North Carolina: Bankruptcy Estate Not Required to Remit Pass-Through Taxes

A U.S. bankruptcy court recently held that a North Carolina income tax withholding law applicable to partnerships was preempted by the Bankruptcy Code and the Internal Revenue Code. The ruling was favorable to the bankruptcy trustee, who had filed a motion with the court seeking to relieve the bankruptcy estate of making certain payments to the North Carolina Department of Revenue.  The debtor LLC manufactured tobacco products in North Carolina and had certain nonresident owners. The trustee had sold tangible assets of the debtor LLC, which generated taxable gains for North Carolina tax purposes. Under North Carolina law, a manager of an LLC with nonresident members is required to withhold and pay to the Department any tax due on the share of income attributable to each nonresident member. The issue at the heart of the case was whether the payment of taxes on behalf of the nonresident owners would constitute a distribution to the members ahead of the creditors of the LLC, which would violate the bankruptcy distribution rules under federal law. In support of its position that the bankruptcy estate should not pay the taxes, the trustee argued that the tax obligations of the members could not create an obligation for the bankruptcy estate, and the North Carolina law was simply a mechanism for collecting taxes owed by the nonresident owners. 

The court agreed that to the extent North Carolina’s statute purported to impose a tax obligation against the debtor LLC, it was preempted by the Internal Revenue Code and federal law.  Notably, under federal bankruptcy and tax law, in corporate and partnership cases under chapters 7 or 11 of the Bankruptcy Code, the bankruptcy estate is liable only for taxes actually imposed on the corporation or partnership, but not for any taxes imposed on partners or members. The court noted that the North Carolina statutes and tax bulletins make it abundantly clear that the members at all times remain ultimately liable for the taxes, and the Department had not argued otherwise. The court concluded that the bankruptcy estate had no liability for the taxes imposed against the resident or nonresident members of the LLC. Please contact Brad Wilhelmson at 312- 665-2076 with questions on In re: North Carolina Tobacco International, LLC.