In Carpenter v. Montana Department of Labor,1 a bankruptcy appellate panel ruled that an individual taxpayer could not discharge in bankruptcy his vicarious liability for unpaid corporate unemployment taxes incurred by a corporation that he owned and managed. Under the Carpenter court's theory, individuals who are held vicariously liable for any tax under state or federal law cannot discharge the tax liability in bankruptcy if the tax would not have been dischargeable if incurred directly by the taxpayer rather than by the corporation. The decision opens the door for states to prevent individuals from discharging tax liabilities owed by corporations that they owned or work for, including taxes on corporate transactions from which they received no financial benefit. This article shows that the Carpenter decision rests on a faulty premise.
A. The Carpenter Case
The taxpayers in Carpenter were the sole shareholders and officers of a corporation that sold and serviced fire protection equipment. Montana law imposed vicarious liability for unemployment taxes on the corporate officer who is "responsible" for causing the corporation to pay the unemployment tax.2 The Montana law identifies the "responsible individual" as the one who directs the filing of the corporation's employment tax returns and directs the corporation's tax payments. Id.
It is important to note that while the taxpayers in Carpenter were also the owners of the corporation's stock, ownership is not the defining characteristic for vicarious liability under the Montana statute. For example, a salaried officer who had no ownership interest in the corporation but was assigned to file the corporation's employment tax returns and direct corporate tax payments would be held vicariously liable for non-payment even if that person had no control over the corporation's money, received no benefit from the corporation's operations, and could not pay the tax on behalf of the corporation because the corporation lacked the funds for payment.
It is a common characteristic of vicarious liability tax rules to impose liability on the individual worker who was required to collect and pay rather than the owners and operators who stood to benefit from the corporation's activities. One can understand the justification for such rules when the accounting officer is supposed to be segregating and turning over trust funds collected from third parties to the government. Trust funds should not be commingled with the corporation's other funds because they belong to the government and not to the corporation. As legal fictions, corporations can only act through their human agents, so it makes perfect sense to impose on the responsible agent the duty to collect, account for and remit the trust funds to the government.
The policy justification for holding non-shareholder corporate agents personally liable for unpaid trust funds quickly breaks down when there is no specific fund or res over which the accounting officer has control, as was the case with the unemployment taxes in Carpenter. The corporation had an obligation to pay the unemployment taxes, but there was no segregated fund of money set aside to make the payment. As Justice Scalia aptly noted in another case, "A trust without a res can no more be created by legislative decree than can a pink rock-candy mountain. In the nature of things no trust exists until a res is identified."3
Under the Carpenter court's theory, one can easily conceive of a situation in which an accounting employee would be held vicariously liable for non-payment of corporate employment taxes or income taxes even though that employee had no ability to force the insolvent corporation to pay the taxes. The Montana vicarious liability statute, like most such statutes, contains no defenses for innocent accounting employees who have ministerial responsibility for reporting and payment but lack the actual ability to cause the corporation to pay.
Because states have the ability to impose vicarious tax liability in any way and against anyone they wish, bankruptcy may be the last refuge of the "responsible" corporate individual who is being held personally liable for the potentially enormous tax liabilities of an insolvent corporation.
When the Bankruptcy Code was enacted in 1978, Congress made it clear that a responsible officer would not be able to discharge his or her vicarious liability for trust fund taxes (such as sales and payroll taxes) collected from a third party source (or withheld from a third party) and not segregated and turned over to the government by the responsible officer. The Bankruptcy Code expressed this rule by providing a priority for "a tax required to be collected or withheld and for which the debtor is liable in whatever capacity."4 Since priority taxes are always excepted from discharge under Section 523(a)(1)(A) of the Bankruptcy Code, trust fund taxes are never dischargeable by the individual who is held responsible for collecting, segregating and remitting the taxes. In theory, at least, the responsible officer was culpable for failing to segregate and account for the trust funds.
The Carpenter panel makes a giant leap, however, when it applies this vicarious tax non-dischargeability rule to non-trust fund corporate tax obligations. The other tax priority provisions (for income, gross receipt, property, employment, and excise taxes, and customs duties) do not contain language prioritizing taxes owed in a vicarious capacity. Congress reserved the "liable in whatever capacity" language solely for trust fund tax liabilities.
The taxpayer in Carpenter argued that the only vicarious taxes given a priority on the face of the priority statute and thereby rendered non-dischargeable are trust fund taxes. Since the unemployment taxes in issue were not trust fund taxes but general corporate excise taxes, the taxpayers in Carpenter argued that their vicarious liability should be non-priority and dischargeable.
In rejecting the taxpayers' argument, the Carpenter court relied solely on United States v. Sotelo,5 a 1978 Supreme Court case decided prior to the enactment of the current Bankruptcy Code. Does Sotelo justify the Carpenter court's expansive reading of the Bankruptcy Code's priority rules?
B. The Sotelo Case
Sotelo was decided shortly before Congress adopted the Bankruptcy Code. The taxpayers were the owners of a corporation that failed to pay $40,751.16 of trust fund taxes withheld and collected from their employees, but not segregated and turned over to the Government. In 1966, Congress identified which taxes would be subject to discharge and which would not. In general, taxes due and owing more than three years before the bankruptcy filing would be dischargeable. However, Congress put certain limitations on the rule allowing the discharge of old taxes. A special rule precluded discharge for taxes "which the bankrupt has collected or withheld from others as required by the laws of the United States or any state . . . but has not paid over." The question in Sotelo was whether the trust fund exception applied only to the direct tax liability of a non-corporate owner or whether it equally applied to the responsible corporate officer. In a 5-4 split decision, the Court in Sotelo ruled that Congress intended to prevent the responsible officer from discharging corporate trust fund taxes.
When the Bankruptcy Code was enacted in 1978, Congress added the "liable in whatever capacity" language to the trust fund taxes priority rule to adopt the holding of Sotelo: "The U.S. Supreme Court has interpreted present law to require the same result as will be reached under this rule."6
By its terms, both the Sotelo decision and Congress's adoption of its reasoning in the Bankruptcy Code applies only to trust fund taxes. Yet the Carpenter panel extends the reasoning of Sotelo to non-trust fund vicarious taxes. The Carpenter panel's theory is as follows: (1) Sotelo held vicarious trust fund taxes to be non-dischargeable even though at the time the trust fund exception did not contain the "liable in whatever capacity" language that it has now, (2) therefore Sotelo stands for the proposition that all vicarious taxes should be non-dischargeable if they would be non-dischargeable if incurred by the debtor directly, and (3) the "liable in whatever capacity" language added by Congress to the trust fund priority rule in the Bankruptcy Code does not prevent other vicarious taxes from being given priority.
The problem with the Carpenter panel's ruling is that it does not consider the Supreme Court's reasoning in Sotelo. The statutory language being interpreted in Sotelo was ambiguous, even without the "liable in whatever capacity" language. Did the exception only apply to the corporation that "collected or withheld" the taxes from others, or did it apply to the responsible corporate officer who, on behalf of the corporation, also "collected or withheld" the taxes? The Sotelo majority thought the language was ambiguous and sought to determine what Congress intended by the statutory language.
The Sotelo Court looked to the legislative history of the 1966 amendments to determine the meaning of the statutory language. The Court determined that the 1966 trust fund exception was made at the behest of the Treasury Department. The Court quoted a letter from the Assistant Secretary of the Treasury, Stanley S. Surrey, to the Chairman of the House Judiciary committee considering the Bankruptcy Act changes:
[The Treasury Department is] concer[ned] with the inequity of granting a taxpayer a discharge of his liability for the payment of trust fund taxes which he has collected from his employees and the public in general. . . . The Department does not believe that it is equitable or administratively desirable to permit employers and other persons who have collected money from third parties to be relieved of their obligation to account for an(d) pay over such money to the government.7
In another letter from a Treasury Department official to the Chairman of the Senate Judiciary Committee considering the Bankruptcy Act changes, the Treasury Department again expressed its view.
[It would be] most undesirable to permit persons who are charged with the responsibility of paying over to the Federal Government moneys collected from third persons to be relieved of their obligations in bankruptcy when they have converted such moneys to their own use.8
The Court in Sotelo concluded that Congress incorporated the final language into the statute to meet the Treasury Department's concerns.
In response to the Treasury Department's concern, the House Judiciary Committee added an amendment that became §17a(1)(e). . . . [T]he amendment was specifically intended to meet "the objection of Treasury to the discharge of so-called trust fund taxes." In agreeing to the House amendment, the Senate Committee noted that Treasury's "opposition" to the bill, to the extent it was based on the fact that responsible persons would have been "relieved of their obligations" for unpaid withholding taxes, was eliminated by the provision that became §17a(1)(e).
There is no reason to believe that Congress did not intend to meet Treasury's concerns in their entirety. While the Department may not have focused on the specific question presented here, it left no doubt as to its objection to the discharge of "persons . . . charged with the responsibility of paying over . . . moneys collected from third persons." Respondent without question is such a person, a point essentially conceded here by virtue of the recognition of respondent's liability. . . . Because Congress specifically contemplated that those with withholding-tax-payment obligations would remain liable after bankruptcy for their "conver[sion]" of the tax funds to private use, we must conclude that the liability here involved is not dischargeable in bankruptcy.9
Last, the Sotelo Court noted that Congress was concerned with the practical effect of allowing the discharge of corporate trust fund taxes in the usual situation where the corporation was insolvent, was going out of business and so would not repay the stolen trust funds, and the corporate officer was responsible for the nonpayment by wrongfully allowing the funds to be commingled with the corporation's funds.
There is absolutely nothing in the Sotelo opinion, not even in dicta, that would extend the non-dischargeability rule to non-trust fund taxes. The theory and legislative history upon which the Supreme Court based its decision in Sotelo has no application to non-trust fund taxes.
Moreover, the Carpenter panel cites nothing to support its theory that Congress's "liable in whatever capacity" language, which was expressly added to the trust fund priority rule to incorporate the specific holding of Sotelo regarding trust fund taxes, does not evidence Congress's intent to allow the discharge of vicarious non-trust fund taxes. The Carpenter court fails to suggest why Congress, when adding the "capacity" language to the priority rule for trust fund taxes, would not have included similar language for other taxes if they intended to treat all vicarious taxes the same way.
C. Lookback Issues
It is important to note that Carpenter may not prevent responsible persons from ever discharging their vicarious non-trust fund tax liabilities. While trust fund taxes are forever non-dischargeable, other tax liabilities have a shelf life after which they become stale and lose priority. In general, income, employment and excise taxes lose their priority in three years, while property taxes and customs duties lose their priority in one year.10
The Carpenter panel recognized that vicarious tax liabilities would also lose their priority after the expiration of the lookback period. The Carpenter panel distinguished a prior opinion, In re Hansen11, which allowed a responsible corporate officer to discharge unemployment excise taxes where the responsible officer filed bankruptcy more than three years after the corporation's excise tax return was due. The Carpenter court emphasized that the corporate officer's vicarious liability should be treated the same way under the bankruptcy priority rules that it would have been had the officer incurred the tax in his or her individual capacity. If state law holds a "responsible person" personally liable for an entity's failure to pay its taxes of whatever kind, the Carpenter panel would treat that individual's vicarious tax liability in bankruptcy as though there were no corporate limitation on personal liability and the taxes had been incurred directly by the debtor.
The Carpenter panel's theory raises many unanswered questions. Would the Carpenter panel's theory extend indefinitely the responsible individual's non-dischargeability for older corporate taxes where no tax return was filed, or possibly for late filed returns under Section 523(a)(1)(B) and (C) of the Bankruptcy Code?12 Would corporate tolling agreements extend the running of the lookback periods for corporate income taxes assessed within 240 days plus tolling before bankruptcy or for income taxes assessable post-petition for the responsible officers who did not enter into the tolling agreements? The priority and dischargeability statutes were simply not drafted with these questions in mind, and they do not suggest any easy answers. What is clear is that Carpenter allows states to impose enormous liabilities on responsible officers that in many cases will not be dischargeable in bankruptcy if other courts follow the Carpenter panel's reasoning.
The result in Carpenter is as troubling as its reasoning. While the Carpenter case involved rather obscure Montana unemployment taxes, the reasoning of the decision would apply to any corporate tax (and presumably any tax of any kind)imposed by state or federal law on a responsible individual. That responsible individual may be an owner of the corporation's stock, but it could also be an employee in an accounting department who did not benefit personally from the transaction out of which the tax arose or from the corporation's failure to pay the tax. Unlike the situation with trust fund taxes, where the responsible individual had control of the funds that were withheld or collected from a third party and the duty to segregate those funds, the responsible individual for other corporate taxes may never have had the ability to cause the corporation to pay the taxes.
The ruling also opens the door to states expanding personal liability for corporate taxes to prevent their discharge in bankruptcy. As the Court in Sotelo recognized, insolvent corporations can, and routinely do, avoid tax liabilities by going out of business. Only if the corporation wants to stay in business or is solvent will the unpaid taxes be paid.13
Unlike the dissolving corporation, responsible individuals continue to have lives after a corporation's insolvency. These liabilities may prevent the responsible individual from receiving the fresh start that is the cornerstone of bankruptcy. At a time when state governments are adopting draconian measures to collect back taxes, such as suspending their drivers' licenses even when taxpayers lack the ability to pay,14 and expanding vicarious liability for "taxes" that were once simply treated as insurance premiums, Carpenter presents state collectors with an expanded opportunity to recover unpaid taxes incurred by insolvent corporations that would normally go out of business without paying. Nothing would prevent a state, for example, from providing that the shareholders of a corporation are personally liable for the corporation's taxes, and thereby prevent the shareholders from discharging that corporate liability in bankruptcy during the applicable lookback periods. Carpenter opens the door to state legislation that would undermine the purpose of the federal bankruptcy laws contrary to Congress's intent when it carefully limited the exceptions to discharge.
One would hope that when the issue next arises in the courts they will take a careful look at the reasons articulated in the Sotelo decision for treating trust fund taxes differently from other taxes. Ideally, courts will recognize that Congress—when it added the "whatever capacity" language solely to the trust fund priority rule—intended to limit priority and non-dischargeability to vicarious trust fund taxes that the responsible officer culpably allowed to be commingled and lost. ■
1 50 B.R. 691, 2015 Bankr. LEXIS 3935 (9th Cir. BAP 2015).
2 Mont. Code Ann. § 39-51-1105.
3 Beiger v. Internal Revenue Service, 496 U.S. 53 (1990) (Scalia, J., concurring). The Court in Beiger held that an instant trust was created when non-segregated trust fund taxes were paid over to the government, preventing the trustee from recovering the funds as preferential transfers under Section 547 of the Bankruptcy Code.
4 11 U.S.C. § 508(a)(8)(C) (emphasis added).
5 U.S. v. Sotelo,436 U.S. 268 (1978).
6 Statement of Rep. Don Edwards, Sep. 28, 1978, 124 Cong. Rec. 32415-16 & Statement of Sen. Dennis DeConcini, Oct. 6, 1978, 124 Cong. Rec. 34015, reprinted at 1978 U.S.C.C.A.N. 6436, 6497 & 6505, 6566 (quoted in footnote 7 in Carpenter).
7 Sotelo, supra note 5, at 276 (emphasis in Sotelo).
9 Sotelo, supra note 5, at 277 (citations omitted).
10 See 11 U.S.C. § 507(a)(8). I apologize to the reader for skirting over the complexity of the lookback rules, which require careful tracking of when the time periods begin and end. For example, the income tax rule covers tax years for which a return was first due to be filed within three years of bankruptcy, and thus may extend to tax years four years before bankruptcy, depending on when the return was first due with extensions, and when during the year the bankruptcy was filed. There are additional rules extending priority for even older taxes that were assessed within 240 days before bankruptcy, with the period subject to long tolling and extension by agreement, and to taxes assessable post-petition. See 11 U.S.C. § 507(a)(8)(A)(i)(ii) and (iii).
11 Cal. Employment Dev. Dep't v. Hansen (In re Hansen), 470 B.R. 535 (9th Cir. BAP 2012).
12 The courts have been ungenerous to debtors seeking to discharge old back taxes when the debtor filed a required tax return after it was due. From its inception, the Bankruptcy Code denied debtors a tax discharge if they did not file a required return at all or filed a late return within two years before bankruptcy. 11 U.S.C. § 523(a)(1)(B). In 2005, Congress added a hanging paragraph at the end of Section 523(a) defining a "return" as one that "satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements)." As a result, the courts have held that late-filed returns are not "returns" at all because they were filed late, thus emasculating the main two-year rule that remains in the statute. See, e.g., Fahey v. Mass. Dep't of Revenue (In re Fahey), 779 F.3d 1 (1st Cir. 2015); McCoy v. Miss. State Tax Comm'n (In re McCoy), 666 F.3d 924 (5th Cir. 2012). Ironically, the Ninth Circuit Bankruptcy Appellate Panel (the same court that issued Carpenter, although with different members), criticized the Fahey and McCoy line of cases for "the perceived harshness resulting from their reading of the statute" and their "gloss over one of the most important rules of plain meaning statutory construction: that the meaning of a statutory term only is considered plain and unambiguous if the term is clearly understood in the context of the words surrounding it and in the context of the larger statutory scheme." United States v. Martin (In re Martin), No. EC-14-1180-KuKiTa, 2015 Bankr. LEXIS 4237 (U.S. B.A.P. 9th Cir. Dec. 17, 2015). The Martin panel allowed for the discharge of late-filed taxes if the taxpayer made a "return" under the standard non-bankruptcy definition set forth in In re Hindenlang: "(1) it must purport to be a return; (2) it must be executed under penalty of perjury; (3) it must contain sufficient data to allow calculation of tax; and (4) it must represent an honest and reasonable attempt to satisfy the requirements of the tax law." United States v. Hindenlang (In re Hindenlang), 164 F.3d 1029, 1033 (6th Cir. 1999). The Martin Court's reading of the statutory language is compelling, and if a conflict develops within the circuits we may finally see that sensible interpretation of the statutory language prevail.
14 For example, New York has adopted a program to suspend the drivers' licenses of taxpayers who owe more than $10,000 in state taxes, even if they lack the ability to pay. According to an Associated Press article titled New York's DMV suspends nearly 8,900 drivers licenses due to overdue taxes, in 2014 New York suspended 8,900 driver's licenses and extracted $56.4 million in payments from 6,500 people using the new law. By 2015, the amount collected had risen to $125 million, and the governor was seeking to lower the delinquency amount for suspension to $5,000. Kenneth Lovett, Andrew Cuomo Wants Driver's Licenses Suspended for People Who Owe at Least $5K in Back Taxes, N.Y. Daily News (February 8, 2015). The article notes that New York is also seeking to prevent delinquent taxpayers from receiving professional and business licenses, permits and grants. Id. Many other states have enacted or are considering similar legislation, despite media reports on the cycle of poverty created by these laws. See Shaila Dewan, Driver's License Suspensions Create Cycle of Debt, N.Y. Times (April 14, 2015).