In re Freedomland, Inc.

• Decision Date: 29 February 1972
• Docket Number: No. 64 B 727.,64 B 727.
• Citation: 341 F. Supp. 647
• Parties: In the Matter of FREEDOMLAND, INC., Bankrupt.
• Court: U.S. District Court — Southern District of New York

341 F. Supp. 647

In the Matter of FREEDOMLAND, INC., Bankrupt.

No. 64 B 727.

United States District Court, S. D. New York.

February 29, 1972.

Whitney North Seymour, Jr., U. S. Atty., by Susan Freiman, Asst. U. S. Atty., New York City, for the United States.

J. Lee Rankin, Corp. Counsel, New York City (Raymond Herzog, Asst. Corp. Counsel, of counsel), for the City of New York.

Howard Karasik, New York City, for trustee William Otte.

David Shandalow, New York City, for Bankruptcy Lawyers Bar Assn., amicus curiae.

MOTLEY, District Judge.

Opinion On Petition To Review

Freedomland, Inc. filed a petition for an arrangement under Chapter 11 of the Bankruptcy Act on September 15, 1964. The arrangement proceeding failed and on August 30, 1965 the debtor was adjudicated a bankrupt. Thereafter, on November 7, 1969 the trustee, William Otte, moved before the referee for an order authorizing him to pay 413 priority wage claimants without withholding therefrom United States, New York State, or New York City income taxes, federal social security taxes, or any other payroll taxes. This relief was granted.

The Bankruptcy Act, Section 64(a), 11 U.S.C. § 104, establishes five categories of claims, in descending order, which are entitled to payment before the general creditors of the bankrupt are paid. The payment of claims for wages earned within the three month period preceding bankruptcy, in amounts not exceeding $600, falls within the second category of priorities. Claims for taxes which "became legally due and owing" by the bankrupt to any governmental body are entitled to a fourth priority.

The trustee was also granted an order specifically declaring that he was not required to: 1) pay to any governmental body any amounts whatsoever in connection with such wage claim distributions; 2) prepare and distribute to the wage claimants employee wage and tax statements and file copies thereof with tax authorities; 3) prepare and file with tax authorities employer wage and tax withholding statements; 4) pay any penalties for failure to withhold and pay or file returns.

The United States, the State of New York, and the City of New York had been given notice of the trustee's application for such a declaration and order, although none had filed a proof of claim for income taxes due on these wages.¹ The 413 wage claimants had filed their proofs of claim within the six month period following the initiation of bankruptcy proceedings on September 15, 1964 as provided by the Bankruptcy Act. 11 U.S.C. § 93. The total of these wages ($80,000) had been scheduled by the bankrupt upon the filing of his September 14, 1965 petition for an arrangement.

The State of New York failed to respond. The City of New York responded claiming that the trustee is required to withhold from any wage claims paid by him New York City income taxes and to report and pay same to the City, although the New York City income tax law was not in existence in 1964 — the time when the wages were earned by the employees. The United States responded claiming that the trustee is liable to: 1) withhold income and social security taxes;² 2) pay such taxes to the United States;³ 3) file the necessary returns (forms W-2 and 941);⁴ 4) furnish each employee with form W-2;⁵ and 5) pay any penalty assessed for failure to withhold, pay and file the returns.⁶

Succinctly stated, the trustee's position in support of his application was as follows:

1) Since 413 priority wage claims have been filed in this proceeding, none of which exceeds $600.00, compliance with federal, state and city tax provisions would be onerous because of the administrative, accounting, and legal costs involved, and the unavailability of relevant information. Public policy, administrative convenience, the scheme of the Bankruptcy Act, and the policy underpinning withholding taxes dictate that the trustee in bankruptcy not be required to withhold taxes and file returns in connection with payments to wage claimants.

2) Making an automatic 25% federal tax deduction (which is the present practice in this District) and a 1% city deduction, in lieu of making an exact calculation of the taxes due from each employee pursuant to progressive tax tables and currently claimed exemptions would constitute a substantial tax over-payment for each employee and therefore would be unconstitutional.

3) A class 2 priority wage claim payment made pursuant to the Bankruptcy Act, § 64a(2), does not constitute wages for the purposes of the withholding and reporting provisions of the Internal Revenue Code;

4) New York City is not entitled to have income taxes for its benefit withheld since, if the wages had actually been paid when due, nothing would have been due the City.

In response to the trustee's claims the United States took the following positions:

1) The bankruptcy court is without power to consider the trustee's application on the ground that a declaratory judgment and injunction with respect to taxes is specifically prohibited. The trustee's remedy is to pay the tax for 1 wage claimant and sue for a refund. Under the doctrine of primary jurisdiction the bankruptcy court should at least refrain from acting until the Internal Revenue Service, the administrative agency to which has been given the authority to interpret and apply the statute, has acted.

2) Assuming the court does have jurisdiction, the Internal Revenue Code requires the trustee to withhold, report and pay income and social security taxes.

3) The 25% flat rate rule prevailing in this District is reasonable in view of the fact that, as the trustee argues, it may often be difficult to determine the correct rate for each employee.

From the adverse decision and order of the referee, the United States and the City of New York filed the instant petition for review.

The referee ruled that the bankruptcy court had jurisdiction of the application made by the trustee for instructions with respect to the proposed distribution to wage claimants, and that the Government's contention with regard to lack of jurisdiction was without merit. This court agrees. The bankruptcy court clearly had jurisdiction to adjudicate the tax claims now made by petitioners in response to the trustee's application for an order. The United States and the City both claim that the taxes in issue are costs and expenses of administration and are therefore entitled to a first priority under § 64(a) of the Bankruptcy Act. 11 U.S.C. § 11a(2) and (2A). See United States v. Randall, 401 U.S. 513, 91 S.Ct. 991, 28 L.Ed.2d 273 (1971) and Nicholas v. United States, 384 U.S. 678, 86 S.Ct. 1674, 16 L.Ed.2d 853 (1966), and cases cited infra where the bankruptcy court's jurisdiction over similar claims was apparently unchallenged.

The gist of the controversy, as the referee saw it, is whether a trustee in bankruptcy is an "employer" who is paying "wages" when he makes a distribution to wage claimants who are entitled to priority in distribution of estate assets by virtue of the Bankruptcy Act, so that as such "employer" the trustee is required to comply with the applicable withholding and reporting provisions of federal, state, and city tax laws.

The referee viewed this question as requiring a decision with respect to "which of two clearly desirable, but countervailing objectives is to be preferred, viz., the collection of taxes or the efficient administration of the estates in bankruptcy."⁷ Viewing the issue in this fashion, the referee preferred the Bankruptcy Act on the ground that "compliance with withholding and reporting requirements of tax authorities is utterly inconsistent with the spirit and letter of the Bankruptcy Act."⁸ He found that compliance with taxing requirements imposes a further burden on the administration of bankrupt estates which is entirely inconsistent with the objective of efficient, expeditious, economic administration of bankrupt estates.⁹ He accordingly held "that a trustee in bankruptcy is not an employer who pays wages when he distributes dividends on account of wage claims whether priority or general."¹⁰

In so holding, the referee expressly rejected the holding to the contrary in the twenty-five year old precedent, United States v. Fogarty, 164 F.2d 26 (8th Cir. 1947), followed in United States v. Curtis, 178 F.2d 268 (6th Cir. 1949) cert. den., 339 U.S. 965, 70 S.Ct. 1001, 94 L.Ed. 1374 (1950); In re Daigle, 111 F.Supp. 109 (D.C.Me.1953); Lines v. State of California, 242 F.2d 201 (9th Cir. 1957) cert. den., 355 U.S. 857, 78 S.Ct. 86, 2 L.Ed.2d 64; In re Connecticut Motor Lines, Inc., 336 F.2d 96 (3rd Cir. 1964). In the Fogarty Case the Eighth Circuit ruled that the payment of wage claims are "wages" within the meaning of applicable federal tax provisions and that the trustee as the person in "control of the payment" of such wages has the duty under the Internal Revenue Code to withhold and pay income and social security taxes thereon. And it appears that no court has yet ruled contrary to the Fogarty court on the issue of the duty and liability of the trustee to withhold and pay such taxes. The Fogarty court viewed the need to protect the future social security benefits of wage earners, which are based solely on wages earned, as of paramount importance in the distribution of wage claims. The able referee, correctly, was of the view that, since this precise question of the liability of a trustee in bankruptcy to withhold and pay has not been passed upon by the Court of Appeals for this Circuit (or the United States Supreme Court), he was free to hold to the contrary.

In rejecting the ruling in the Fogarty case, the referee concluded that the "basic vice of Fogarty was its consideration of the problem before it merely as a tax case without giving due regard to the consequences to orderly, efficient, economic bankruptcy administration which necessarily ensue from that ruling."¹¹ In deciding not to follow the Eighth Circuit, the referee relied completely...