Chapter 11
Working Group Proposal #5: Exclusion of Payroll Deductions from Property of the
Estate
The filing of a bankruptcy petition creates an estate that is comprised of all legal or equitable
interests of the debtor as delineated in 11 U.S.C. § 541(a). The estate encompasses funds
held in a debtor’s bank accounts. The estate is not intended to include property that
actually is held for another party. [ FN: See ,
e.g. , Begier v. Internal Revenue Service , 495 U.S. 53 (1990) (prepetition payment of
trust fund taxes to IRS from general accounts was not transfer of property of
estate).]
Employers frequently hold funds deducted from employees’ paychecks in their general
accounts awaiting periodic transfer to third parties. In addition to tax obligations, payroll
deduction is a standard means by which employees remit a variety of payments owed to third
parties. [ FN: A nonexhaustive list of the kinds
of payments routinely made through payroll deductions would include: 401(k) and other
retirement and savings program contributions, health insurance premiums (including supplemental
benefits such as optical and dental coverage), flexible spending account contributions for
dependent care and medical expenses, credit union and other loan repayments, membership or
agency union dues, child support and other wage garnishment obligations, and charitable
contributions.] Employers with cash flow problems are even more likely
to have these withheld monies intermingled with their general funds at the time of the bankruptcy
filing rather than in special segregated accounts for transfer in a timely fashion. When an employer
acts as a conduit for these payments, the employer’s failure to remit these payments to the
appropriate third parties can create serious financial problems for employees who may be brought
into default on these various obligations. There is little question that these funds do not constitute
the employers’ property, but without clear statutory guidance the funds become
"trapped" in the bankruptcy estate.
The Recommendation
The Commission should recommend that Congress amend 11 U.S.C. §
541(b) to clarify that funds deducted from paid wages, held by a debtor/employer, and
owed by employees to third parties do not fall within the definition of
"property of the estate."
Reason for the Change
Many popular benefit programs are administered through payroll deductions. Some are
completely voluntary, whereby the employer acts purely as a conduit, while others are
employer-sponsored, where the employer makes its own contribution as well. [ FN: With respect to employer-sponsored benefit
plans or employer-matched charitable contributions, this proposal deals only with the employee
’s contribution, and does not address the monies owed by the
employer.] Credit union and other loans often are repaid directly through
payroll deductions for the convenience of both the employee and the lender. Union dues are paid
by the employee through payroll deductions under applicable law. Court-ordered support
obligations may have to be paid through payroll deductions, as are other payments made through
wage garnishments. In this process, a portion of an employee’s wages are withheld from
that employee’s paycheck, held by the employer, and periodically transferred to the
appropriate third party. It is typical for the employer to hold the funds in its general operating
account rather than in a segregated account in the interim period.
When an employer files for bankruptcy before making the requisite transfers to the relevant
third parties, those funds are caught in the debtor’s estate, yielding numerous adverse
consequences as employees involuntarily become delinquent in their obligations to the third
parties. For example, where employees’ insurance payments do not reach their insurance
companies, their insurance coverage is jeopardized. The employees may end up in default on their
loans or support obligations as a result of the nonpayment to third-party transferees.
The current laws do not provide adequate options for employees to remedy this situation. It
may not be possible for employees to duplicate their payments to the third parties. Even if they
could, pursuing reimbursement through the bankruptcy claims process often yields only a small
percentage of the duplicated payments when the bankruptcy payouts ultimately are made.
Sometimes, the trapped funds are freed through a first-day order authorizing the payment of
prepetition wages, although often these orders are limited only to payments owed directly to the
employee and not to third-party transferees.
Other efforts by employees in the bankruptcy process to free the funds and have them paid to
third party transferees have not always been successful. Courts may require that the employees
establish the existence of a trust, a task that is especially difficult when funds are not kept in a
segregated account and often cannot be traced sufficiently to satisfy the strict requirements of
trust law. ERISA plan contributions are more likely to be recoverable due to regulations that
deem employee contributions to be ERISA plan assets, and thus are excluded from the
employer’s bankruptcy estate. [ FN:
See In re College Bound Inc. , 172 B.R. 399 (Bankr. S.D. Fla. 1994) (tracing
requirement does not apply because funds are deemed to be assets of ERISA plan under express
statutory trust).] However, the lack of traceability can be fatal to the
collection of non-ERISA benefit plans and other types of third-party payments. [ FN: See In re Columbia Packing Co. , 35
B.R. 447 (Bankr. D. Mass. 1983) (employees unable to direct debtor to remit withheld funds to
third party transferees because "general cash account is property of the estate. No separate trust
fund was created for these employee payroll deductions ").] Moreover,
some courts have held that aconstructive trust cannot be imposed without proving fraudulent
conduct or wrongdoing. [ FN: See In
re Lee Way Holding Co. , 113 B.R. 410 (Bankr. S.D. Ohio, 1990) (avoiding postpetition
transfer of union dues to union owed from prepetition wage deduction).]
Proving the existence of an express trust is an even more insurmountable undertaking, requiring a
showing of intent of the parties, among other factors. [
FN: Id. , at 412.]
Much confusion and inconsistency could be eliminated through a statutory amendment that
would make clear that withheld funds are not property of the estate. The change would obviate
the need to employ the cumbersome and ill-fitting trust analysis. This clarification would be
consistent with both bankruptcy and nonbankruptcy policy. The policies and purpose behind the
creation of a broad bankruptcy estate would not be undermined by such an amendment that
reinforces the basic tenets of what properly belongs in the debtor’s estate. Moreover,
bankruptcy policy does not favor attempts to allocate disproportionate losses to nonadjusting
creditors; to a large extent, employees are involuntary, nonadjusting creditors who will not be able
to amortize the loss over time and often do not even know they have entered a debtor-creditor
relationship when they agree to have funds withheld from their paychecks.
The clarification also would be consistent with other social policies favoring savings plans,
insurance, support obligations, and the like. The clarification would maximize the safety of the
wage deduction mechanism for insurance payments and retirement fund payments, which many
would agree is in the best interest of everyone.
In addition to furthering bankruptcy and nonbankruptcy policy, this proposal also has an
important jurisprudential effect because it would eliminate the need to expand the constructive
trust doctrine. In general, constructive trusts offer a remedy that is best used sparingly, but one
that often is sought even if it is not readily applicable. When parties successfully convince a court
to impose a constructive trust, perhaps even "automatically" in the context of the
first-day order, the court may have achieved an outcome that is socially defensible, but at the cost
of generally weakening the doctrinal concept of the constructive trust. This has troubling
implications in other contexts, where a flexible application of the constructive trust doctrine may
not be nearly as desirable. Codifying the wage deduction exclusion will enable courts to "do
the right thing" without stretching the trust doctrine in ways that will have negative
repercussions in other situations.
It is important to note the issues that would not be implicated by this proposal. This
proposal has no effect on an employer’s independent obligation to contribute to employee
benefit funds or on a claim arising from nonpayment of that obligation. In addition, the
recommendationonly affects deductions from wages that actually have been paid "on the
books." The clarification would not enable an employee to obtain a priority repayment of a
portion of her wages if the employer has suspended all wage payments. The goal is to
obtain equality among employees, such that those who chose to make direct payments are not
better off than those who used their employer as a conduit for payments. Thus, because the
clarification only would affect amounts withheld from wages that already have been paid, this
recommendation would have no direct implications for the wage priority claim provision. [ FN: 11 U.S.C. §507(a)(3),
(4).] It merely would establish that the withheld funds are not property of
the estate at all.
Competing Considerations
One might argue that the suggested provision is special purpose legislation that would
further complicate the interpretation and application of section 541. However, many people who
have discussed this issue have agreed that trapped funds withheld by the employer, which acts
merely as a conduit, truly are not property of the estate, akin to withheld taxes. Thus,
while this might constitute special interest legislation in the literal sense, it is wholly consistent
with the notion of property of the estate and is not a carve-out or special exception.
Although this proposal does not alter what constitutes a priority wage claim, it could be
argued that the wrongful withholding of these monies also should give rise to a priority
fraud claim in certain situations, i.e., when the employer has spent the withheld money
and has no wherewithal to remit payment to third party transferees. However, in a situation where
the employer/debtor is cash starved, it is unlikely that even priority claimants will get repaid at all,
thus obtaining an additional priority claim is likely to be a hollow victory.
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