A recent bankruptcy case, United States v. Sperry, 2013 WL 1768664 (S.D.Ind. 2013) highlights a problem faced by managers of failing businesses. In Sperry, the principal stockholder of a corporation was held personally liable for federal taxes owed by the corporation. The corporation in question was an S corporation. The income tax liability of an S corporation generally passes through to the shareholders anyway, but the taxes in Sperry were not income taxes. Rather, they were employment taxes, such as social security taxes, which are generally the company's responsibility even in the case of an S corporation. Although it was the principal (Sperry) who was in bankruptcy, federal taxes are difficult to discharge in bankruptcy, and while the issue was not discussed in the court's opinion, these taxes were probably not dischargeable. The question of whether Sperry was personally liable, then, was of the utmost importance.
Most business managers are familiar with the basic rule that a responsible person can be held personally liable if a corporation fails to remit to the IRS withholding monies (often referred to as trust fund taxes) on behalf of its employees. Withholding monies are considered trust funds under federal tax law. However, social security taxes do not fall into that category and are considered non-trust fund taxes. Even so, the court held that Sperry was personally liable when the corporation failed to pay its employer share of social security taxes.
The court cited a federal statute, 31 U.S.C. § 3713, which states that the U.S. Government must be paid first when a person indebted to the Government is insolvent and (1) the debtor is without enough property to pay all debts and makes a voluntary assignment of property, (2) the debtor's property is attached, or (3) an "act of bankruptcy" is committed.
Many people would have little sympathy for Sperry. He took money that could have been used to pay the taxes, and used it instead to pay down the balance of a credit card (which included some personal expenses) and of a promissory note that the corporation owed to him personally. The court found that after considering the balance of the promissory note, the corporation was insolvent because the amount of its liabilities exceeded the value of its assets. The court also found that the payment of the promissory note when there were outstanding social security taxes constituted an "act of bankruptcy." As a result, Sperry was personally liable for the taxes under 31 U.S.C. § 3713.
Although the facts in Sperry did not elicit sympathy because Sperry favored himself at the expense of the IRS, the way the law is written, Sperry would have been personally liable even if he had simply paid payroll or the electric bill. The statute imposes personal liability for taxes owed by an insolvent company if the person whose job it is to make out the check to the IRS does not do so, but uses the money for any other purpose, including the payment of legitimate operating expenses.
The key issue that determines whether there is a duty to pay the IRS before other creditors is whether the company is "insolvent." The question of what "insolvent" means is not answered in the statute. The reported case precedent states that the company would be considered "insolvent" if the amount of its liabilities exceeds the fair market value of its assets. However, there is some case law, particularly older cases, which suggest that the mere inability of the company to pay its debts as they come due evidences insolvency. Because of the ambiguity, as well as the fact that insolvency will be determined in retrospect, it is best that anyone who is responsible for paying the taxes (or other amounts owed to the Government) make sure that the Government does get paid, irrespective of solvency.
While Sperry is a recent case, it is not an aberration. The law established under 31 U.S.C. § 3713 is not new and imposes personal liability on any representative of a person or an estate that pays a debt to any party before paying the claims of the Government. Sperry is simply one of the most recent of many cases that impose personal liability on a responsible person for failure to pay what the Government is owed before paying other creditors. In addition, while Sperry was the principal of the company, even an office manager who is merely an employee of the company might be held liable when acting as a representative of the company. Therefore, when a company goes out of business, any person who is responsible for paying the taxes should consult an attorney before paying other creditors, if there are outstanding taxes owed to the IRS.
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