Even when corporate retailers collect California sales taxes from customers, the individuals running the entity face liability for that debt.
That’s because, , if the business doesn’t pay, state law allows collection from the business owners themselves The rules are complicated and the results can be harsh if the business falls behind. So business people need to understand the rules.
Plus, know that bankruptcy can discharge the individual’s liability, if the timing is right.
Sales tax while business operates
Entrepreneurs expect that doing business as a a corporation protects them from the debts of the corporation. But, some taxes are an exception.
For instance, corporate officers are personally liable for the trust fund portion of employee withholding. Members of pass-through entities like LLC’s are liable for the tax debts of the entity.
California sales taxes are not a trust fund tax; that is, although the price of goods to the customer is increased by the amount of the tax, the tax is actually a tax on the seller. So, the personal liability for the individual owners that would arise from a trust doesn’t come into play.
But state law builds in protections for the state should the business fail to pay the tax. As long as a business operates, the state can’t look to the owners to pay the tax.
But once a corporation shuts down or dissolves, the rules change.
When individual tax liability arises
When the business of a corporation or LLC is terminated, dissolved or abandoned, the state can assess unpaid sales taxes against any person who was responsible for acting for the entity. California Revenue and Taxation Code 6829.
Assessment of the tax against the individual is made by notice of deficiency. That notice can be made within 3 years of the board receiving knowledge of the termination, dissolution or abandonment. Importantly, notice given to any other state agency doesn’t equal notice to the tax board.
If the business doesn’t file a return, it has 8 years to assess the tax against the responsible individuals.
When sales taxes remain assessable
Federal bankruptcy law allows an individual to discharge certain taxes, often after those taxes reach a certain age. Importantly, tax liability which hasn’t been assessed against the individual, but is still assessable when the bankruptcy case is filed, is not dischargeable.
So, for California sales taxes, the issue is whether the time for the state to assess a responsible person for the sales tax has run out before the bankruptcy was filed. In the seminal 9th circuit case of Ilko, the court held that it was not the three years from the corporation’s filing of the tax return that started the assessment window running with respect to the shareholder. Rather, it was the cessation of the business that started the period. Because his bankruptcy case was filed within three years of business closure, the tax was still assessable at filing, and thus not dischargeable.
Thus, the two critical questions are 1) whether the business filed a return (triggering the 3 year assessment period) and 2) when the tax authority (these days known as CDTFA) got knowledge of the termination, dissolution or abandonment of the business.
Bankruptcy rules on sales tax discharge
California sales taxes are subject to the usual bankruptcy limits on the discharge of taxes. Three rules define taxes that can be discharged:
- The taxes first came due more than 3 years before the bankruptcy is filed
- A return (if required) for the tax year must have been on file for 2 years
- The tax must have been assessed more than 240 days before filing
I can find no statute requiring the exposed individual to file the return, so I conclude that the “2 year rule” doesn’t apply to California sales tax.
So, the individuals behind the corporation or LLC can’t discharge sales tax liability when the notice of deficiency was issued less than three years before filing, OR, if the state still has time to properly assess the taxes against the debtor.
If the business has unpaid sales taxes, the individuals behind the business need to give the CDTFA explicit notice that the business has ceased, to start the clock ticking on their personal exposure for those taxes.