When a company files a bankruptcy petition, a variety of potential claims against its creditors arise under the Bankruptcy Code. Preferential transfers are an example; under the Bankruptcy Code, transfers made within ninety days of the bankruptcy filing can be recovered if a creditor received an interest in a debtor’s property on account of a pre-existing debt while the debtor was insolvent, and the transfer of property puts the creditor in a better position than it would have had in a Chapter 7 liquidation. 11 U.S.C. § 547(b). There are some additional nuances, including a longer preference period for insiders and a variety of potential defenses.
Last week, the Fourth Circuit addressed a fairly basic question: are trust fund tax payments made to the IRS voidable preferences? The answer was a resounding no. In re Firstpay, Inc., 2014 U.S. App. LEXIS 23381 (4th Cir. Dec. 12, 2014).
Firstpay involved a payroll processing company; each pay period, it received from each of its clients funds that consisted of taxes owed for the client’s employees, the wages of the employees and a fee to Firstpay. In re Firstpay, Inc., 2014 U.S. App. LEXIS 23381, slip op. at *2-*3. Firstpay was supposed to deposit the tax money in a designated account and then remit it to the IRS when quarterly payments were due. Id., slip op. at *3. Unfortunately, some of the funds were diverted, which ultimately resulted in the bankruptcy filing. This left many of Firstpay’s clients with tax obligations that they thought they had paid.
The bankruptcy trustee launched a multi-pronged attack on the IRS, the bulk of which failed. When the case reached the Fourth Circuit, the only question left was whether the tax payments that were made in the ninety days preceding the bankruptcy filing involved Firstpay’s property.
Given the fact that the payroll company had agreed to hold the tax funds and pay them over to the government on behalf of its clients, the Fourth Circuit had little trouble determining that the funds were held in trust. Id., slip op. at *9-*15. Nor did the fact that funds were commingled trouble the Court; following prior Supreme Court authority, the Fourth Circuit concluded that the funds could be traced and connected to the relevant trust. Id., slip op. at *20 (citing Begier v. IRS, 496 U.S. 53, 58-67 (1990)).
The outcome is hardly a surprise: the Supreme Court in Begier reached the same conclusion in dealing with payroll tax payments by an employer (among other things), and it is hard to see a reason why the outcome should change when the tax money is handled by an intermediary.
Jim Malone is a tax attorney in Philadelphia; he focuses his practice on federal, state and local tax controversies. This post is intended to provide background on a relevant issue; it is not intended as legal advice. © 2014, Malone LLC.