State Taxes and Bankruptcy -- Overview
When most people think about taxes and bankruptcy, they think about the IRS. But state tax debts are just as common -- and in many cases, the same federal bankruptcy rules that govern federal taxes also apply to state taxes. The Bankruptcy Code does not distinguish between federal and state taxing authorities for most purposes.
However, different types of state taxes are treated differently. State income taxes follow the same timing rules as federal income taxes. Property taxes have their own rule. And sales taxes that a business collected but failed to remit are in a category by themselves -- they can never be discharged.
State Income Taxes
State income taxes are treated identically to federal income taxes under the Bankruptcy Code. The same three timing tests apply:
- 3-year rule (11 U.S.C. Section 507(a)(8)(A)(i)): The state tax return must have been due (with extensions) more than 3 years before the bankruptcy filing.
- 240-day rule (11 U.S.C. Section 507(a)(8)(A)(ii)): The state must have assessed the tax more than 240 days before the filing.
- 2-year rule (11 U.S.C. Section 523(a)(1)(B)(ii)): The state tax return must have been filed more than 2 years before the bankruptcy petition.
If all three tests are met and there was no fraud or willful evasion, the state income tax debt can be discharged.
State-Specific Complications
While the federal timing rules apply uniformly, the assessment process varies by state. Some states assess taxes immediately upon processing a return, while others have longer processing timelines. A few important differences:
- Assessment dates: Some states do not use the same terminology or process as the IRS. You may need to request a state tax transcript or account statement to determine the assessment date.
- Extensions: State extension rules may differ from federal rules. Some states automatically grant an extension if you received a federal extension; others require a separate state extension request. The 3-year clock runs from the state's due date, including state-specific extensions.
- Separate state filings: If you lived in multiple states, each state's taxes are evaluated separately. You might be able to discharge taxes owed to one state but not another.
Practical tip: Contact your state's department of revenue (or equivalent agency) and request a complete account transcript showing assessment dates, payment history, and any adjustments. This is the state equivalent of the IRS Account Transcript.
Property Taxes
Property taxes have their own priority rule under 11 U.S.C. Section 507(a)(8)(B). Property taxes or assessments on real property are priority claims if they became due within 1 year before the bankruptcy filing (or became due after the filing).
This means:
- Property taxes due more than 1 year before filing: Not priority claims. Can potentially be discharged as general unsecured debt.
- Property taxes due within 1 year before filing: Priority claims. Cannot be discharged in Chapter 7; must be paid in full in Chapter 13.
Lien complication: Even when property tax debt is dischargeable, the tax lien attached to the property survives bankruptcy. The county or municipality can still foreclose on the property to collect the lien, even after your personal liability is discharged. See Tax Liens for more detail.
In Chapter 13, delinquent property taxes must typically be addressed in the plan to prevent foreclosure. Many Chapter 13 plans cure property tax arrears over the life of the plan while the debtor continues to pay current taxes directly.
Sales Taxes -- The Trust Fund Problem
Sales taxes that a business collected from customers are "trust fund" taxes under 11 U.S.C. Section 507(a)(8)(C). These are always priority claims and can never be discharged in bankruptcy, regardless of how old they are.
The logic is straightforward: when a business collects sales tax from a customer, the business is holding that money in trust for the state. The money was never the business's money to spend. Using it for other purposes is essentially a breach of trust.
Who Is Liable?
The business entity is primarily liable for unremitted sales taxes. But many states also have "responsible person" statutes that allow the state to assess the trust fund portion against individual officers, directors, or managers who had authority over the business's financial decisions -- similar to the IRS Trust Fund Recovery Penalty for payroll taxes.
No escape: Trust fund sales taxes survive both Chapter 7 and Chapter 13 as nondischargeable priority claims. In Chapter 13, they must be paid in full through the plan. In Chapter 7, the full amount survives discharge. There is no timing test that makes them dischargeable.
State Tax Liens
State tax liens behave just like federal tax liens in bankruptcy. A properly filed state tax lien survives the bankruptcy discharge. Your personal liability for the underlying tax may be eliminated, but the lien remains attached to property you owned at the time of filing.
This creates a practical problem: if you own a home and the state has filed a tax lien, discharging the personal liability does not remove the lien from your home. If you later sell the home, the lien must be satisfied from the sale proceeds.
Chapter 13 provides more tools for dealing with state tax liens. In some cases, the lien can be valued and paid through the plan at the value of the property it attaches to, rather than the full amount of the tax debt. This is particularly useful when the property is worth less than the total liens against it.
Practical Steps for State Tax Debt
- Request state tax transcripts: Get assessment dates, filing dates, and lien information from your state's tax authority.
- Identify the type of tax: Income tax, property tax, and sales tax have different rules. Classify each debt correctly.
- Check for trust fund exposure: If you operated a business, determine whether any of the state tax debt involves collected-but-unremitted sales taxes.
- Apply the timing tests: Run the 3-year, 240-day, and 2-year calculations for each state income tax year, just as you would for federal taxes.
- Check for liens: Search your county's records for any filed state tax liens. Liens survive discharge even when the underlying debt is eliminated.
- Consider Chapter 13: If you have a mix of dischargeable and nondischargeable state taxes, Chapter 13 can structure repayment of the priority taxes while the non-priority taxes are treated as general unsecured claims.
Frequently Asked Questions
Are state income taxes treated the same as federal in bankruptcy?
Yes. The Bankruptcy Code's timing rules for tax discharge -- the 3-year rule, 240-day rule, and 2-year filing rule -- apply equally to state and federal income taxes. If a state income tax debt meets all the timing requirements and there was no fraud, it can be discharged just like a federal tax debt.
Can I discharge property taxes in bankruptcy?
Property taxes can be discharged if they became due more than 1 year before the bankruptcy filing, under 11 U.S.C. Section 507(a)(8)(B). However, any tax lien attached to the property survives the discharge. This means the taxing authority can still foreclose on the property even though your personal liability has been eliminated.
What about state sales tax debt?
Sales taxes that a business collected from customers but did not remit to the state are classified as "trust fund" taxes. Under 11 U.S.C. Section 507(a)(8)(C), these are always priority claims and can never be discharged in bankruptcy, regardless of their age. They must be paid in full.
Do state tax liens survive bankruptcy?
Yes. State tax liens survive bankruptcy just like federal tax liens. The personal liability for the tax may be discharged, but the lien remains attached to property you owned when you filed. Chapter 13 offers some tools for addressing tax liens through the repayment plan, but Chapter 7 does not eliminate them.
Related Resources
Tax Liens and Bankruptcy -- what happens when liens survive discharge
Nondischargeable Debts -- complete guide to debts that survive bankruptcy
Section 523(a) Exceptions to Discharge -- the full list of nondischargeable debts
Payroll Taxes and Bankruptcy -- trust fund taxes for employers
Check Your Bankruptcy Discharge Eligibility
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