The Third Circuit recently ruled In re Calabrese (click to read the full opinion) that New Jersey sales taxes, which are required to be collected by an owner of a restaurant, are entitled to trust fund priority under the United States Bankruptcy Code, and thus, are not dischargeable in bankruptcy.  This opinion is in line with Second, Seventh and Ninth Circuits.

Appellant Michael Calabrese operated “Don’s What a Bagel, Inc.,” which filed for reorganization under Chapter 11 of the Bankruptcy Code. As proprietor of a restaurant, Calabrese was required by New Jersey law to collect sales tax from his customers. N.J. Stat. Ann. §§ 54:32B-3(c)(1), 54:32B-12(a), 54:32B-14(a). After failing to confirm a reorganization plan, the bankruptcy was converted to Chapter 7.  Calabrese also filed for personal bankruptcy under Chapter 13.

The State of New Jersey Department of Taxation (New Jersey) filed several secured proofs of claim in Calabrese’s individual bankruptcy. Calabrese moved to have the claims reclassified as unsecured, and the Bankruptcy Court granted his motion. New Jersey thereafter filed amended proofs of claim alleging that Calabrese owes $63,437.19 in taxes collected while operating his business from 2003 to 2009.

Calabrese moved to expunge the claims, and after briefing and a hearing, the Bankruptcy Court held the taxes at issue are trust fund taxes under 11 U.S.C. § 507(a)(8)(C) rather than excise taxes under § 507(a)(8)(E). Calabrese appealed that decision to the District Court, which affirmed.

The Third Circuit was required to decide whether the sales taxes held by Calabrese are “trust fund” or “excise” taxes under 11 U.S.C. § 507(a)(8). Excise taxes receive priority, and are nondischargeable, if they are less than three years old, as measured from the date of the bankruptcy petition.  See 11 U.S.C. § 507(a)(8)(E) (priority); 11 U.S.C. § 523(a)(1)(A) (“A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt . . . for a tax or a customs duty . . . of the kind and for the periods specified in section 507(a)(3) or 507(a)(8) of this title, whether or not a claim for such tax was filed or allowed . . . .”). Trust fund taxes are always prioritized and are never dischargeable irrespective of the age of the debt. See 11 U.S.C. §§ 507(a)(8)(C), 523(a)(1)(A).

After considering the statutory framework and the legislative history, the Third Circuit stated that “[w]e also find significant the fact that third-party sales taxes resemble trust fund taxes more than other sales taxes even though the source of taxation is a sales transaction. After all, such taxes are owed not by the debtor, but are merely held by the debtor on behalf of the party that owes the tax to be transferred to the taxing authority at a later time.”  The Court then looked at New Jersey’s own treatment of its sales tax and stated that “[u]nder New Jersey law, “the vendor collects the tax from its customers, and holds it in trust until it is reported and turned over to the State. This is not a tax imposed on the vendor but on the vendor’s customer, and as such is what is commonly called a ‘trust fund’ tax.” [citations omitted].

Based on this analysis, the Court finally concluded that “public policy concerns weigh against Calabrese, primarily because sales taxes collected by a retailer never become the property of the retailer…”  That is, the Court said that the sales taxes are retained by the retailer in trust for the state.  Accordingly, the Court affirmed the District Court (which affirmed the Bankruptcy Court) and held that Calabrese’s sales-tax obligation is subject to Section 507(a)(8)(C) and is not dischargeable. 

This case may have an important consequence on owners of New Jersey retail businesses if they do not pay their sales tax.  First, lenders need to understand that the Third Circuit (in line with NJ state Courts) have held that sales taxes in NJ are entitled to trust fund status, and thus, collected sales taxes arguably are not subject to a lender’s lien.  Secondly, there may be personal liability for any person who is responsible to collect sales taxes, and the failure to remit those sales taxes will not be dischargeable in bankruptcy.  The failure to pay sales taxes in NJ could have a substantial adverse impact, and thus, owners and lenders would be wise to understand consequences of not paying those taxes.