Trustee Can't Recover Payments to IRS from Debtor Payroll Co.

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By Daniel Gill

May 13 — Trust-fund taxes collected by a debtor payroll company in Chapter 7 were not property of the estate subject to the trustee's preferential transfer avoidance power, the Third Circuit ruled.

A two-member panel of the Third Circuit entered an opinion May 5 with two distinct holdings: First, it ruled that separate pre-petition transfers by the debtor in this case could not be aggregated to meet and exceed the minimum value threshold necessary to support an action to avoid and recover a preference.

Second, the court determined that payroll tax withholding payments made to the debtor payroll company did not constitute “property of the estate” to satisfy that requirement to recover preferential transfers.

The third judge on the panel had “assumed inactive status” after argument and panel conference but prior to the issuance of the opinion.

Same Transferee but Different Debts

Section 547(b) of the Bankruptcy Code authorizes a Chapter 7 trustee to sue to recover payments made “to or for the benefit of a creditor” if those payments were made on account of an antecedent (pre-existing) debt within 90 days prior to the commencement of the bankruptcy case and while the debtor was insolvent.

This “avoidance power” is limited by certain statutory exceptions, including Section 547(c)(9) which requires that “the aggregate value of all property that constitutes or is affected by such transfer is less than $5,000.” The actual dollar amount is slightly higher by operation of Section 104 and related regulations; for the transfers in this case the minimum claim was $5,850. The Third Circuit said that it had not previously examined this provision.

The trustee's complaint was to avoid five particular payments made to the IRS for payroll taxes. Four of the five transfers were amounts less than $5,850, but the trustee argued that since they were all paid to the same transferee, the IRS, those transfers should be aggregated, thereby surpassing the statutory minimum.

The court disagreed. Although the transferee was the same, the payments were made on account of separate and distinct antecedent debts made for the benefit of separate and distinct creditors—Net Pay's clients which delivered funds to Net Pay to be paid to the client's employees and to the IRS for those employee's tax withholdings. Because the creditors and debts were distinct, the court said it could not permit aggregating the smaller transfers without rendering the minimum transfer defense practically ineffective.

No Loophole Created

The court said that its ruling was not an invitation for clever creditors to attempt to skirt preference avoidance exposure by taking multiple payments in amounts less than the Section 547(c)(9) minimum.

Those transfers, the court said, “may nevertheless be aggregated if they are, in effect, a single transfer on account of the same debt.”

Trust Fund Taxes Not Property of the Estate

The fifth transfer subject to the trustee's complaint was for over $32,000, so the Section 547(c)(9) defense discussed above did not apply. The court resolved this transfer by concluding that the actual funds transferred were not in fact property of the debtor — a requirement for an avoidable preference — but instead were held in trust for the benefit of another.

The court relied on Section 7501 of the Internal Revenue Code and its detailed analysis of the U.S. Supreme Court's decision in Begier v. Commissioner, 496 U.S. 53 (1990) in its interpretation of when and to what extent the money collected by Net Pay from its clients would be considered held in trust. The court explained that “section 7501(a) of the Internal Revenue Code creates a special statutory trust in favor of the United States for taxes withheld from employee paychecks (otherwise known as ‘trust fund' taxes).”

The court said that because in Begier the Supreme Court noted that trusts created under section 7501 of the IRC are not like other trusts (which might have specific tracing or other requirements), the court was not required to do a tracing analysis on the funds collected and disbursed by the debtor. The court relied on IRC section 7501 to find that the money paid by Net Pay's clients was for the purpose of paying taxes and therefore constituted funds in trust, in which Net Pay had no equitable interests.

In its holding, the Third Circuit extended the reasoning of the Begier decision to apply to third parties holding property on behalf of the companies obligated to withhold taxes.

Debtor's Principal Arrested

The attorney general for Pennsylvania issued a press release on May 11 stating that Net Pay's CEO and owner, William Simon Sullivan, Jr., was arrested and being charged for theft and fraud crimes directly related to alleged misappropriation of the trust fund taxes collected by Net Pay.

According to the press release, Sullivan is alleged to have used funds collected by Net Pay for the purpose of paying payroll or related taxes for other improper purposes, including paying the company's business expenses, and for Sullivan's personal expenses including home renovations, travel and personal vehicles.

Sullivan is also alleged to have taken funds from newer clients to pay tax obligations of existing clients. Bail was set at a preliminary arraignment in the amount of $150,000.

Markian R. Slobodian, Harrisburg, Pa., argued the case in his capacity as Chapter 7 trustee. The IRS appeared at oral argument by Ivan C. Dale, U.S. Dept. of Justice, Washington D.C.

To contact the reporter on this story: Daniel Gill in Washington at

To contact the editor responsible for this story: Jay Horowitz at

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