No, bankruptcy typically cannot discharge payroll tax debt. Federal bankruptcy law specifically excludes these taxes from discharge in both Chapter 7 and Chapter 13 cases. If you’re a business owner or officer who failed to pay over withheld employment taxes, you may face personal liability through the Trust Fund Recovery Penalty.
As a bankruptcy and IRS solutions law firm based in New York, John D’Amato, PLLC regularly works with business owners struggling under payroll tax burdens. We’ve seen how quickly these obligations can spiral out of control and threaten personal assets. Understanding your options requires knowing exactly what the law allows and what remains off the table.
What Are Trust Fund Taxes?
The IRS treats payroll taxes as “trust fund taxes” because employers hold them in trust for the government. When you run a business with employees, you’re required to withhold federal income taxes and the employee portion of Social Security and Medicare taxes from each paycheck. You’re simply holding it until the time comes to remit payment.
Which Part of Payroll Tax Is Considered Trust Fund Tax?
Note that these payroll trust fund taxes are only the employee’s portion of payroll taxes. It is part of the wages that an employee has earned, but is withheld by the employer on the government’s behalf. The employer must then forward it to the taxing authority.
The other component of payroll taxes is the employer’s portion, which is an equal tax amount that the employer must directly pay instead of taking out of the worker’s wages. The employer’s matching share of Social Security and Medicare taxes is not considered a trust fund and can potentially be discharged in bankruptcy.
However, the withheld employee portion carries special protections under federal law. The IRS takes the collection of these funds seriously because they represent taxes workers have already paid through their wages.
Bankruptcy cannot discharge trust fund payroll taxes (withheld income tax and employee FICA). Non‑trust‑fund portions (such as older employer FICA in some scenarios) may be treated differently and can sometimes be dealt with more like other priority tax claims.
Why Bankruptcy Won’t Eliminate Payroll Tax Debt
According to the IRS Bankruptcy FAQ, trust fund taxes are excepted from discharge in bankruptcy. This rule applies regardless of which chapter you file under.
For Chapter 7 cases, the Bankruptcy Code allows discharge of personal liability for certain tax debts older than three years, but trust fund taxes don’t qualify. The law treats them as priority claims that survive bankruptcy.
Chapter 13 offers a broader discharge for some debts. However, changes made by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 closed what was once a potential loophole. For any Chapter 13 case filed on or after October 17, 2005, trust fund taxes cannot be discharged. This is true whether or not the debts were included in your repayment plan.
The Trust Fund Recovery Penalty Explained
If your business fails to pay over withheld employment taxes, the IRS can assess the Trust Fund Recovery Penalty against you personally. According to IRS guidance on employment taxes, this penalty equals 100% of the unpaid trust fund taxes.
The IRS may pursue this penalty against any “responsible person” who willfully failed to collect or pay over the taxes. Responsible persons often include:
- Corporate officers and directors
- Business owners
- Bookkeepers or accountants with the authority to pay bills
- Anyone with check-signing authority who chose to pay other creditors instead of the IRS.
Potential responsible persons are those with authority over financial decisions as potential responsible persons. Bookkeepers, accountants, or check‑signers may qualify if they truly have authority and exercise willful preference for other creditors, but status alone is not automatically determinative.
The penalty amount covers the withheld income tax plus the employee’s share of FICA taxes. It doesn’t include the employer’s matching portion, interest, or other penalties assessed against the business.
How New York Courts Handle These Cases
When a business owner seeks a bankruptcy discharge of payroll tax obligations, the court must apply federal law. The U.S. Supreme Court established in the case of United States v. Sotelo that trust fund liability is nondischargeable. This precedent binds all bankruptcy courts nationwide.
If you file for personal bankruptcy while your business has outstanding payroll taxes, the automatic stay won’t prevent the IRS from pursuing the Trust Fund Recovery Penalty against you. Federal law explicitly allows the IRS to continue investigating and assessing this penalty against individuals even when the business itself is in bankruptcy.
Attorney John D’Amato has represented New York clients facing these exact situations. The key is understanding that while bankruptcy may provide relief from some debts, payroll tax obligations may require a different strategy.
What Options Do You Have?
Since bankruptcy won’t eliminate payroll tax debt, you may need to consider other approaches. The IRS offers several programs that may help reduce or manage your liability.
IRS Installment Agreements
According to the IRS, businesses owing $25,000 or less in payroll tax may qualify for an In-Business Trust Fund (IBTF) Express Installment Agreement. These arrangements allow you to pay the debt over 24 months without providing detailed financial statements.
Larger debts may require more negotiation. That is you may need to submit financial information and work with the IRS to establish terms. Interest continues to accrue during the payment period, but this approach stops more aggressive collection actions like levies.
Offers in Compromise
An offer in compromise lets you settle your tax debt for less than the full amount owed. The IRS will consider your income, expenses, asset equity, and ability to pay when reviewing your application.
This option isn’t available if you’re currently in bankruptcy. You must also be current on all tax filings and estimated payments before submitting an offer. The IRS generally approves offers only when the proposed amount represents the most they could reasonably expect to collect.
“Currently Not Collectible” Status
If you truly cannot pay anything toward your payroll tax debt, the IRS may temporarily delay collection. This status doesn’t eliminate the debt. Interest and penalties continue accruing. But it provides breathing room while your financial situation improves.
Recent Bankruptcy Filing Trends
Federal court statistics show bankruptcy filings have been climbing after years of decline. According to U.S. Courts data, total bankruptcy filings rose 13.1% in the 12-month period ending March 31, 2025. The Administrative Office of the U.S. Courts reported 529,080 total cases filed during that period.
Business filings increased 14.7%, from 20,316 to 23,309 cases. These numbers remain well below historical highs but suggest more businesses are seeking relief from overwhelming debt.
Frequently Asked Questions on Bankruptcy With Payroll Tax Debt
Can I discharge the employer’s share of payroll taxes in bankruptcy?
Potentially. The employer’s matching contribution for Social Security and Medicare taxes isn’t classified as a trust fund. These amounts may be dischargeable if the wages were paid and the return due more than three years before filing. Discharge depends on multiple timing and fraud and evasion rules, not just a due‑date and timely‑filing test.
Will filing for bankruptcy stop the IRS from assessing the Trust Fund Recovery Penalty?
No. The automatic stay in bankruptcy doesn’t prevent the IRS from investigating or assessing the Trust Fund Recovery Penalty against responsible persons. When only the business is in bankruptcy, the stay in that case does not bar the IRS from pursuing TFRP against responsible individuals. If your business is in bankruptcy but you’re not personally in bankruptcy, collection efforts can proceed against you without restriction.
What happens if my business paid some payroll taxes but not all?
Taxpayers can designate how voluntary payments are applied (and often direct them to trust fund portions). If not designated, the IRS may apply payments in its own best interest and does not automatically apply them to trust fund taxes first.
If your business files Chapter 11 and proposes a reorganization plan, the bankruptcy court may order that plan payments go toward trust fund taxes before other IRS debts. This can reduce personal exposure under the Trust Fund Recovery Penalty.
How long does the IRS have to collect payroll tax debt?
The IRS generally has 10 years from the assessment date to collect any tax debt. This period can be extended by certain events, including bankruptcy filing. When you file for bankruptcy, the collection clock stops running for the time the case is pending, plus an additional six months.
Key Points to Remember
- Only the trust fund portion (withheld income and employee FICA) has this nondischargeable status. The employer’s share is not a trust fund tax and may be dischargeable under certain conditions.
- The Trust Fund Recovery Penalty can make business owners personally liable for 100% of unpaid trust fund taxes.
- Both Chapter 7 and Chapter 13 exclude trust fund taxes from discharge.
- Filing for business bankruptcy doesn’t stop the IRS from pursuing the Trust Fund Recovery Penalty against responsible persons.
- IRS installment agreements and offers in compromise may provide alternatives to bankruptcy.
Contact John D’Amato for Help With Your Bankruptcy and IRS Solutions Case
Facing payroll tax debt requires careful planning and the right legal strategy. While bankruptcy may not discharge these obligations, other options exist that could reduce your liability or make payment more manageable.
John D’Amato is a respected bankruptcy and IRS solutions attorney serving clients throughout New York. His extensive experience in both IRS cases and bankruptcy law can be advantageous in crafting a strategic solution to payroll tax debt issues.Visit John D’Amato’s profile to learn more about his experience and approach. Call (716) 703-9099 to schedule a free consultation.