Court Upholds 2 Bankrupt Firms on Tax Collections

The Supreme Court today made it more difficult for the federal government to collect all taxes owed by bankrupt corporations.

By an 8-1 vote, the court thwarted the government’s attempt to hold officials of bankrupt corporations personally responsible for paying the owed taxes.

The controversy stemmed from the two types of federal taxes owed by employers--”trust fund” and “non-trust fund” taxes--and the differing consequences of non-payment.

Trust fund taxes are those withheld from employees’ paychecks, representing those employees’ personal income tax, unemployment insurance and Social Security taxes.

Should an employer fail to pay any trust fund taxes, the government can collect an equivalent sum directly from the officials who were responsible for collecting and paying them.

An employer also may fail to pay its ordinary corporate income taxes or other non-trust fund taxes--those to be paid directly by the corporation and not withheld or collected from someone else.

The government generally cannot impose personal liability on corporate officials if a corporation’s non-trust fund taxes go unpaid.

A Massachusetts corporation called Energy Resources Co. filed for bankruptcy reorganization in 1983 while owing about $1 million in federal taxes, most of which were trust fund taxes.

As part of its court-ordered reorganization, the taxes owed by Energy Resources were to be paid over four years. In making the first payment, the bankruptcy trustee told the Internal Revenue Service to apply it to trust fund taxes owed.

But the IRS refused, contending the payment could be applied to the corporation’s tax debt as the government agency chose.

The same sequence of events occurred after a Rhode Island corporation called Newport Offshore filed for bankruptcy reorganization in 1985.

Federal judges in both states ruled that the IRS had to apply the tax payments as specified, and those rulings were upheld by the Boston-based U.S. 1st Circuit Court of Appeals.

The appeals court acknowledged that having the trust fund taxes paid off first hurts the government’s chances of collecting all the money owed.

If the reorganized corporation were to run out of money with trust fund debts still owed, the government might collect them from the people who were to collect and pay that money. But if all the trust fund taxes have been paid when a reorganized corporation runs out of money, the government could not go after the corporation’s officers.

Today’s decision upheld the two corporations’ legal victories.

Writing for the court, Justice Byron R. White said a bankruptcy court “may order the IRS to apply tax payments to offset trust fund obligations where it concludes that this action is necessary for a reorganization’s success.”