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Trust Fund Taxes and the Secured Lender

Spring 1997

Our Financial and Business Restructuring Practice Group would be happy to assist you with any questions relating to this article.

Many businesses are required in their normal business operations to collect or withhold certain "trust fund taxes" for the benefit of various federal or state taxing authorities such as the Internal Revenue Service or the Wisconsin Department of Revenue. A trust fund tax is one required to be withheld or collected by a business from another party where that business is merely a collecting agent for the appropriate taxing authority. Common examples of trust fund taxes include state or federal income taxes withheld from the pay of an employee and sales taxes collected from a purchaser of retail goods.

Generally, a party holding collected trust fund taxes must pay those taxes to the taxing authority on a monthly or quarterly basis. That is well and good when available cash is sufficient to pay all of a business’ obligations. However, when money runs short, many businesses view collected trust fund taxes as an additional source of cash. Plain and simple, that is wrong and illegal and should not be done.

Trust Fund Taxes in Bankruptcy

The claim of a taxing authority for payment of trust fund taxes will be a priority claim in the event of a corporate bankruptcy and will be a nondischargeable claim in an individual bankruptcy, whether that individual is directly liable as the "taxpayer" or liable by virtue of the "responsible party" provisions of state or federal tax laws. Under the Bankruptcy Code, a priority claim must be paid ahead of many other kinds of claims. A nondischargeable tax claim automatically "survives" an individual’s bankruptcy, which means that the taxing authority will be able to pursue collection of that claim notwithstanding the bankruptcy.

It seems, then, that parties in possession of trust fund taxes should always pay them over to the taxing authorities. However, the issue is a bit more complicated. Many companies obtain financing by granting to a bank a security interest in inventory and accounts receivable. The real problem arises when a bank claims that trust funds should be used to pay the bank as proceeds of the bank’s collateral.

A Secured Lender’sCompeting Claim

Generally, funds held in trust by a business never become property of the business. If that is true, a bank’s security interest should not attach to those funds. But some courts have struggled with the conflict between a bank and a taxing authority over the ownership of collected, unpaid trust fund taxes. In In re Honey, the 8th Circuit Court of Appeals held that a perfected security interest took priority over the claim of the Internal Revenue Service to collected, unpaid trust fund taxes. The Court held that because the IRS did not order the funds segregated or did not have a lien against them, they could be considered part of the bank’s collateral, subject to its security interest. That in itself is somewhat surprising because there was no question the funds were trust funds. However, to make matters worse, the officers of the business were still assessed with responsible party liability for failing to pay those taxes. Consider for a moment the implications of that ruling. First, if a business pays its taxes instead of applying this "collateral" to its bank debt, it could be guilty of misapplying its lender’s property. On the other hand, if the taxes don’t get paid because the funds go to a business’ secured lender, as in Honey, the officers of the company can be personally at risk for their payment. The implications of either action can be far-reaching and should be carefully considered by a company, its officers and its bank when money runs short.

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