The Surety v. The Internal Revenue Service (Round 2)
In this Surety Today Blog post we will discuss the surety’s potential liability to the Internal Revenue Service (“IRS”) under the Internal Revenue Code. This is round II of the fight between the surety and the IRS. In round I, the first blog post on the fight between the IRS and the Surety, we focused on the IRS claims under the bonds. As I noted in the first blog post, the moto of the IRS is – “We are the IRS, we’ve got what it takes to take what you’ve got.” In this post we will discuss the statutory provisions which might come into play for a surety that gets involved with some form of financing or funds control with the principal.
When the surety initiates funds control, whether joint control with the principal or some other surety controls over the principal’s use of the bonded contract funds, including under a financing agreement, the surety may become directly liable for the principal’s withholding taxes as a result of the surety’s payment of the wages of the principal’s laborers on the bonded contracts. In the event the surety utilizes funds control, with or without surety financing, and the surety has taken control over the principal’s receipt and determination of the principal’s use of the bonded contract funds in order to reduce the surety’s potential or ultimate loss, the IRS may contend that the surety has liability. In this scenario, the Internal Revenue Code creates potential tax liability for the surety under three sections and theories. See George J. Bachrach, Michael A. Stover & Shane C. Mecham, Ch. 4, Financing the Principal, in Bond Default Manual 338-41 (Mike F. Pipkin, Carol Z. Smith, Thomas J. Vollbrecht & J. Blake Wilcox eds., Am. Bar Ass’n, 4th ed. 2015); James D. Ferrucci, The Surety, the IRS and Payroll Taxes (unpublished paper submitted at the Twenty-Seventh Annual Surety Claims Institute annual meeting on June 20, 2002). This post will address those three sections.
1. Section 3401 [26 U.S.C. § 3401]
The surety’s mere exposure or liability for wages under a bond does not make the surety liable for withholding taxes. United States v. Crosland Constr. Co., 217 F.2d 275 (4th Cir. 1954); General Cas. Co. of America v. United States, 205 F.2d 753 (5th Cir. 1953). However, under Section 3401, the surety may be liable for withholding taxes as the “employer” when it exercises a sufficient degree of control over the principal’s employees and, more importantly, when the surety exercises control over the payment of the wages to those employees. Section 3401 defines “employer” traditionally as “the person for whom an individual performs or performed any service, of whatever nature, as the employee of such person . . .” but then adds, “except that—(1) if the person for whom the individual performs or performed the services does not have control of the payment of the wages for such services, the term “employer” . . . means the person having control of the payment of such wages, . . .” “Control” has been held to mean legal power to control actual payment of wages. Century Indem. Co. v. Riddell, 317 F.2d 681 (9th Cir. 1963). Thus, the more control the surety exercises over the principal’s funds, the more likely it could be deemed to be an employer.
Two bad things may happen if the surety is found to be an “employer”: (a) first, the surety may be liable for both the employees’ share of the amounts of withholding taxes that were required to be deducted and paid to the IRS AND the employers’ share of those taxes; and (b) second, as an “employer,” the surety may be liable for penalties for the “employer’s” failure to file quarterly tax returns and failure to deposit the withholding taxes with the IRS.
2. Section 6672 [26 U.S.C. § 6672]
Under Section 6672 of the Internal Revenue Code, a surety may be held liable for the tax indebtedness of a contractor if it exercises control over the funds of the contractor with which the contractor could have paid the withholding taxes. See Pacific Nat’l. Ins. Co. v. United States, 422 F.2d 26 (9th Cir. 1970) cert. denied, 398 U.S. 937 (1970); Fid. & Cas. Co. of New York v. United States, 490 F.2d 960, 964 (Ct. Cl. 1974). Under Section 6672, the degree of the surety’s control over the bonded contract funds may make the surety a “responsible person” which can lead to imposition of a penalty. A responsible person need not have exclusive control over a company’s finances, but need only have significant control. U.S. v. Carrigan, 31 F.3d 130 (3rd Cir. 1994). Thus, it has been held that a responsible person need not formally own any shares of the company and need not hold any formal officer position if they have practical authority over company’s finances. Similarly, a person need not have the final word over payment of creditors nor over the company’s financial affairs to constitute significant control to qualify as a “responsible person.” There may also be multiple responsible persons.
The penalty can be equal to the amount of the taxes that were to be withheld by the principal. The surety’s “willful” failure to pay the withheld taxes as a “responsible person” may subject the surety to liability beyond the amounts withheld for the principal’s laborers on the bonded contracts. See Anderson v. United States, 561 F.2d 162, 166 (8th Cir. 1977). See also Fidelity & Cas. Co. of N.Y. v. United States, supra.
There are two conditions. In the first instance, the “responsible person” must have been “required to collect, truthfully account for, and pay over any” payroll taxes – namely the person, individually or jointly, who has the ability to determine what bills should or should not be paid, and when. In the second instance, the “responsible person” must have willfully failed to perform those required functions of collecting, accounting for, and paying over the withholding taxes to the IRS. “Willful” is not a wrongful act. “Willful” means “in general, a voluntary, conscious, and intentional act.” Thus, a surety’s decision NOT to pay withholding taxes to the IRS from the controlled funds and to pay, instead, other creditors to reduce the surety’s loss, is taking a “willful” action as a matter of law.
The reality is that the surety exercising funds control over the bonded contract funds to reduce its bond losses, whether it is financing the principal or not, could be considered to be a “responsible person.” Furthermore, under the loose definition of “willful,” the surety preferring to pay other creditors and not pay the withholding taxes to the IRS may face tax liability to the IRS for those withholding taxes.
3. Section 3505 [26 U.S.C. § 3505]
Under Section 3505, which specifically mentions the “lending” surety, the financing surety may be liable for withholding taxes if it is a “net payroll lender.” The surety is liable to the IRS for 100% of the withholding taxes, plus interest, when the surety directly pays the wages of its principal’s laborers (whether as funding from a controlled account or the payment of a payment bond claim) [Section 3505(a)]. However, when the surety indirectly funds, advances, or provides financing for the payments of those wages to the principal “with actual notice or knowledge” that the principal will not withhold and pay over the necessary payroll taxes, the surety is liable to the IRS for taxes and interest totaling up to 25% of the advances made for payroll [Section 3505(b)]. Section 3505 liability may be unavoidable by the financing surety. Section 3505(b) liability may be cheaper for the surety than Section 3505(a) liability depending upon the amount of the surety financing for the principal’s wages.
In order to protect the surety from the tax liabilities of Section 3505 and litigation with the IRS, the normal financing agreement between the surety and the principal should contain specific provisions for the payment by the surety and the principal of all withholding and payroll taxes. Furthermore, at the time the tax payments are paid by the surety and the principal, the surety must file quarterly Form 4219 with the Internal Revenue Service. See Form 4219, Statement of Liability of Lender, Surety, or Other Person for Withholding Taxes under Section 3505 of the Internal Revenue Code.
In summary, the takeaway is that when the surety takes some kind of control over the principal’s receipt and use of the bonded contract funds, whether the surety is financing the principal or not, the surety must be very careful about the payment of the payroll taxes to the IRS and reporting such amounts as required by the IRS.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (email@example.com) or any member of the Surety and Fidelity Practice Group.
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