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IRS Not Required to File Proof of Claim for Certain Taxes Arising From Employee Wages Earned Pre-petition But Paid Post-petition

In re Goody’s LLC, No. 09-10124 (CSS) (Bankr. D. Del. May 13, 2014)

A recent Opinion issued by Judge Sontchi analyzed a motion filed by the debtors in In re Goody’s LLC to enforce plan injunctions and determine liability for certain employment taxes.  The issue in Goody’scentered on the post-petition payment of allowed pre-petition wage claims.  The debtors withheld employment taxes (the “Withheld Amounts”) from the wage payments, filed requisite tax returns, deposited the Withheld Amounts with the Internal Revenue Service (the “IRS”), and requested the IRS to apply the Withheld Amounts to the employees’ federal income and Social Security taxes related to the wages (the “Trust Fund Liability”).  Instead, the IRS applied the Withheld Amounts to the debtors’ Social Security and Medicare taxes related to the wages (the “Employer Liability”) and contended that the Trust Fund Liability remained outstanding.

The debtors objected to the IRS’s application of the Withheld Amounts to the Employer Liability.  The IRS did not file a proof of claim related to the pre-petition liability and thus, according to the debtors, the confirmed plan barred the IRS’s application and collection.  The IRS disagreed, asserting that the Employer Liability did not arise until the wage payments were made to the employees post-confirmation and the subsequent tax forms were filed, as employers are not required to withhold and turnover the taxes until that time.

The Court examined and relied upon several decisions of courts outside the Third Circuit for its conclusion that the IRS’s claim to the Employer Liability arose when the wages were earned pre-petition because the critical date is when taxes accrue, not the date of their assessment.  Notwithstanding the foregoing, Judge Sontchi held that the failure of the IRS to file a proof of claim did not bar its collection of the Employer Liability.  Under United States Supreme Court precedent, the “employer” required under the Internal Revenue Code to pay the Employer Liability is the entity making the wage payments to the employees.  See Otte v. United States, 419 U.S. 43 (1974) (holding the bankruptcy estate liable for taxes on account of post-petition payments for pre-petition wage claims because the estate, rather than the bankrupt corporation, was the liable “employer”).  Accordingly, the Court in Goody’s found that the “payment of the pre-petition wages (and the subsequent filing of the 941 tax returns) trigger[ed] the IRS’s right to payment[, and as] such, the IRS was not obligated to make a claim in these cases until the Debtors’ paid the wages.”

Facing a valid claim for Employer Liability, the debtors sought to have the Court reallocate the payment of the Withheld Amounts from the Employer Liability to the Trust Fund Liability.  It was advantageous for them to do so in order to avoid the imposition of the Trust Fund Liability onto the liquidating trustee (i.e., the individual who paid the pre-petition wage claims and thus, responsible for the collection and payment of the taxes) and the triggering of certain indemnification provisions under the confirmed plan.  The Court did not address the issue directly because it found that the debtors failed to make a factual record supporting their burden of proof.  However, in making this finding, the Court relied on the United States Supreme Court decision in In re United States v. Energy Res., 495 U.S. 545 (1990), which held that a bankruptcy court has authority to order the allocation of IRS payments if the designation is necessary to the success of a plan.  Judge Sontchi observed that courts are split regarding the applicability of Energy Resources to Chapter 11 liquidating plans, but noted the persuasiveness of those finding affirmatively for its applicability.