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Working Group Proposal #3: "Trust Fund" Taxes


The Internal Revenue Code requires an employer to withhold or deduct federal income and social security taxes from the wages of all of its employees. [ FN: 26 U.S.C. §§3102(a), 3402(a) (1994).] Since federal law requires an employer to hold the funds "in trust" for the federal government, [ FN: Id. §7501(a). Section 7501(a) provides: Whenever any person is required to collect or withhold any internal revenue tax from any other person and to pay over such tax to the United States, the amount so collected or withheld shall be held to be a special fund in trust for the United States. The amount of such fund shall be assessed, collected, and paid in the same manner and subject to the same provisions and limitations (including penalties) as are applicable with respect to the taxes from which such fund arose. Id. (emphasis added).] these taxes are commonly referred to as "trust fund taxes." Federal corporate tax liabilities owed directly by the business, such as corporate income tax and social security contributions, are generally referred to as "nontrust fund taxes." Although an employer regularly collects the trust fund taxes as the wages are paid to the employees, the employer is required to remit the trust fund taxes collected to the federal government on a quarterly basis. [ FN: Treas. Reg. §31.6151(a) (1977).] Section 6672 of the Internal Revenue Code ("I.R.C.") imposes personal liability upon any officer, member, or employee of a corporation or partnership who is responsible for collecting the trust fund taxes for the failure to turn over the amounts collected to the federal government ("responsible persons"). [ FN: See 26 U.S.C. §6672 (1994). See also id. §§3102(b), 3403. The term "person " is defined to include: "an officer or employee of a corporation, or a member or employee of a partnership, who as such officer, employee, or member is under a duty to perform the act in respect of which the violation occurs. " Id. §6671(b). Courts have interpreted a "responsible person " to be an individual who possesses ultimate authority and makes the final decisions with regard to which bills to pay. See, e.g. , Gephart v. United States , 818 F.2d 469 (6th Cir. 1987); Mueller v. Nixon , 470 F.2d 1348 (6th Cir. 1972), cert. denied , 412 U.S. 949 (1973); Dudley v. United States , 428 F.2d 1196 (9th Cir. 1970); Cooper v. United States , 539 F. Supp. 117 (E.D. Va. 1982), aff ’d , 705 F.2d 442 (4th Cir. 1983). The personal liability imposed under the statutes is for the amount of the trust fund taxes not accounted for and turned over, plus interest and penalties: Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over. 26 U.S.C. §6672 (1994).] Personal liability is not, however, imposed for nontrust fundtax liabilities. [ FN: United States v. Technical Knockout Graphics Inc. ( In re Technical Knockout Graphics Inc. ), 833 F.2d 797, 799 (9th Cir. 1987).]

The loss to the United States Treasury when an employer fails to remit the taxes collected can be substantial. The imposition of personal liability on responsible persons thus serves as an insurance policy of sorts for the government since the employee is automatically credited with the payment of the withheld funds regardless of whether the employer, in fact, remitted the collected revenue to the government. [ FN: Slodov v. United States , 436 U.S. 238, 243 (1978).] The threat of personal liability for trust fund taxes is designed to ensure that such taxes get paid when due and deter persons responsible for employee withholdings from misappropriating the funds. [ FN: See United States v. Huckabee Auto Co. , 783 F.2d 1546 (11th Cir. 1986).] In furtherance of this policy, Congress has excepted the personal liability imposed on responsible persons under I.R.C. § 6672 from the purview of the bankruptcy discharge. [ FN: See 11 U.S.C. §§523(a)(1)(A), 507(a)(8)(C) (1994).]

Although an employer is liable for the payment of trust fund taxes, it is quite common for an employer to nevertheless use the funds withheld from the wages of employees as a source of operating capital during the interim between the collection and payment dates. Such a practice becomes particularly acute when a business begins experiencing cash flow problems since such taxes "can be a tempting source of ready cash to a failing corporation beleaguered by creditors." [ FN: Slodov v. United States , 436 U.S. 238, 243 (1978). The United States Supreme Court has acknowledged that: It is a common phenomenon of business failure that even an "honest " businessman, in attempting to salvage a business which appears headed for insolvency, will frequently "borrow " money of other people without their consent if he can get his hands on it. The one fund which he is almost always able to lay his hands on is the taxes he has withheld and is currently withholding from his employees for the Government. United States v. Sotelo , 436 U.S. 268, 277 n.10 (1978).] In at least some cases, the decision to raid the trust fund fails to stave off bankruptcy.

When the employer files for relief under the Bankruptcy Code, it frequently owes both nontrust fund taxes and trust fund taxes; typically, the employer fails to segregate the funds withheld from the employees’ paychecks and uses the money to finance its shortfall. The Internal Revenue Service ("IRS") generally applies payments to unsecured, nontrust fund taxes first, thus preserving its recourse against the principals responsible for the trust-fund delinquency and enhancing its potential for collection of the full amount due. [ FN: In a nonbankruptcy law context, it is only in circumstances in which the payments remitted are deemed "voluntary " that a taxpayer may designate that the payments be applied to a particular tax liability. See, e.g. , O ’Dell v. United States , 326 F.2d 451 (10th Cir. 1964). Where the payments are "involuntary, " received by the I.R.S. as a result of distraint, levy, or other a legal proceeding, the IRS can apply the payments in accordance with its existing policies and procedures. Liddon v. United States , 448 F.2d 509, 513 (5th Cir. 1971), cert. denied , 406 U.S. 918 (1972). The majority of courts has held that payments made pursuant to bankruptcy proceedings were per se "involuntary. " See, e.g. , United States v. Pepperman , 976 F.2d 123, 127 (3d Cir. 1992)(Chapter 7); IRS v. Energy Resources Co. ( In re Energy Resources Co. ), 871 F.2d 223, 230 (1st Cir. 1989), aff ’d , 495 U.S. 545 (1990)(finding that payments made to the IRS by a debtor pursuant to a confirmed plan were involuntary payments); United States v. Technical Knockout Graphics Inc. ( In re Technical Knockout Graphics Inc. ), 833 F.2d 797, 802 (9th Cir. 1987)(Chapter 11). The voluntary-involuntary distinction that governs the allocation of tax payments by debtors developed from a decision of the United States Supreme Court in National Bank v. Mechanics ’ Nat ’l Bank , 94 U.S. 437 (1876), where the Court held: The rule . . . as to the application of payment is, that the debtor or party paying the money may, if he chooses to do so, direct its application; if he fail, the right devolves upon the creditor; if he fails, the law will make the application according to its own notions of justice. Id. at 439.] The personal liability imposed by I.R.C. § 6672 on responsible persons, however, serves as strong incentive for the debtor’s principals to construct a plan which delegates any tax payments made through a bankruptcy proceeding to the trust fund portion of the total tax liability prior to any application of payments to the nontrust fund portion. [ FN: The failure of a corporation ’s reorganization will not abrogate the personal liability of a responsible person for the ultimate payment of trust fund taxes.] Since an allocation of payments to those tax obligations that do not carry what in essence amounts to personal guarantees correspondingly reduces the amount of personal exposure, the number of collection sources available to the IRS is reduced. Indeed, in cases where the plan is confirmed and then fails, it becomes impossible for the government to collect any portion of the nontrust fund tax liabilities if the trust fund liabilities have been satisfied under the plan first. If the payments on account of the debtor’s tax liability under a plan satisfy the trust fund liability, but not the nontrust fund portion, the nondebtor’s personal liability will be effectively discharged. [ FN: A corporate dissolution has the practical effect of discharging a corporate debtor from its unpaid tax liabilities. United States v. Pepperman , 976 F.2d 123, 130 (3d Cir. 1992)(citing United States v. Sotelo , 436 U.S. 268, 278 (1978)).] The IRS has thus opposed plans whichprovide for the designation of plan payments toward the payment of trust fund taxes first.

Courts were divided on the issue of whether the debtor could formulate a plan which provides for the designation of plan payments between trust and nontrust fund tax liabilities. [ FN: Compare In re Technical Knockout Graphics Inc. , 833 F.2d 797 (9th Cir. 1987); DuCharmes & Co. v. State ( In re DuCharmes & Co. ), 852 F.2d 194 (6th Cir. 1988); In re Ribs-R-Us Inc. , 828 F.2d 199 (3d Cir. 1987)(authority holding that payments made in connection with a bankruptcy proceeding are involuntary payments for which the debtor forfeits the right to designate the allocation) with United States v. Energy Resources Co. ( In re Energy Resources Co. ), 871 F.2d 223 (1st Cir. 1989), aff ’d , 495 U.S. 545 (1990); United States v. A & B Heating & Air Conditioning ( In re A & B Heating & Air Conditioning ), 823 F.2d 462 (11th Cir. 1987), vacated , 486 U.S. 1002 (1988), on remand , 861 F.2d 1538 (11th Cir. 1988), further opinion , 878 F.2d 1311 (11th Cir. 1989)(authority finding the nonbankruptcy law distinction between voluntary-involuntary payments to be irrelevant since the bankruptcy court could use its equitable powers to allocate tax payments).] The United States Supreme Court resolved the conflict in the 1990 decision of United States v. Energy Resources Co. [ FN: 495 U.S. 545 (1990).] In Energy Resources, two corporate employers in a consolidated case crafted chapter 11 plans of reorganization that designated all tax payments to the employers’ trust fund tax liability prior to the satisfaction of any nontrust fund portion. [ FN: Id. at 547.] The plans were confirmed over the objection of the IRS. The Supreme Court held that a bankruptcy court has broad, equitable power to order the allocation of the initial payments made under the plan to the misappropriated trust fund tax liability if it concludes that such a designation "is necessary to the success of a reorganization plan." [ FN: Id. at 548-49 (citing 11 U.S.C. §§105(a), 1123(b)(5), & 1129, and noting that bankruptcy courts have the authority to modify traditional debtor-creditor relationships). The Court made its decision without regard to whether or not the payments were rightfully considered voluntary or involuntary. See id. Such a characterization is thus no longer determinative of whether a debtor may designate the application of plan payments toward the satisfaction of tax liabilities. Instead, the Court redirected the focus of the analysis to effects of the allocation on the debtor ’s ability to successfully reorganize.] Such an opaque standard has provided little guidance as to what factors should be considered by the bankruptcy court in the exercise of its broad discretion. [ FN: Some courts have narrowly interpreted the holding in Energy Resources and made detailed findings which justified the conclusion that the debtor did or did not meet the burden of showing that an allocation scheme was necessary to the success of a reorganization. See, e.g. , United States v. Pepperman , 976 F.2d 123 (3d Cir. 1992); In re Classic Chem. & Supply Co. , 198 B.R. 112 (Bankr. E.D. Pa. 1996). Other courts, however, have concluded that bankruptcy courts are not required to to set forth any "specific findings " as to how a payment designation will aid in the success of the debtor ’s reorganization: "The court must just conclude that it is necessary for a reorganization ’s success. A bankruptcy court may, in fact, make specific findings, but there is no mandate that they be set forth in an opinion and order. " IRS v. R.L. Himes & Assocs. Inc. ( In re R.L. Himes & Assocs. Inc. ), 152 B.R. 198, 201-02 (S.D. Ohio 1993). See, e.g. , In re M.C. Tooling Consultants Inc. , 165 B.R. 590 (Bankr. D.S.C. 1993)(concluding in a cursory fashion that the debtor ’s allocation of payments to the trust fund portion of taxes was necessary for an effective reorganization).] To the extent that bankruptcy courts arerequired to balance the competing interests of the IRS and the debtor on a case-by-case basis, litigation will be necessary to decide if the designation provisions in plans of reorganization will be necessary to a successful reorganization.

Confusion over tax allocations has only multiplied since the Supreme Court’s decision in Energy Resources. The Court’s rationale has been expressly found applicable in the context of a chapter 13 reorganization. [ FN: See, e.g. , In re Klaska , 152 B.R. 248, 251 (Bankr. C.D. Ill. 1993)(permitting chapter 13 debtors to amend their plan to provide for the designation of plan payments).] The majority of courts has not extended Energy Resources to allow the designation of tax payments in the context of a chapter 7 case or in a liquidation under chapter 11. [ FN: See, e.g. , SBA v. Preferred Door Co. ( In re Preferred Door Co. ), 990 F.2d 547 (10th Cir. 1993); United States v. Pepperman , 976 F.2d 123, 128-31 (3d Cir. 1992); United States v. Kare Kemical Inc. ( In re Kare Kemical Inc. ), 935 F.2d 243, 244 (11th Cir. 1991); Jehan-Das Inc. v. United States ( In re Jehan-Das Inc. ), 925 F.2d 237, 238 (8th Cir.), cert. denied , 502 U.S. 810 (1991); Sonntag v. United States ( In re Equipment Fabricators Inc. ), 127 B.R. 854 (D. Ariz. 1991), aff ’d , 990 F.2d 1257 (9th Cir. 1993)(Table); In re Gregory Engine & Mach. Servs. Inc. , 135 B.R. 807, 810 (Bankr. E.D. Tex. 1992); In re Laminating Inc. , 148 B.R. 259, 261 (Bankr. S.D. Tex. 1992); In re Arie Enters. Inc. , 116 B.R. 641 (Bankr. S.D. Ill. 1990). In such cases, the courts have generally permitted the IRS to allocate payments to cover nontrust fund tax liabilities before trust fund liabilities.] A significant number of other courts has, however, expanded the rationale and holding of Energy Resources in recent years and supported the authority of bankruptcy courts to compel the IRS to allocate payments in the context of a chapter 11 liquidation. [ FN: See, e.g. , IRS v. Creditors Comm. ( In re Deer Park Inc. ), 10 F.3d 1478 (9th Cir. 1993); United States v. Flo-Lizer Inc. ( In re Flo-Lizer Inc. ), 164 B.R. 749 (S.D. Ohio 1994); In re 20th Century Enters. Inc. , No. 90-23698, 1994 WL 779356 (Bankr. N.D. Miss. Jan. 20, 1994). The Bankruptcy Appellate Panel in Deer Park rejected the government ’s contention that a liquidation under chapter 11 was not a reorganization: Such a broad statement fails to recognize that a debtor ’s continuing participation in a planned, orderly liquidation may in fact be necessary to bring about the maximum recovery for the creditors, as opposed to the amount realized from a forced sale. The Bankruptcy Code recognizes this in §1129(a)(11), by providing that liquidation may be contemplated in a valid chapter 11 plan of reorganization, despite the label "reorganization. " Although the word "reorganization " might commonly bring to mind ongoing operations, Congress explicitly placed language providing for liquidation within chapter 11, which is titled "Reorganization. " Had Congress not intended to include liquidation as an acceptable type of reorganization plan, then presumably all provisions dealing with liquidation would fall within chapter 7, which is specifically titled "Liquidation. ." . . Liquidation under a chapter 11 plan is not the same as a chapter 7 liquidation. A liquidation under chapter 11 allows the debtor in possession, one who is presumably more familiar with the assets of the debtor ’s organization and its respective values, the ability to plan for an orderly divestiture of the assets over time as opposed to a chapter 7 trustee, who is generally less familiar with the debtor ’s assets. A chapter 11 plan, even though a liquidating plan, must still conform to the same statutory requirements of any other chapter 11 reorganization. A liquidating plan is desirable when the debtor in possession can bring about a greater recovery for the creditors than would a straight liquidation under chapter 7. IRS v. Deer Park Inc. ( In re Deer Park Inc. ), 136 B.R. 815, 818 (Bankr. 9th Cir. 1992), aff ’d , 10 F.3d 1478 (9th Cir. 1993)(finding the designation of payments to be necessary for the success of a liquidating plan since the services of the former officer were need to ensure his continued assistance with the liquidation).] Some courts have even suggested thata designation might be possible in a chapter 7 case. [ FN: See generally In re Classic Chem. & Supply Co. , 198 B.R. 112, 115 (Bankr. E.D. Pa. 1996); In re Schilling , 177 B.R. 862, 864-65 (Bankr. N.D. Ohio 1995).] The practical result in such cases is that responsible persons can completely avoid the payment of the nontrust fund portion of tax liability in contexts that never contemplate a "true" reorganization, where no business entity will remain as a viable going concern after the bankruptcy proceeding. [ FN: See generally NLRB v. Bildisco & Bildisco , 465 U.S. 513, 528 (1984)( "The fundamental purpose of reorganization is to prevent a debtor from going into liquidation, with an attendant loss of jobs and possible misuse of economic resources. "); H.R. Rep. No . 595, 95th Cong., 1st Sess. 220 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6179 ( "The purpose of a business reorganization case, unlike a liquidation case, is to restructure a business ’s finances so that it may continue to operate, provide its employees with jobs, pay its creditors, and produce a return for its stockholders. ").]


The appropriate sections of the Bankruptcy Code should be amended in order to overrule the decision of the United States Supreme Court in United States v. Energy Resources Co. and allow taxing authorities to allocate payments made in the course of bankruptcy in a manner that preserves alternative sources of collection.

Reasons for the Change

Section 6672 of the Internal Revenue Code was enacted by Congress for a very specificpurpose: to provide a means by which the IRS can collect tax obligations held in trust from the party responsible for withholding the taxes and misappropriating the funds collected in order to maximize the public fisc. When an employer is permitted to engage in a strategy which permits a bankruptcy court to use its equitable powers to compel the allocation of tax payments toward the satisfaction of trust fund taxes, the burden of nonpayment and business failure is improperly shifted from the debtor’s principals to the general creditors and taxing authority. Such a policy effectively turns the IRS into a prepetition lender of operating capital to struggling business enterprises that are otherwise unable to obtain credit. By insisting that payments made under a plan be applied first to nontrust fund tax obligations, the burden of paying trust fund taxes rests where it belongs, with the parties directly responsible for the nonpayment or misappropriation of funds already collected in the first instance.

The uncertainty which has resulted from an amorphous, case-specific standard established by the Supreme Court in Energy Resources has spawned a significant amount of litigation over whether the particular allocation scheme is essential or necessary to a successful reorganization. The need for a legislative solution is underscored by the incentive created for the principals of distressed businesses to misappropriate public funds and subsequently frustrate the objective of I.R.C. § 6672 by defaulting under the terms of a confirmed plan after the exposure of personal liability has been extinguished. [ FN: See, e.g. , Bernstein v. Donaldson ( In re Insulfoams Inc. ), 184 B.R. 694 (Bankr. W.D. Pa. 1995). See also In re T. Craft Aviation Serv. Inc. , 187 B.R. 703, 710 (Bankr. N.D. Okla. 1995)(noting that the decision of the Supreme Court creates a haven for tax-dodgers).]

Competing Considerations

The proposal is contrary to the position adopted by the National Bankruptcy Conference ("NBC"). The NBC has concluded that permitting a debtor to designate the application of plan payments between trust and nontrust fund taxes fosters successful reorganizations in most circumstances. [ FN: See Reforming the Bankruptcy Code, The National Bankruptcy Conference ’s Code Review Project , Final Report 79 (May 1, 1994).] The NBC reasons:

By finding that the plan is feasible, the bankruptcy court implicitly determines that the IRS will collect all of its tax debts. The debtor is in the best position to determine the necessity of such an allocation, and the Conference recommends that in such cases the debtor’s allocation be given a strong presumption. [ FN: Id.]

The unassailable fact that most confirmed plans fail undermines the position of the NBC. However, it must be recognized that the successful reorganization of a company usually depends on management’s cooperation, effort, and, in some cases, capital infusion. Debtor’s management, who are generally critical to the success of a plan and the parties personally responsible for trust fund liability, would in some cases be unwilling to participate in the reorganization effort or advance funds for rehabilitation if corporate tax payments are allocated to trust fund liability before nontrust fundliability. In such circumstances, it is frequently argued that there would be no incentive for management to save jobs or preserve going concern value for the general creditors who would receive little, if any, distribution upon an immediate liquidation. It is questionable policy, however, to abrogate congressional intent with respect to taxation by creating what essentially amounts to haven for principals who raid the tax payer’s purse for a perceived, and often unrealized, greater good.


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