Can a Bankruptcy Trustee Force the IRS to Surrender Trust Fund Taxes Paid by a Bankruptcy Payroll Company?

It is not uncommon for a for-profit corporation to outsource payroll services to an independent payroll company (“Payroll Provider”) to help administer payroll tasks.  A corporation typically advance funds to the Payroll Provider near the end of a payroll cycle, which are in turn used by the Payroll Provider to pay wages to the corporation’s employees and pay corresponding trust fund obligations to the various taxing authorities.

But what happens when the Payroll Provider files bankruptcy within 90 days of paying trust fund obligations to the IRS?  The issue is one of “preferential transfer.”  This issue was addressed in Slobodian v. United States of America, 533 B.R. 126 (Bankr. M.D.PA 2015), where the Payroll Provider paid $32,297 to the IRS within the period 90 days prior to the Payroll Provider filing bankruptcy.

In Slobodian, The Chapter 7 trustee filed an adversary complaint against the IRS alleging that the IRS payment was a preferential transfer because it was made within 90 days of the bankruptcy filing.  The trustee sought disgorgement of the $32,297 so that the funds could be redistributed to all creditors according to their statutory rights.

The Slobodian court ruled that in order to disgorge a purportedly preferential transfer, a trustee must demonstrate a (1) transfer of an interest of the debtor in property (2) to or for the benefit of a creditor (3) for or on account of an antecedent debt owed by the debtor, and (4) made while the debtor was insolvent.  11 U.S.C. §547(b).

So the big issue for the Slobodian court to determine was whether the $32,297 payment constituted a “transfer of an interest of the debtor in property.”  The IRS argued that the Payroll Provider never possessed an interest in the property for preference action purposes, and instead held the transferred funds in trust, to be transmitted to the United States pursuant to the Payroll Provider’s payroll service agreement with the corporation that provided the funds to the Payroll Provider.  The IRS asserted that the funds were held in a special statutory trust for the United States pursuant to 26 U.S.C. §7501(a), which states “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 of tax so collected or withheld shall be held to be a special fund in trust for the United States.”  The special trust applies to Social Security, Medicare, and income taxes that Congress requires employers to withhold from employees’ paychecks, commonly referred to as “trust-fund taxes.” Id. at 134, citing Begier v. Internal Revenue Service, 496 U.S. 53, 54 (1990).

The Slobodian court agreed with the IRS and found that corporation’s channeling of trust fund taxes through the third-party Payroll Provider did not dilute the protections of the 26 U.S.C. §7501(a) trust.  The corporation tendered the funds to the Payroll Provider which collected the funds pursuant to its payroll services agreement and withheld both trust fund and non-trust fund taxes from the collected funds before ultimately distributing employee paychecks.  Therefore, the Payroll Provider did not own an equitable interest in the property it held in trust for the corporation, and thus the $32,297 payment was not “property of the estate” for purposes of preferential transfers of 11 U.S.C. §547(b).

The IRS was allowed to retain the payment and the corporation received full credit for the trust fund payments.

Practice Pointer: Be careful when dealing with payroll providers.  Perform due diligence on the providers before tendering money to them.  Make sure the funds tendered by the corporation to the payroll service are made from a segregated trust fund account and not from the corporation’s general operating account.  The preferred method would be two separate payments being made to the payroll service: one payment for employees; and one payment for the taxing authorities.  This preferred method would buttress a corporation’s argument that the trust fund payments were tendered to the payroll service in trust as part of a 26 U.S.C. §7501(a) trust fund. It may not be “convenient” but it is following best practices.

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