Certain transfers made within 90 days of a bankruptcy filing can be set aside by the bankruptcy trustee 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 puts the creditor in a better position than it would have been in a Chapter 7 liquidation had the transfer not occurred.
The rationale behind this statutory construction is to avoid allowing the debtor to unfairly favor any specific creditor at the expense of others. Because the transfer is so close to the bankruptcy filing, it is viewed as property of the estate and thus should be equitably distributed amongst creditors according to the priority scheme outlined in the Bankruptcy Code.
The IRS is no exception to the rule on preferential transfers, it is a creditor just like the rest. Therefore, paying the IRS for delinquent taxes, penalties, and interest owed within the 90-day period prior to filing bankruptcy may result in recovery of that payment back into the bankruptcy estate.
However, the payment for a trust fund tax liability is unique in respect to the payment of other tax debts. Trust fund tax liabilities typically arise when an employer withholds payroll taxes from its employees. The courts view any prepetition payment of trust fund taxes as a payment of funds that are not the debtor’s property. Instead, this property is being held “in trust” on behalf of employees and customers. Under I.R.C. § 7501, a trust fund is created at the moment payments from customers (excise/sales taxes) and to employees (FICA and withholding taxes) are made. As a result, if the debtor makes a payment of trust fund taxes within the 90-day preference period, he/she is making a payment of funds that are not the debtor’s property and thus cannot be avoided by the trustee and brought back into the estate.
To top it off, the United States Supreme Court’s decision in Begier v. IRS, 496 U.S. 53 (1990) held that no actual separate account or trust fund pursuant to I.R.C. § 7501 need be created. In that case, American Airlines paid their trust fund taxes from their general operating account within the preference period which did not qualify as a preferential transfer. The key element of the Supreme Court’s analysis was that, unlike common law trusts, I.R.C. § 7501 does not create a trust in particular property, but rather a trust in an abstract “amount.” As such, it concluded that a debtor’s act of voluntarily paying trust fund taxes is sufficient to establish the required nexus between the amount held in trust and the trust funds paid.
Lastly, trust fund taxes are priority claims and may be nondischargeable in bankruptcy. Because these taxes can be paid from any source within the preference period, it is incumbent on debtors to pay as much of their nondischargeable trust fund liability with money that would otherwise become property of the estate upon filing bankruptcy. This will minimize the nondischargeable trust fund liability exposure and properly deplete cash that would otherwise go to dischargeable unsecured claims.
However, it is essential that the taxpayer specifically designate the payment to the trust fund portion of the liability. Otherwise, the Service will apply the payments to the non-trust fund portion so as to preserve their right to collect the trust fund portion from responsible person individually. Feel free to contact us to ensure that the proper designations are made.
