Category Archives: Application of Tax Payments

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.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

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Will I Lose my Tax Refund if I File Bankruptcy?

Here’s a common fact pattern.  A taxpayer files bankruptcy in June of a tax year and receives an IRS tax refund in April of the following calendar year.  What happens to the non-exempt portion of the IRS tax refund?  The taxpayer would want to keep the refund, but the Chapter 7 trustee would want a turnover of the refund for the benefit of the unsecured creditors.

That issues was addressed in In re Mooney, 526 B.R. 421 (Bankr. M.D.GA 2015).  In Mooney, the parties agreed that the taxpayer should be allowed to keep the portion of the tax refund representing income earned after the bankruptcy case was filed to December 31.  The IRS argued that the taxpayer should be allowed to keep the same percentage of the tax paid after filing bankruptcy to the total tax refund; so if 25% of the tax payments were tendered after filing bankruptcy, then the taxpayer would be allowed to keep the same 25% of the total refund.

The Mooney court, rejected the IRS’ approach and adopted a “pro rata by days approach.”  Id. at 428.  The court held that the refunds should be prorated to the date of filing based on the number of calendar days before and after the bankruptcy filing date.  So, since the taxpayer filed bankruptcy on the 177th day of the year with 188 days remaining, then the trustee would be allowed to seize the percentage of the total refund that reflects 177/366, or 48.49%.  Similarly, the taxpayer would be allowed to retain the percentage of the total refund that reflects 188/365, or 51.51%.

Practice Pointer:  File as early in the calendar year as possible if a taxpayer is expecting a large refund. An early filing preserves the argument that the income was earned after the bankruptcy filing and the maximum share of the tax refund would be protected by the taxpayer.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Are Estimated Tax Payments Paid to the IRS Protected from Seizure in Bankruptcy?

Yes, estimated tax payments made to the IRS immediately before filing bankruptcy could be protected from seizure by the Chapter 7 trustee, according to In re Mooney, 526 B.R. 421 (Bankr. M.D.GA 2015).  In Mooney, an individual taxpayer tendered to the IRS $36,700 in estimated tax payments two days before filing Chapter 7 bankruptcy.  The Chapter 7 trustee wanted to seize those payments and filed a motion for turnover pursuant to 11 U.S.C. §542(a), arguing that the estimated tax payments were credits against the future tax liability and constituted “credits” that are property of the bankruptcy estate which are subject to turnover.  The taxpayer opposed the turnover motion and argued that the tax payments/credits are not within the taxpayer’s “control” because those payments can only be refunded by the IRS after the payments are applied to taxes due for the year in which the payments were made, citing Rev. Rul. 54-149, 1954-1 CB 159-60.

The Georgia bankruptcy court noted that the Eleventh Circuit in which it sits has never published a decision on the issue. But, the court noted that the Ninth and Tenth circuits have published conflicting opinions.  So the bankruptcy court analyzed both approaches.

Adopting the reasoning of the Tenth Circuit in the case of Weinman v. Graves (In re Graves), 609 F.3d 1153 (10th Cir. 2010), the Mooney court started its analysis by finding the tax credits were property of the bankruptcy estate.  But, the court noted that the Chapter 7 trustee succeeded only to the title and rights in the tax credits that the taxpayer had at the time the bankruptcy case was filed, nothing more.  The Mooney court believed the trustee’s interest in the tax creditors were limited to the same extent as a taxpayer’s interest in the application of a prior year tax refund, by the strictures of 26 U.S.C. §6513(d), which makes a taxpayer’s refund application election irrevocable.  A taxpayer would have no right to any cash refund of the estimated tax payments until their current tax liability is determined and then only if they are entitled to a further refund.

Finally, the court held that the bankruptcy estate’s interest in the pre-payment is limited to the taxpayer’s contingent reversionary interest in the pre-payment attributed to pre-petition earnings.  Stated differently, if the taxpayer is entitled to a refund after their current year tax liability was satisfied, then the Chapter 7 trustee is entitled to demand turnover of any amount of such refund attributable to the prepetition earnings.

Practice Pointer:  Tendering estimated tax payments to the IRS for the current year (or applying a tax refund from a prior year) prior to filing bankruptcy is a clever strategy to deplete non-exempt assets that would otherwise be seized by the trustee and distributed to the unsecured creditors.  Step two of the strategy would be to minimize the tax refund in the current year since the Chapter 7 bankruptcy trustee would be entitled to demand turnover of any amount of the refund attributable to the prepetition earnings. Taxpayers receiving a paycheck could reduce their tax withholdings in an effort to minimize the tax refund.  Self-employed taxpayers could seek to minimize refunds by minimizing net income from delayed income recognition and expedited expense recognition.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.

Does taxpayer have the right to choose which tax years a Chapter 13 payment shall be applied?

That issue was addressed in In re Fielding, 522 B.R. 888 (Bankr. N.D.TX 2014).  In Fielding, a taxpayer filed Chapter 13 bankruptcy owing the IRS approximately $539,000 for multiple tax years.  The taxpayer sold his residence after filing bankruptcy to generate cash to reduce the secured debt owed to the IRS and to make the Chapter 13 plan more affordable.

The issue before the Fielding court was whether the taxpayer may apply, at the taxpayer’s own discretion, proceeds from the sale of an exempt asset to tax debt owed to the IRS.  The taxpayer argued that the taxpayer has the right to allocate sale proceeds to whatever tax years the taxpayer desires.  The IRS maintained that the IRS has the right to apply payments to portions of debt according to the IRS’ existing policies and procedures, including applying payments to the oldest tax liability, including the penalties and interest associated with that liability.

The Fielding court began its analysis by citing the 1990 U.S. Supreme Court decision, United States v. Energy Res. Co., Inc., 495 U.S. 545 (1990), which held that a bankruptcy court has the authority to order the IRS to apply tax payments made as designated by the taxpayer when the designation is necessary to ensure a successful reorganization.  The Fielding court then analyzed the facts of the case and determined that the taxpayer’s allocation was indeed necessary to ensure a successful reorganization.

Granting the taxpayer relief on an alternative theory, the Fielding court found that the taxpayer’s payment of the sale proceeds constituted a “voluntary payment” which allowed the taxpayer to allocate payments to any tax year of the taxpayer’s choosing.  The court rejected the IRS’ position that the payment was “involuntary” because it was part of a bankruptcy proceeding.  The court pointed to the voluntary nature of a Chapter 13 case versus an involuntary Chapter 7 case.  Plus, the court noted that the sale proceeds were exempt under Texas law and that the application of the payments to the IRS would not violate the “best interest of the creditors” text of 11 U.S.C. §1325(a)(4) because the unsecured creditors were not entitled to the exempt funds.

Practice Pointers:  The taxpayer should have attempted to sell the homestead prior to filing bankruptcy so that there would be no question that the sale proceeds were “voluntary payments” to the IRS.

For follow-up questions, contact attorney Robert V. Schaller by clicking here.