Failure of Employer to Designate Payment to Employer's Trust Fund Taxes (12/10/12)

In paying less than all of the tax assessments that are due, it may become critical for the taxpayer to designate how the tax payment should be applied among the tax, penalties and interest, as a recent decision of the Sixth Circuit reminds us.  In re: Southeast Waffles, LLC v. United States, 2012 U.S. App. LEXIS 24991 (6th Cir. 2012), here.  In that case, the employer sent in undesignated payments to be applied against assessments for the employer's withholding tax obligations, penalties and interest.  As undesignated payments, the IRS applied the payments to the employers penalties.  The employer then went into bankruptcy.  In the bankruptcy proceeding, the employer argued that the application of the payments to the penalties was voidable because the penalties would have had a lower priority and would have been discharged, vis-a-vis the employer, in the bankruptcy proceeding.  (Note that these are penalties for the employer's direct payment obligation and are not trust fund recovery penalties (TFRP) under Section 6672 even though they relate to the trust fund liability; as to responsible persons, TFRP are not dischargeable.)

In my Federal Tax Procedure Text I discuss the issue of designating payment as follows (footnotes omitted):

We focus now on the issues confronting the taxpayer in making the payment of less than the amount of the IRS assessment.  The question here is whether the taxpayer can designate as among the various components of aggregate tax owed (e.g., as among years or within the same year as among taxes, penalties and interest). 

The taxpayer is permitted generally to so designate a voluntary payment to the IRS.  Voluntary for this purpose means any payment not resulting from the Government’s compulsory collection measures (e.g., levy), that we discuss later in this chapter.  If, however, the taxpayer fails to designate the application of the payment, the IRS can apply the payment as it sees fit. 

Designation may be critical in certain cases.  We shall give examples which are by no means exhaustive, but should illustrate the concepts:

Example 1: We discussed above that a taxpayer unable to pay the total amount assessed (tax, penalties and interest) may be able to satisfy the jurisdictional prerequisite for refund litigation by paying only the tax.  In this case, it is important for the taxpayer to designate the application of the payment to the tax to meet Flora’s full payment requirement. 

Example 2: A taxpayer subject to a trust fund tax recovery penalty under § 6672 (“TFRP”) who desires to contest the liability with the minimum payment must insure that he meets the required minimum payment for at least one quarter.  The standard technique is to pay for one quarter, with a specific payment designation (see text at pp. 621 ff.).  If he fails to do so, the IRS may apply any payment as it sees fit, and, as applied, the minimum jurisdictional amount paid may not be satisfied.   

Example 3: In planning at the employer level to minimize the potential application of the TFRP, the employer in making payments to the IRS should designate that the payments are for the trust fund taxes rather than any other taxes or penalties (even employer penalties for failure to pay the trust fund taxes) the employer may owe.  To illustrate, if a corporate employer owes delinquent corporate income taxes and penalties as well as trust fund taxes, the corporate employer should designate payments to the trust fund taxes.  The reason is that, if the corporation goes belly up, its nontrust fund taxes will be collectible only from the corporate assets based upon bankruptcy priorities (and thus may not be collectible at all), but its trust fund taxes will follow and be collectible from the responsible persons. 

Example 4: The taxpayer may desire to designate some or all of the payment as interest rather than as principal.  One reason the taxpayer may do so is in order to get a current deduction for the interest. 

Example 5:  The taxpayer may desire to designate the years to which the payment is to be applied.  To use an extreme example, a taxpayer owing taxes for years 1 and 2 which were assessed 9 and 8 years ago, respectively, might consider making a payment of the Year 2 tax in the hope that the IRS will allow the statute of limitations to lapse on Year 1 with pursuing a collection suit to reduce the assessment to judgment. 

How does the taxpayer make the designation?  The designation should be in a written transmittal letter accompanying the payment, as well as being indicated on the check.  

In the foregoing discussion, I have assumed that the payment occurs after assessment.  As we discussed above, however, a taxpayer facing an audit may desire to make a pre-assessment payment.  Can the taxpayer designate how a pre-assessment payment is made?  Generally, advance payments should be applied according to the taxpayer’s instructions.

In Southeast Waffles, the Bankruptcy Appellate Panel (for a discussion of the Bankruptcy Appellate Panel and its role, see here) stated the issue:

The issue squarely before this Panel is whether [SEW] received less than reasonably equivalent value when the IRS applied prepetition payments made by [SEW] to the penalty portion of the tax liability. SEW argues that it received "zero" value for the payment when the IRS applied [SEW's] payments to the penalty portion of the liability rather than applying the payment to the tax or interest portion of the liability. [SEW] then argues that because it received "zero" value for the payment, the transfer (payment) must be avoided as a fraudulent transfer.

On appeal to the Sixth Circuit, the panel focused on taxpayer's argument that the application of the payments to the employer's penalties were not for "reasonably equivalent value" in the Bankruptcy Code's fraudulent transfer provisions.  But the IRC's noncompensatory penalties are not addressed in those provisions.  The Court concluded:

Congress's silence is understandable because noncompensatory penalties assessed and collected by the IRS do not fit neatly into the fraudulent transfer context. The purpose of allowing debtors to avoid fraudulent transfers is to discourage creditors from gaining unfair advantages as a result of a debtor's insolvency and potential bankruptcy. The IRS, on the contrary, is "an involuntary creditor." In re Haas, 31 F.3d 1081, 1088 (11th Cir. 1994). Tax penalties arise not through contractual bargaining but by operation of statute, and no value is or can be given in exchange. It would defy common sense to find that debtors could avoid such penalties when the IRS was doing only what the tax statutes require. 

The impact of a decision to allow avoidance of noncompensatory penalties as fraudulent transfers would be enormous. As noted by both the Bankruptcy Court and the BAP, such a decision could open a Pandora's box of litigation by debtors seeking not only to avoid all sorts of noncompensatory fines and penalties that are commonly encountered in bankruptcy cases but also to recover any prepetition payments made in satisfaction of those fines and penalties. Yet, despite the important ramifications to debtors, creditors, and the governmental units that have occasion to assess and collect noncompensatory fines and penalties, and despite a bankruptcy landscape that included no cases wherein courts had ever decided that noncompenstory tax penalties should be treated as fraudulent transfers, the legislative history of the Bankruptcy Code provides no evidence that Congress ever conducted hearings or heard debate or otherwise considered whether noncompensatory fines and penalties should be included within the purview of the fraudulent-transfer statute. See Midatlantic Nat'l Bank v. N.J. Dep't of Envtl. Prot., 474 U.S. 494, 501 (1986) (noting that "[t]he normal rule of statutory construction is that if Congress intends for legislation to change the interpretation of a judicially created concept, it makes that intent specific"). That Congress would be silent about such a matter throughout ten years of careful consideration and investigation is utterly inexplicable unless Congress (and the Tennessee Legislature) did not intend to change the landscape by making noncompensatory penalties and fines avoidable as fraudulent transfers. Indeed, like the Bankruptcy Court before us, we conclude that the fraudulent-transfer statutes were not meant to provide debtors with either a means to avoid tax penalties legitimately imposed or a means to recover prepetition payments made in satisfaction of those penalties.

Now, back to the original point.  Practitioners should be diligent in counseling employers that they can generally designate payments and how to make the designations in the best interests of the employer and its officers.