Alabama – When Laws Collide: U.S. Attorney’s Office Addresses Tax Consequences of Paying Wages to a Bankruptcy Trustee

By Preston R. Burch, Ogletree Deakins (Columbia)*

The Friday, October 10, 2008, edition of The State newspaper (Columbia, South Carolina) carried an article about the possible Wells Fargo-Wachovia merger.  The article stated the merger could cause “major job cuts.”  In an economic downturn such as the current one, employees are going to suffer job losses.  Any employment attorney will tell you that will result in more employment-related lawsuits being filed by former employees against their former employers.  Any bankruptcy attorney will tell you that will result in increased bankruptcy filings.  But what happens when these two areas of the law intersect?  What are the consequences if a third area of the law is introduced into the mix, such as the federal tax laws?  In such a three-way collision, the legal consequences can be difficult to ascertain.

In a pending Chapter 7 bankruptcy case in the Northern District of Alabama, the filing party had an employment law claim against her former employer that arose prior to the bankruptcy filing.  Under bankruptcy law, the cause of action became the property of the bankruptcy estate.  The lawsuit was tentatively settled for a sum of money that was allocated to attorneys’ fees and back wages.  It was undisputed that the back wages belonged to the bankruptcy trustee and would be taxed to the bankruptcy estate.  Internal Revenue Code Section 1398.  However, there was a disagreement as to how the wage payment was to be treated for federal employment tax purposes.

The CPA for the bankruptcy trustee maintained that the employer should report the wages on a Form W 2 for FICA tax purposes and withhold and remit the appropriate amount of employee FICA tax.  The CPA then wanted the employer to report the back wages for federal income tax purposes on a Form 1099 to be issued to the bankruptcy trustee without any federal income tax withholding whatsoever.  The employer was understandably concerned about such an unusual method of reporting wages.  Any failure to properly withhold and report the wage income would subject the employer to civil penalties and interest.  If the employer were deemed to have willfully failed to comply with its federal employment tax obligations, there were potential criminal penalties.

Ogletree Deakins represented the employer as to its tax obligations concerning the wage payment.  The employer and bankruptcy trustee could not agree as to the proper reporting and withholding method for the wages.  The reason this seemingly simple issue became a disputed matter is due to the dearth of legal authorities pertaining to the payment of wages to a bankruptcy trustee.  After hearing from both sides in an informal conference call, the bankruptcy court instructed the parties to submit their positions in writing to the office of the local U.S. Attorney.  The U.S. Attorney would then coordinate with the Internal Revenue Service (“IRS”) as to the correct federal employment tax consequences.

By an informal information letter dated October 9, 2008, the IRS, acting through the U.S. Attorney’s office for the Northern District of Alabama, agreed with the positions espoused by the employer.  According to the U.S. Attorney’s letter, the employer in this situation “is legally obligated to make appropriate withholding.”  Further, the letter stated the applicable Treasury Regulation “prescribes that a Form W 2 is the appropriate format” for reporting the wages.  As far as coordinating the wage reporting and the bankruptcy estate’s income tax obligations, the letter referenced IRS Notice 2006 83.  To ensure that the filing party does not benefit from the income tax withholding, the bankruptcy trustee should obtain a turnover order against the filing party.  To the best of the author’s knowledge, this letter represents the only legal authority in the country that directly addresses the issue of how to withhold and report wages to be paid to a bankruptcy estate.

* Rad Burch is a shareholder in Ogletree Deakins’ Columbia, South Carolina, office where he represents employers in ERISA benefit matters and employment tax issues.