy if certain conditions are satisfied, and these conditions are typically not very difficult for a taxpayer to satisfy.
Depending on state law a sales tax is assessed either on the purchaser, or on the seller. Where the tax is assessed on the pur chaser at the retail end a duty is imposed on the retailer to collect the tax and pay it over to the taxing entity. As such the tax is a “trust fund tax” for which the retailer’s liability is nondischargeable in bankruptcy by operation of the United States Bankruptcy Code, 11 U.S.C. § 507(a)(8)(C). For example, the sales tax im posed under Washington state law is assessed against the purchaser, and is therefore a trust fund tax that the retailer may not discharge in bankruptcy.
However, a tax imposed not on the purchaser but rather on the retailer is an excise tax assessed on the retailer for the privilege of doing business in the state. California’s sales tax is imposed on the retailer for the privilege of doing business in California and therefore is an excise tax, not a trust fund tax.
In Chapter 7 any debt, including a tax, is dischargeable unless explicitly excepted from discharge by the Bankruptcy Code. The United States Bankruptcy Code, section 507(a)(8)(E), provides that an excise tax is nondischargeable in Chapter 7 if a required tax return was due within three years of filing a bankruptcy, or, where a return is not required, the taxable event occurred within three years of fil ing the bankruptcy. Since a sales tax return is typically due only af ter the taxing event (i.e., the sale) has occurred, the due date of the return will always be more recent than the date of sale. Accordingly, where a return is required the rule can be shortened to state that if the due date of the return is within three years of the Chapter 7 bankruptcy, it is not dischargeable. In addition, Section 523(a)(1)(B) of the Bankruptcy Code provides that a tax for which a return is required is nondis chargeable if the required return was either not filed at all, or was filed within two years of the bankruptcy, or where the return was fraudulent, or where the taxpayer was guilty of a willful attempt to evade or defeat the tax. The California Revenue & Taxation Code requires a quarterly sales tax return, and thus these rules apply.
In a nutshell, it can be said that a California sales tax for a particular taxable period is nondischargeable in Chapter 7 if it falls into any of the pitfalls described above. For example, In George v. SBE the corporation stopped paying sales taxes over to the Board of Equalization after July 1, 1984 and ceased doing business in March, 1985; the individual husband and wife sharehold ers filed personal bankruptcy on May 29, 1985. Obviously, the sales tax return due dates fell within three years of the bankruptcy, and if they were excise taxes, were nondischargeable in Chapter 7. The debtors unsuccessfully argued that the liability asserted against them was not a tax. The court rejected this argument and held that their liability was for a nondischargeable excise tax.
It might be presumed, then, that as long as the sales tax avoids each of the pitfalls described above it is dischargeable. But there is a little more to it. In California the sales tax has been held to be more than a mere excise tax; it is also a tax “on or measured by income or gross receipts.” In In re Raiman the bankruptcy court held that the sales tax was a tax measured on income or gross receipts. Like sales taxes, personal income taxes in California are assessed on or measured by income or gross receipts. The significance of the Raiman ruling is that it subjects the dischargeability of sales taxes to the same criteria for discharge as for personal income taxes. The criteria for discharge of income tax encompass the same rules as for excise taxes, and adds one more, the 240-day assessment rule. Accordingly, as long as the sales tax satisfies the rules for discharge of income taxes, the sales tax will be dischargeable and we don’t have to concern ourselves with the rules for discharge of an excise tax.
The rules for discharge of the sales tax are the same as for personal income taxes. The rules for discharge of personal income taxes in Chapter 7 bankruptcy are:
ˆ 1) The most recent due date for the sales tax return is over three years prior to the bankruptcy filing date (including any extension of the due date given per R&T Code § 6459);
ˆ 2) The tax was assessed personally against the individual at least 240 days prior to the bankruptcy filing date;
ˆ 3) The tax return was actually filed more than two years before the bankruptcy filing date;
ˆ 4) The return was not fraudulent; and
ˆ 5) For the quarter in question the taxpayer was not guilty of a willful attempt to evade or defeat the tax.
So, it can be said that a sales tax is dischargeable in Chapter 7 bankruptcy if it satisfies each of the rules described above.
In evaluating whether a particular sales tax is dischargeable in Chapter 7 careful thought should be given to the question when, exactly, was the taxpayer assessed personal liability for the tax? This date must be known in order to determine whether the 240-day assess ment rule has been satisfied (rule #2, above).
The problem is that for sales taxes the Revenue & Taxation Code is not exactly clear when this date is. For bankruptcy purposes the bankruptcy courts have filled this deficiency by ruling that a state tax is “assessed” when it becomes administratively final, in other words, when the taxpayer may no longer appeal the assessment within the taxing entity’s appeal procedures. The trap for the unwary is that the date of personal assessment may be different for a sole proprietor and a responsible officer of a close corporation, and is different in the case of a petition for redetermination of a proposed additional as sessment pursuant to Rev. & Tax Code § 6561. In any event, however, by the time the taxpayer has become desperate enough to seek advice about bankruptcy it’s a good bet the 240-day period has expired.
What if the taxpayer never filed his quarterly sales tax returns? This as a fairly common situation, and it would make the sales tax liability nondischargeable in Chapter 7. However, there is another option. Unlike Chapter 7, the requirements for discharge in a Chapter 13 bankruptcy do not include a requirement that a tax return be filed.
To be dischargeable in Chapter 13 only two of the five rules need be satisfied 1) the due date of the return must be over three years old, and 2) the tax must have been assessed for at least 240 days; the tax return filing, the no-fraudulent return, and the no-willful evasion rules do not apply.
In a high percentage of cases the taxpayer has, one way or the other, satisfied the rules for discharge, if not in Chapter 7 then in Chapter 13. Accordingly, where a taxpayer’s delinquent sales tax liability is impossible to pay, playing the bankruptcy card may be the a feasible solution.