If you are a sole proprietor, it is likely that your business taxes will not be discharged in Chapter 7 bankruptcy. If you operate your small business as a sole proprietor, you are personally responsible for all of your business debts, including tax debt. Atlhough a Chapter 7 bankruptcy wipes out or “discharges” most business debts, taxes are different. 

Read on to learn what types of taxes can and cannot be discharge in bankruptcy, and when your tax debts might be paid in full through the Chapter 7 bankruptcy.

Priority Treatment for Tax Debt

Most tax debts that came due or arose within three years prior to the bankruptcy are given priority in bankruptcy proceedings. This means that these taxes must be paid in full before the trustee begins payment of  most of your other debts (such as unsecured lines of credit or credit card debts). There are some obligations that are paid before taxes, such as the fees for the trustee and any professionals that were hired to assist with the liquidation, but taxes have a very high priority.

Liquidated Assets May Cover the Tax Debt

In Chapter 7 bankruptcy, the trustee liquidates nonexempt assets to pay your creditors. As discussed above, in many cases the trustee must pay your tax debts first with these funds. If your business has assets that the trustee liquidates in the bankruptcy that are sufficient to cover the tax debt, you could come out of the bankruptcy with your tax debt paid in full.

When Your Liquidated Assets Are Not Enough to Pay the Tax Debt in the Bankruptcy

Priority tax debts are not discharged in your bankruptcy. If your liquidated assets are not enough to pay your priority tax debts in full, you will continue to owe these debts when the bankruptcy is over.

However, some tax debts are not eligible for priority treatment -- these can be discharged. Other types of tax debts can never be discharged in bankruptcy.

Taxes That Can Never Be Discharged in Bankruptcy

Taxes that are referred to as “trust fund” taxes are never discharged in bankruptcy. These include all taxes that are technically being paid by someone other than the business, with the business being responsible only for collecting the tax and depositing it with the taxing authority. Employee withholding and sales taxes (but not excise taxes -- check your state laws) are included in this category. 

Taxes That Can Be Discharged in Bankruptcy

Some tax debts can be wiped out in bankruptcy. To be eligible for discharge, the tax debt must meet the following criteria:

• it is more than three years old
• it was assessed at least 240 days before the bankruptcy filing (this time frame can be affected by offers of compromise, and may be difficult to determine when audits are done or amended returns are filed)
• the tax return must have been filed at least two years before the bankruptcy, and
• the taxpayer cannot have committed tax fraud or be guilty of tax evasion.

Tax Liens Remain After Bankruptcy

Tax liens survive bankruptcy. Even if your personal obligation for the tax debt is discharged, the lien remains. After you receive a discharge, the taxing authority may be able to force a sale of the property or, if you decide to sell the property, the tax will have to be paid from the proceeds of the sale.

For more information, see Nolo's section on Chapter 7 Bankruptcy for Small Businesses.