The Surety v. The Internal Revenue Service (Round I)
In this Surety Today Blog post we will discuss the surety’s rights and obligations with respect to the Internal Revenue Service (“IRS”). There are several topics to discuss regarding sureties and the IRS including the possible claims that the IRS may have against the surety for the payment of the principal’s withholding tax obligations to the IRS, instances when the surety and the IRS make competing claims and assert their priorities to the bonded contract funds on one or more bonded projects and other issues. This post will address the issue of IRS claims against the surety for the principal’s tax obligations and subsequent posts will address other issues.
A few years ago, I gave an in-house webinar for a large surety on this subject. Thematically, I set up the webinar as a boxing match between the IRS and the Surety. I started off with some theme music from one of the Rocky movies followed by the familiar “Let’s Get Ready to Rumble” announcer. The IRS was in the red corner weighing in as an over-bloated government agency with over 74,000 employees and the moto – “We are the IRS, we’ve got what it takes to take what you’ve got.” The surety of course, was the lean mean fighting machine, with history, wisdom and equity on its side. Today’s post is “Round I” in the fight between the IRS and surety, where the IRS makes direct claims against the bonds.
IRS Claims for Payroll Taxes Under the Miller Act
After July 15, 1967, a surety is liable under the Miller Act for taxes imposed on wages related to the bonded project. Congress decided that under the Miller Act a surety should be liable under the Performance Bond for these particular wage related taxes. The Miller Act now provides:
(1) In General. – Every performance bond required under this section [Miller Act] specifically shall provide coverage for taxes the Government imposes which are collected, deducted, or withheld from wages the contractor pays in carrying out the contract with respect to which the bond is furnished. (clarification added).
40 U.S.C. §3131(c).
The good news is that the liability for taxes under the Miller Act is limited to those relating to wages for labor on the bonded project, as opposed to the other multitude of taxes that are out there. While Congress placed the liability for such taxes squarely in the surety’s lap, they also placed a notice requirement and a limitations period upon the IRS in order to seek recovery.
The Miller Act provides that the Government shall give the surety written notice with respect to unpaid taxes within 90 days after the date when the contractor files a return or if no return is filed, within 180 days from the date when a return was required to be filed. The Miller Act further provides that the Government may not bring a civil action on the bond for the taxes unless the notice is timely given and such civil action is filed within 1 year of the date that the notice is given.
It has been held that as long as the notice was timely, the government need only “substantially comply” with the notice requirements. The Fourth Circuit stated that the purpose of the notice requirement is to alert a surety of the principal’s default on payment of its withholding taxes and that payment of the debt is expected from the surety. The Miller Act does not require the government to detail with specificity the contracts, bonds, and amount of delinquent taxes. The fact that a timely notice may contain certain factual errors and imperfections does not relieve a surety from its legal obligation to perform. United States v. Am. Mfrs. Mut. Cas. Co., 901 F.2d 370, 374 (4th Cir. 1990). Of course, the express liability under the Miller Act for wage taxes is limited to the Miller Act surety, the Act does not apply to the lower tier bonds or non-Miller Act projects.
IRS Claims Against Non-Miller Act Payment and Performance Bonds
Historically, the IRS has attempted to assert claims against payment bonds and performance bonds for wage withholding taxes on non-Miller Act projects including state and local projects. In United States Fidelity & Guaranty Co. v. U.S., 201 F.2d 118 (1952), the IRS asserted that under the payment bond the surety assumed responsibility for the principal’s obligation to pay for labor and material, which the IRS contended included the obligation to pay payroll taxes. The 10th Circuit held that the obligation of the principal to pay payroll taxes arose from statute and the subcontract provision requiring payment of taxes was merely declaratory of the existing liability under the federal tax laws. Thus, the Court concluded that the failure to pay taxes was not a breach of contract. Equally important, the Court also held that the duty to pay payroll taxes was not within the principal’s obligation to pay for labor and was therefore not covered by the payment bond.
The Fourth Circuit observed that from the statutes and regulations it seems clear that when an employer withholds the tax from an employee’s wage and pays the balance to the employee, the employee (the laborer) has been paid in full. The full wage has been received. The employer has discharged its contractual obligation to pay the full wage, which is what the payment bond covers. Thereafter, only the liability to pay the tax remains. That is a tax liability for which the employer alone is liable to the Government. United States v. Crosland Const. Co., 217 F.2d 275 (4th Cir. 1954). There have been no recent cases in which the IRS has sought to recover payroll taxes under a payment bond.
While the IRS may have given up on the payment bond avenue of attack, it has not gone away; rather the IRS simply shifted the attack to the performance bond. The primary theory employed by the IRS now is to assert that based on the language of the bonded contract requiring payment of taxes, the IRS is a third-party beneficiary under the performance bond. In U.S. v. Phoenix Indemnity Co., 231 F.2d 573 (4th Cir. 1956), the principal entered into a contract with the Housing Authority of the City of Fayetteville, North Carolina for the construction of low cost housing. The bonded contract provided that the principal was required to provide and pay for all materials, labor and taxes. The principal defaulted and the co-sureties agreed to complete the work. Subsequently, the IRS determined that the principal had failed to pay certain taxes, including the payroll withholding taxes.
The trial court ruled that the sureties had no liability under the bonds for the taxes. However, the Fourth Circuit in Phoenix reversed and ruled that because of the contract language, the principal, as part of its performance of the contract was required to withhold and pay payroll taxes and because the contract was incorporated into the bond it was the surety’s obligation under the performance bond to satisfy the principal’s obligation to pay the taxes. With no real analysis, the Court held that “the performance bond was made for the government’s protection and it is entitled to sue thereon as a third party beneficiary.”
The Fifth Circuit in U.S. v. Maryland Casualty Co., 323 F.2d 473, 474 (5th Cir. 1963) rejected the Fourth Circuit ruling in Phoenix. In Maryland Casualty, the IRS sued the surety for recovery of payroll withholding taxes under the performance bond issued by the surety for a subcontractor. It was stipulated that the principal did not pay the taxes. The trial court dismissed the IRS’ suit. The IRS appealed and the Fifth Circuit affirmed the dismissal. The bonded subcontract provided that the principal was to “keep records and make payments on all Federal and/or State Payroll Taxes and/or deductions.” However, the Court held that tax liability is based squarely on statutes and any contractual language regarding payment of taxes was merely declaratory of an existing statutory obligation. Thus, the failure to pay taxes is not a breach of contract, but rather a breach of the statutory obligation, therefore, there is no liability under the performance bond. The IRS asserted that it was a third-party beneficiary of the bond, but the Maryland Casualty court noted that the IRS had the burden of establishing that it was the intended beneficiary of the bond and it had failed to meet that burden. The Court noted that there was nothing on the face of the bond to indicate an intention to make the IRS an intended beneficiary.
Courts in other jurisdictions have gone in both directions on the issue of the surety’s exposure under a performance bond to payroll withholding taxes. The most recent case, Island Ins. Co. v. Hawaiian Foliage & Landscape, Inc., 288 F.3d 1161 (9th Cir. 2002) found the surety liable for such taxes under its performance bond. In that case, the surety bonded a landscaping subcontractor on a golf course project for the city and county of Honolulu. The principal defaulted and failed to pay various state and federal taxes. The surety filed a declaratory judgment action seeking a declaration that it was not liable for the taxes. The trial court granted summary judgment in favor of the surety. The Ninth Circuit reversed. The subcontract clearly required the subcontractor to pay all applicable taxes, including payroll withholding taxes. The bond clearly covered performance of the subcontract. Thus, the Court concluded that reading the subcontract and the bond together, the IRS was a third-party beneficiary of the bond. There is a dissenting opinion in the case that basically gets the issue right and would find no liability under the bond.
Let’s call Round I a draw. The IRS can recover under a Miller Act performance bond, but only because of interference by Congress in amending the Miller Act. The IRS cannot recover under the payment bond but may be able to recover under a non-Miller Act performance bond. The takeaway here is that a surety may have exposure under its performance bond to the IRS for certain taxes if the language of the bonded contract and the bond together evidence an intent by the parties to benefit the IRS and you are in one of the jurisdictions that accepts that reasoning or you have a Miller Act performance bond.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.