Many practitioners engaged in Chapter 11 bankruptcy proceedings, as well as the IRS, are discovering that the designation of tax payments either to trust fund liabilities or to non-trust fund liabilities in a Chapter 11 reorganization is not a clear and unencumbered matter. The IRS has determined that a taxpayer may designate how voluntary payments of tax may be applied to various tax liabilities, and that involuntary payments may not be so designated.(1) However, tax payments made by a corporation in a Chapter 11 proceeding, generally regarded to be involuntary payments, may, in certain circumstances, be applied to specific tax liabilities as designated by the taxpayer.

Taxpayers have encountered significantly divergent court interpretations concerning the designation of such tax payments by corporations. Several recent cases have clearly demonstrated the willingness of some courts to allow the IRS to apply these payments as it desires. However, the First Circuit recently determined in In re Energy Resources, Inc. that the IRS must apply these payments as the bankruptcy court has designated. These decisions highlight the tension that can often result from conflicting objectives of the Internal Revenue Code and the Bankruptcy Code.

Background and Definitions

Sec. 7501 stipulates that whenever any person is required to collect or withhold any federal revenue tax (federal individual income taxes, social security taxes, and federal unemployment taxes) from an employee's pay, the amount thereof is to be held in a special fund in trust for the U.S. These taxes have become known as trust fund taxes. They contrast with taxes such as federal corporate income taxes, which the corporation has an obligation to pay, but which are not held in trust, and which are referred to as non-trust fund taxes.

Sec. 6672 states that if the amounts withheld for trust fund taxes are not remitted to the government, any person responsible for collecting and remitting them is subject to a penalty equal to the amount of the unpaid tax. Because of this rule, once a corporation declares bankruptcy the IRS prefers to designate any corporate tax payments to non-trust fund liabilities first and any remainder to trust fund liabilities. Naturally, if the IRS is not able to collect the trust fund taxes from the corporation it can attempt to do so from any individual responsible for their payment. This increases the likelihood of collecting the entire amount due. On the other hand, the responsible individuals would prefer that any payments be designated to trust fund liabilities first to relieve them of any obligations. The question for the courts is, who has the right to designate the payments--the taxpayer or the IRS?

Involuntary Payments versus Voluntary Payments

It will be helpful to define what is meant by "voluntary payment" and "involuntary payment." The Tax Court has defined an involuntary payment as follows:

"Any payment received by agents of the United States

as a result of distraint or levy or from a legal proceeding

in which the Government is seeking to collect its

delinquent taxes or file a claim therefor." The characterization of a payment as involuntary cannot be made solely on the basis of administrative action, but must entail the actual seizure of property or money. A voluntary payment is simply any payment that is not involuntary.

This distinction is important because in Rev. Rul. 79-284, the IRS provides that a taxpayer who voluntarily submits a payment to the IRS may designate the liability to which the payment will apply. The IRS has also stated as an internal policy that when the taxpayer makes a payment involuntarily, the taxpayer may not designate the allocation. Thus, the IRS asserts that the ability of a taxpayer to designate a payment depends solely on whether it has been voluntarily made.

Judicial Interpretations

The Circuit Courts have provided varying interpretations concerning a taxpayer's designation made during a Chapter 11 reorganization. Whereas the First Circuit and the Eleventh Circuit have ruled that the taxpayer can so designate, the Third, Sixth, and Ninth Circuits have determined that such payments may not be designated. However, another question, whether the law permits a bankruptcy court to order the IRS to allocate an involuntarily made payment to a debtor's trust fund tax liability, has been explicitly addressed by the First Circuit, and vaguely addressed by some of the other circuits.

In re A & B Heating & Air Conditioning

In 1987, the Eleventh Circuit, in A & B Heating & Air Conditioning, was presented with the issue of whether a corporation in a Chapter 11 bankruptcy reorganization had the right to designate that its tax payments should be first applied to trust fund liabilities. The court ruled that payments made under Chapter 11 reorganizations should not be automatically labeled as involuntary, although they may not always be voluntary either. The court concluded that allocation questions should be decided on a case-by-case basis.

The court based its decision on two lines of reasoning. First, it noted that there is strong precedent for the argument that payments made in the context of a non-liquidating Chapter 11 proceeding are voluntary payments. The Eleventh Circuit specifically noted the reasoning of the bankruptcy court:

"Court involvement in the context of a Chapter 11

reorganization case is not the type which results in seizure

of property or money as in a levy. Unlike a taxpayer

faced with a government instituted collection proceeding

which may lead ultimately to levy upon the taxpayer's

assets, a Chapter 11 debtor enjoys great latitude in how

and if a plan is proposed and thus how and when the

IRS will be paid. Section 1129 Bankruptcy Code

requires only that a plan provide for payment of

prepetition taxes over a period not to exceed six years from

the date of assessment in order that it may be confirmed.

The debtor propounding a plan has a number of options

which dictate the conclusion that payments to the IRS

pursuant to a confirmed Chapter 11 plan of

reorganization are voluntary." The Eleventh Circuit agreed with the conclusion of the bankruptcy court that the payments should be considered as voluntary in these circumstances, in which case the IRS, according to its own policy, must accept the taxpayer's designation.

The Eleventh Circuit also addressed the relationship of the bankruptcy court to the IRS. While noting that controversy arises because of the conflicting policies behind the Bankruptcy Code and the Internal Revenue Code (IRC), the court reasoned that: 1) Congress has enacted a Bankruptcy Code which details how creditors are to be paid; 2) the Bankruptcy Code expresses a preference toward reorganization rather than liquidation; and 3) permitting the IRS to allocate tax payments is detrimental to the reorganization plan, because frequently the only hopes for the future viability of the corporation are the officers of the corporation who would be pressured to pay the trust fund taxes out of their own pockets. The court concluded that in the absence of a congressional statement that the IRC is to take priority over the Bankruptcy Code, it will not categorize such tax payments as involuntary.

In re Ribs-R-Us, Inc.

Only a month after the Eleventh Circuit's decision, the Third Circuit determined that the payment of pre-petition tax liabilities were involuntary payments and could not be designated by the taxpayer. The bankruptcy court had confirmed the taxpayer's plan of reorganization, which included a provision that allowed the taxpayer to direct how the tax payments were to be applied. The taxpayer argued that payments should be construed as involuntary only if they result from enforced collection measures such as a levy, which would lead to the actual seizure of property. The taxpayer had voluntarily applied to reorganize under Chapter 11 bankruptcy. As a result, it could voluntarily remove itself from Chapter 11 if the plan of reorganization was not approved and pursuing another avenue to solve its problems could be justified.

The Third Circuit rejected this reasoning, arguing that it ignored the crucial distinction between pre-petition and post-confirmation payments of tax liabilities. The court determined that since the debtor is subject to an express judicial order, the payments are involuntary. The court relied on the dissenting opinion of the bankruptcy appellate panel, which stated:

"Debtors who file under any chapter of the bankruptcy

code have few, if any, options. As a practical matter,

they file bankruptcy because it is a last chance for a

relatively ordered financial liquidation or rehabilitation

rather than the out-of-control financial debacle facing

them on the eve of bankruptcy." The court also expressly stated that by allowing the taxpayer to designate payments, the purposes of Sec. 6672 would be undermined, because it would shield the two sole shareholders of the corporation from potential personal liability, since they were also the persons responsible for making the trust fund tax payments.

In re Technical Knockout Graphics, Inc.

In 1987 the Ninth Circuit Court of Appeals confirmed the position of the Third Circuit in Technical Knockout Graphics, Inc. This case was similar to Ribs-R-Us in that the main issue was whether the tax payments made were voluntary or involuntary. The taxpayer argued that the payments were voluntary because it had no obligation to make any payments prior to filing a reorganization plan. The court stated that by filing the bankruptcy petition, the taxpayer was using the authority of the court to keep its creditors at bay, and that this system could not be abused by also allowing the taxpayer to designate its payments in such a manner that the only party benefited was the responsible taxpayer.

It should be noted that the bankruptcy appellate panel, in affirming the bankruptcy court's approval of the taxpayer's plan of reorganization, stated that the main issue was not whether the taxpayer could designate its payments, but whether the bankruptcy court had the power to order such an allocation. Thus, the appellate panel had distinguished between the issue of: 1) involuntary versus voluntary payments; and 2) the bankruptcy court's power to designate payments. However, the Ninth Circuit in deciding for the IRS, only addressed the first issue.

In re DuCharmes & Company

In 1988, the Sixth Circuit followed the same reasoning of the Third and Ninth Circuits in Ducharmes & Company. The Sixth Circuit did not provide any additional rationale for its ruling besides citing the precedents set by the Third and Ninth Circuits.

In re Energy Resources Co., Inc.

More recently, in 1989 the First Circuit was presented with the same issue, and, reversing the trend which had been set by the Third, Ninth, and Sixth Circuits, the First Circuit more closely aligned itself with the Eleventh Circuit in holding that the taxpayers could designate to which liabilities the payments should be applied. The First Circuit specifically addressed two questions. The first dealt with whether the payments were voluntary or involuntary. The arguments for each were summarized as follows:

Voluntary:

1. The debtor may choose voluntarily to enter a Chapter 11 reorganization proceeding.

2. The Chapter 11 proceeding offers the taxpayer protection from the IRS, and it need not pay its tax debts for six years.

3. Chapter 11 gives the taxpayer many options for structuring payment and considerable latitude as to how and when the IRS will be paid.

4. In general, third parties who have agreed to take over the bankrupt corporation provide the money used to pay the IRS. These third parties are not required in any way to provide these funds.

5. If a Chapter 11 plan is not approved, the court may simply dismiss the case. The court is not required to convert the case into a Chapter 7 liquidation.

6. It is common for a debtor to propose which of a creditor's several debts a particular payment should satisfy.

Involuntary:

1. Once a debtor files for reorganization under Chapter 11, all its assets vest in the bankruptcy estate.

2. The trustee is no longer free to spend the debtor's money. The trustee must act as a fiduciary for the benefit of the creditors.

3. The bankruptcy court determines the extent of the debtor's tax liability.

4. The reorganization plan submitted by the debtor must provide that all tax claims will be paid within six years.

5. A bankruptcy court order confirming the plan requires the debtor to carry out the plan.

6. If the debtor violates the plan, the court may convert the proceeding into a Chapter 7 liquidation.

The First Circuit after considering the above factors and the interpretation that the IRS offers in its own rules and regulations, decided that the payments should be construed as involuntary, as did the Third, Ninth, and Sixth Circuits. However, the court added that this conclusion only means that the IRS's own rules and regulations do not compel it to accept the taxpayer's designation of how to apply the payments.

The First Circuit added another factor that none of the previous decisions had explicitly considered. Does a bankruptcy court possess the legal power to order the IRS to apply a payment in a way that runs counter to the IRS's own internal policies? The First Circuit concluded that the bankruptcy court does indeed have this power. The bankruptcy courts have two primary responsibilities: 1) to ensure that creditors have the best possible chance of receiving what the debtor owes them; and 2) to provide the financially troubled corporation with an opportunity to make a fresh start. The bankruptcy courts clearly have a preference for reorganization rather than liquidation. In support of its decision, the First Circuit proposed the following:

"Suppose, for example, that certain third parties that

included "responsible" individuals were willing to

advance enough money to rehabilitate the corporation only

if the court would assure them that the reorganized

corporation would pay its "trust fund" tax debts first.

That assurance would diminish the likelihood that the

third parties would have to pay the debts personally;

without it they might prefer immediate liquidation,

which could mean total payment of all tax debt, and a

guarantee that no tax penalty will be assessed against

them personally." The court provided that in such a scenario it would be reasonable for the bankruptcy court to allow the designation of tax payments to trust fund liabilities, because it would increase the chances that the debtor would maximize payments to its general unsecured creditors.

The court also noted that its decision does not impair the ability of the IRS to collect all taxes due, because the bankruptcy court cannot approve the plan of reorganization unless it expects the bankrupt company to be able to completely pay its creditors within six years. The First Circuit determined that the bankruptcy court is in a much better position than the IRS to assess the viability of the plan of reorganization. If the bankruptcy court decides the interests of creditors would best be served by designating, that tax payments be applied first to trust fund liabilities then the IRS should accept that judgment, as must all other creditors.

The court further reasoned that the IRS could not circumscribe the bankruptcy court's statutory powers with an internal policy. Finally, the court correctly pointed out that the IRS's position reduces the possibility of trust fund taxes ultimately being collected by the Service. Sec. 6672 was enacted to ensure that trust fund taxes, not total taxes, were collected. In fact, by applying tax payments to non- trust fund tax liabilities first, the IRS is reducing the probability that the trust fund taxes will actually be collected Figure 1 summarizes the position of the various circuit courts on this issue.

The Interpretive Problem

The primary problem that the Circuit Courts have is weighting the conflicting priorities of the IRC and the Bankruptcy Code. Whereas the purpose of the IRC is to insure that the federal government receives the revenue legally due them, the purpose of the Bankruptcy Code is to maximize the probability that creditors, including the IRS, will receive the amounts owed, and, that the bankrupt company will be able to reorganize and continue its existence. It is natural that these policies would condiction occasion.

This conflict is the result of a "three-way tension," as explained by the Senate in enacting the current Bankruptcy Code:

"A three-way tension thus exists among (1) general

creditors, who should not have the funds available for

payments of debts exhausted by an excessive accumulation

of taxes for past years; (2) the debtor, whose "fresh start"

should likewise not be burdened with such an

accumulation; and (3) the tax collector, who should not lose

taxes which he has not had reasonable time to collect or

which the law has restrained him from collecting."

There are three parties who have a direct interest in the fate of the insolvent company: the corporation itself, the IRS, and other general creditors. Some party must be responsible for deciding whether the interests of all creditors would best be protected by immediate liquidation (creditors would collect only a portion of what is due them) or by allowing a reorganization with a plan to pay all creditors within six years. Thus, the interpretive problem is one of deciding who has the authority to make this decision, the Bankruptcy Court or the IRS.

Who Should Decide?

The authors believe that the decision by the First Circuit is the best reasoned approach to resolving this conflict. The parochial view of the IRS neglects the rights of the other general creditors, as well as the debtor whom the Bankruptcy Code was designed to protect. Although the Senate recognized this tension it did not provide that the preferences of the IRS should take precedence over the rights of other general creditors and the debtor. There is no basis for assuming that Congress automatically preferred that the tension be resolved in favor of the IRS. Thus, we believe that it is the Bankruptcy Court's mandate to relieve this tension. The debtor, the general creditors, and the IRS must concede to the professional judgment of the Bankruptcy Court as to which reorganization plan will best serve all parties concerned.

Conclusion

Currently, the IRS's position that a taxpayer in Chapter 11 is unable to designate tax payments first to trust fund liabilities is clearly disadvantageous to the taxpayer, which the Circuit Courts are split on the issue. The interpreting problems associated with the designation make it almost impossible to develop general rules that are consistent applicable. Legislative action or an clarfying Supreme Court ruling are needed to resolve the problem. Figure 1 Omitted

(1)See IRS Policy Statement P-5-60, reprinted in Administration, Internal Revenue Manual (CCH) 1305-15.

Ted D. Englebrecht, PhD, is KPMG Peat Marwick Professor of Accountancy at Georgia State University. Dr. Englebrecht has written extensively on taxation and estate planning topics. He has previously published articles in professional publications. Gregory A. Carnes, MS (Tax), is a doctoral candidate at Georgia State University. Prior to his doctoral studies he was a senior tax consultant with Ernst & Whinney. Mr. Carnes has previously published articles in professional publications.