Discharging Unpaid Withholding Taxes in Bankruptcy

When a business owes unpaid taxes, bankruptcy can provide the business or its owner with a fresh start. The unpaid Federal taxes can be discharged if certain requirements are met. One of these requirements is that the tax returns for the unpaid taxes are filed within certain time periods. But what if there are more than one tax form that can be used and what if the taxpayer only files one of the forms? Will that suffice? The court addresses this in Quezada v. United States, No. 1:18-cv-00797 (W.D. Texas-Austin 2019).

Facts & Procedural History

The taxpayer is a bricklayer. His business focused on masonry projects.

The business functioned as a general contractor. Like other general contractors, his business would hire subcontractors and by materials for jobs.

The business was taxed as a sole proprietorship. It deducted the amounts paid to contractors on his Form 1040, Schedule C.

The business did not obtain social security numbers from some of its contractors and it did not make backup withholding for the contractors.

The taxpayer filed his income tax returns and Forms 1099 for the contractors for the 2005-2008 tax years.

In 2014, the IRS assessed a $1.2 million in backup withholding and penalties and interest for the 2005-2008 tax years.

The taxpayer filed for Chapter 11 bankruptcy in 2016 in an attempt to discharge the tax debt.

About Chapter 11 Bankruptcy

Chapter 11 bankruptcy allows a business to be reorganized and/or eliminate debt. It allows the business to continue operating.

Chapter 11 bankruptcy is usually filed by those who have larger debts and those who have business activities that can be continued to make money.

The bankruptcy starts with a petition and, if successful, results in a negotiated payment plan approved by the creditors and the bankruptcy court.

Corporations that file under Chapter 11 can discharge their taxes if they the reorganization plan is affirmed. For individuals, generally, older tax debts can be discharged. To qualify, the applicable tax returns have to be filed and a time period has to pass before the bankruptcy petition is filed (there are several rules, but generally, if the return was filed more than 3 years before the petition is filed, the taxes may be dischargeable in bankruptcy).

With respect to the requirement to file a tax return, what all tax returns have to be filed?

Withholding Tax and Filing Requirements

Businesses are generally required to file a Form 1099 to report income paid to contractors. If the contractor fails to provide a Social Security Number or Employer Identification Number, the business has to withhold taxes and file those with the IRS. The the taxpayer has to file a Form 945 to report the withholdings to the IRS.

In this case, the taxpayer filed the Forms 1099 but not the Form 945. It didn’t file the Forms 945 as it apparently didn’t believe or understand that it had a requirement to make withholding or file the forms.

The IRS claimed that the withholding tax was not discharged as the Forms 945 was not filed.

The taxpayer argued that the Forms 1099 he filed satisfied the tax return filing requirement. Thus, the taxpayer argued that the withholding tax was discharged as the tax returns in question were filed timely.

The court noted that the taxpayer had conceded that it did not obtain the information to make withholdings and was required to file Forms 945. This concession was enough for the court to conclude that the taxpayer’s tax return filings were incomplete. As a consequence, the court concluded that the tax return filing requirement for bankruptcy had not been met.

Missing Taxpayer Numbers is a Common Problem

This case could be a problem for taxpayers. General contractors and other businesses almost always have some missing taxpayer numbers for their contractors. This is just the nature of business records and that many contractors do not want income reported to the IRS under their name and taxpayer number. This issue could come up in most bankruptcies involving businesses that hire contractors.

If the IRS isn’t able to collect on its underlying income taxes as the Form 1040 was filed timely, can the IRS impose withholding taxes and recoup the lost revenue?

While Chapter 11 bankruptcies are relatively rare for individual and smaller businesses, the same rules apply to Chapter 7 bankruptcies. Chapter 7 bankruptcy is often used to discharged tax debts. Individuals and small businesses that file Chapter 11 or 7 bankruptcy should review whether backup withholding was required for contractors and how best to comply with the withholding requirements given the bankruptcy timing rule.