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Bankrupt Payroll Processing Company Cannot Reclaim Funds Transferred to IRS.
(Parker Tax Publishing January 13, 2015)

The Fourth Circuit ruled that a payroll processing company going through bankruptcy could not reclaim $28 million transferred to the IRS during the 90 days preceding the filing for bankruptcy. The company had no claim to funds that were held in trust for its employer-clients and were not the company's personal property. In re: FirstPay, Inc., 2014 PTC 592 (4th Cir.).


Prior to bankruptcy, FirstPay, Inc. provided payroll processing services as well as tax reporting and depositing services for numerous employer-clients. Before each payroll date, FirstPay would withdraw funds from client checking accounts and deposit the withdrawn funds into a tax account to cover following amounts: (1) payroll and withholding taxes for which the client was liable; (2) payment of the client's employees' wages; and (3) fees owed to FirstPay for its services.

FirstPay's service agreements with its employer-clients provided that it would hold the tax funds until taxes were due and then remit payments to taxing authorities. However, not all of the funds were used for that purpose. While some funds were transferred to the IRS, FirstPay also conducted several fraudulent transfers from the tax account to an operating account used to pay its own business expenses, and also transferred funds to an exchange and reimbursement account used for lavish personal expenditures by FirstPay's principals. As a result of FirstPay's misappropriation of its clients' funds, a substantial portion of its clients' tax obligations went unpaid, and remained due and owing at the time of the bankruptcy proceedings.

OBSERVATION: Although the experiences of FirstPay's clients are by no means typical, the case illustrates the risks inherent in entrusting tax remittances to a payroll processor. As FirstPay perpetrated its fraud, it fully remitted the tax payments of some clients, partially remitted the tax payments of others, and made no payments at all on behalf of the rest. The clients in the latter two groups are faced with the prospect of having to pay their payroll and withholding taxes twice: once to FirstPay (years ago), and a second time directly to the IRS.

In 2003, creditors filed an involuntary Chapter 7 bankruptcy petition against FirstPay in the U.S. Bankruptcy Court for the District of Maryland. In 2005, the bankruptcy estate's trustee sought a judgment that the Government had no claim for taxes or penalties against FirstPay clients whose payroll taxes were paid to FirstPay, but not ultimately remitted to the IRS; avoidance of FirstPay's payments of its clients' payroll taxes to the IRS as preferences under 11 U.S.C. Sec. 547 and as fraudulent conveyances under 11 U.S.C. Sec. 548 and Maryland law; and turnover of avoided transfers under 11 U.S.C. Sec. 550. After a series of appeals and remands, the Fourth Circuit was asked to determine, for purposes of recovering the funds, whether the nearly $28 million FirstPay transferred to the IRS during the 90 days preceding the bankruptcy filing constituted "an interest of the debtor in property" under 11 U.S.C. Sec. 547(b).

Appeal and Analysis

The Trustee's main argument was that the transfer of the tax funds to the IRS qualified as a "transfer of an interest of the debtor in property" under 11 U.S.C. Sec. 547(b), as opposed to funds that FirstPay held in trust for the benefit of its clients. The Trustee proffered that, upon transfer to the debtor, the client tax funds became a debt the debtor owed its clients and therefore the debtor's subsequent transfer of those funds to the IRS was a transfer of an interest of the debtor in property constituting an avoidable preference under 11 U.S.C. Sec. 547(b).

In limited circumstances, a trustee in bankruptcy is permitted to avoid and recover certain payments made by an insolvent debtor preferentially for the benefit of some creditors prior to the filing of the bankruptcy petition. 11 U.S.C. Secs. 547(b), 550(a). These avoidable preferences include transfers made on or within 90 days before the petition is filed. However, the trustee can only avoid a "transfer of an interest of the debtor in property," as only the debtor's property would have been available for distribution among creditors in the absence of the transfer.

Whether an amount is considered an interest of the debtor in property, as opposed to being held in another form such as a trust, depends on state law. Under Maryland law, a trust exists where the legal title to property is held by one or more persons, under an equitable obligation to convey, apply, or deal with such property for the benefit of other persons (From the Heart Church Ministries, Inc. v. African Methodist Episcopal Zion Church, 803 A.2d 548 (Md. 2002)).

The Fourth Circuit Court agreed with the bankruptcy court and the district court, concluding that FirstPay lacked the requisite ownership in the funds paid over to the IRS to categorize them as a transfer of an interest of the debtor in property, and therefore the transfer was not an avoidable preference under 11 U.S.C. Sec. 547(b). The Circuit Court based this conclusion on the fact that the funds were held in trust by the debtor. The court found that all the elements of a valid trust under Maryland law were satisfied, and relied on the unambiguous terms of the service agreements to conclude the tax funds were intended to be held by FirstPay, as an intermediary, only for payment of the clients' taxes and therefore constituted trust property, as opposed to debt.

The Trustee alternately argued the funds transferred to the IRS had been comingled and therefore could not be deemed trust property. However, the court disagreed, finding the funds were not so "mingled and merged" with FirstPay's general assets or dissipated to the point that would prevent the funds from filling the purpose of the trust, but, rather, were identifiable and thus could be traced and connected to the trust.

As the funds were held in trust, they were not a transfer of an interest of the debtor's property within the meaning of 11 U.S.C. Sec. 547(b), thus the Circuit Court held that the transfer was not avoidable, and thus the trustee was unable to reclaim the funds transferred by the debtor to the IRS.

The Court expressed sympathy to the affected employee-clients, many of whom were still liable for the taxes FirstPay failed to remit. However, it noted that the employers had assumed the risk of FirstPay's mishandling of their funds when they selected the firm for vital payroll processing and tax reporting services. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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