19811029a Baker Mckenzie Letter

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Octc=er 19, 1981 Mr. :·iarc Paiva ~amilton Taft & COffi?any 1255 Post Street San Francisco, CA 94109 Re:

Charac:erization of Funds 'E'or Tax Payments

~ichheld

by Employer

Dear Marc: Per your request, this letter Q1SCUSSes the characterization of funds withheld by employers from employee pay checks in satisfaction of federal and sta~e income taxes, Social Security taxes, and state ~nemployment insurance '. taxes. This letter is limited to a discussion of the Internal Revenue Code ("I.R.C."), t~e California Revenue and Taxation Code ("Cal. Rev. & Tax. Code"), ;:he California Unemployment Insurance Code ("Cal. U. Com. Code"), and the general responsibilities and duties of a trustee as reflected in the California Civil Code ("Cal. Civ. Code"). An employer is required to withhold from the wages of employees amounts in respect of federal income taxes (I.R.C. § 3402], Social Security taxes [I.R.C. § 3102], state income taxes [Cal. U. Corn. Code § 13020], and state unemployment insurance "taxes [Cal. U. Com. Code § 986]. The employer is liable for the deduction and witr.holding of taxes. I.R.C. 5 3403: Cal. U. Corn. Code § 13021. Characterization of Withheld Funds Funds that are withheld or collected as income tax or Social Security Tax are to be held by the employer as " a special f:..1nd in trust for the United States." LR.C. § 750l. u.s ..... Hill, 368 F.2d 617,66-2 ::.S.T.C. ~[9736 at 87382 (5th

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employer aE "3 special fund in tr'Jsc for the S't'ate ot Cali=ornia rCcl. -,:. Com .. Cocie § 13070]; '..."hile :~nds withheld 2.5 unemcl~vmen~ :'nsurance tax .:i r e t 0 be \.; i t h he 1 d "i n t r L1 st. Cal . - U • - Ca ~ . :: 0 d e § 9 8 6 • The duty to keep Withheld taxes as a trust arises as the taxes are withheld from wages regardless of the or~scribed dace for ~ayment to the government and does not termi~ate until the taxes are paid over. ';stleforc ' I . U.S., 75-1 U.S .T.C. I! 9464 ( D. ~1 i nn. 1975). ll

II

During the ?eriod the funds are held i~ trust, the person holding the f~ndsassumes, with a few except~ons discussed ~elow, the duties and resDonsibilities of a ~rustee as such duties and responsibiliti~s are mandated under common law. ~arsh v. Home Federal Savinas & Loan Assn, 66 Cal. App. 3d 674, 136 Cal. Rptr. 180 (4th D.C.A. 1977). In general, a trustee is a fiduciary and is bound to act in the highest good faith toward his beneficiary, must make full disclosure of material facts, must not acquire any adverse interest, and must not use his position to gain any advantage over the beneficiary or to make any special ~rofit. Cal. Civ. Code §§ 2228-2233. A trustee normally should not ~ingle trust property with his own, but if he do.es willfully mingle the trust funds with property of his own, he is absolutely liable for their safety and for the value of thei~ use. Cal. Civ. Code §§ 2236. A trustee has a general duty to invest funds for the benefit of the beneficiaries, but he must account over to the beneficiaries any interest earned. Cal. eiv. Code § 2262. In investing, reinvesting, or otherwise managing trust property, a trustee must exercise the judgment and care which people of prudence, discretion, and intelligence exercise in the management of their own affairs. Cal. eiv. Code § 2261. California law provides a-fairly liberal description of the type of investment a prudent person would make, including every kind of property, real, personal, or mixed, and every kind of investment which a prudent person might enter into. Id. Notwithstandin~ the foregoing, the parties to the trust may alter or waive any of the standard pro~isions and duties. Rest. 2d, Trusts § 216. It is possible for the parties to a trust arrangement to authorize commingling of funds, to authorize the trustee to retain any income rrom the trust assets, and

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?age Three :0 consent ~o various ki~ds of investmen~s. The ~ase G[ :·;acsh Va HOi7le Federal Savir.qs &. Loan Assn. 66 C::. ';?p . .,)0 6 7 4 , 1 36 Cal.. R~ t: r--:. 1 8 0 (4 t h D. C .. rl.. 1 9' 7 7), i spa =- tic u 1 a t 1 Y instructive. At issue in Marsh was the proprie~~ and :egality or ':he lIimpoundll or llreserve" accounts :::.lstomar-ily required by savings and loan 2ssocia~ions and ba~Ks in connection with residential ~ortgages to insure ~ayment of ~axes and insurance.. The suit was a class action seeking general and punitive damages and seeking an acco~nting of interest on the impound accounts, which were customarily held ~ithout interest. I

The Court first determined that the impound accounts trusts, not escrOws. It then considered in detail the nature of a trust and the duties of a trustee, observing that the beneficiary of ' the trust may ~aive the right to any income and may authorize the commingling of Eunds. Thus, the Court noted that the deed of trust authorizing the impound account stated specifically that the payments by the plaintiff would be held by Home Federal "in its general fund without interest," and concluded that the parties had agreed that the trustees could commingle and use the trust funds, but did not have to account for any interest earned. ~onstituted

9.

The statute and cases indicate that the trust funds created by I.R.C. § 7501, Cal. U. Com. Code § 986, and Cal. U. Com. Code § 13070 are subject to some modification of the general rule. Thus, although normally a trustee must segregate the assets of a trust and not commingle the assecs with his personal funds, see Cal. eiv. Code § 2236, it is not generally required that the-Iunds withheld for taxes be held separately from the general accounts of the corporation or chat they be deposited in a separate bank account, Slodov v. ~.S., 436 U.S. 238, 78-1 U.S.T.C. ,[ 9447 at 84,206 (1978); Newsome v. U.S., 431 F.2d 742, 70-2 U.S.T.e. ~ 9504 at 84,1~9 (5th Cir. 1970). The Treasury or the Franchise Tax Board, as the case may be, may specially require that withheld taxes be put into separate accounts, however, in the event the employer has failed previously to make appropriate deposits, payments, or returns for such taxes, I.R.C. § 7512; Cal. Rev .. & Tax. Code 5 18492. Furthermore, there is nothing in the statute or any regulation or case with which we are acquainted to imply that the government is entitled to any additional interest on the trust funds doring the period such funds are held in trust. Thus, it would follow that if an employer decided to forego interest on the trust funds, he, too, could do so.

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The foregoing discussion has considered the situation of an emclover. There does noe appear to be any case law, regulation, or statute dealing wit~ an :~dependent agent who actually pays over the taxes to the sovernment. The funds presumably are still trust funds, and che holder of those funds still bears the responsibilities of a trustee. Presumably, however, the collecting agent may use the f~nds in the same manner as the employer ~ight have, ana is noe required, insofar as the Internal Revenue Service or the Franchise Tax Board are concerned, to segregate the =unds from the general fund of the collecting agent. Penalties The normal penalty for a breach of fiduciary duty by a trustee is the amount of the loss to the beneficiary. A similar penalty is imposed by I.R.C. § 6672 or Cal. Rev. & Tax. Code § 18815: any person required to collect, account for, and pay over withholding taxes who willfully fails to collect, account for, or pay over such tax, is liable for a penalty equal to the total amount of the tax evaded, not collected, not accounted for, or paid over. ~ The test is " w illfullness." Basicallv, "willfullness" does not require anintent to deprive the government of its taxes, Newsome v. U.S., suora, 70-2 U.S.T.C. at 84,151, but can be evidenced merely by use of the withheld funds for any other corporate purpose, regardless of any expectation that adequate funds would be available at the due date for the taxes. WavchofE v. U.S., 79-2 U.S.T.C • • 9602 at 88,195 (S.D. Tex. 1979). Any person who voluntarily and consciously risks the withheld taxes in the operation of a corporation is subject to liability under I.R.C. § 6672 (Cal. Rev. & Tax. Code § 18815) if subsequently the corporation is unable to remit the withheld taxes. ~ewsome v. U.S., supra. In addition to the civil penalties, however, there are also ciminal penalties. I.~.C. § 7202 provides that any person required to collect, account for, and pay over any tax who willfUlly fails to collect, account for, or pay over such tax shall be guilty of a felony and, upon conviction thereof, shall be fined not more than S10,000, or imprisoned not more

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than five years. o~ both, together with the costs of prosecution. Cal. Kev. & Tax. Code § 19408 imposes a fine of nat mOre than $2,000 or imprisonment [no staeed maximuml, or both for the similar offense. Although the penalties under these sections have been imposed only rarely and only in particularly egregious situations, there is considerable need to be concerned about the potential criminal penalties as well.

If you have any questions or comments.concerning the foregoing, please do not hesitate to contact us.

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L. Kimpert

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