In re Freedomland, Inc.

• Citation: 480 F.2d 184
• Decision Date: 08 June 1973
• Docket Number: 72-1551,72-1716.,No. 427,805,Dockets 72-1546,804,427
• Parties: In re FREEDOMLAND, INC., Bankrupt.
• Court: United States Courts of Appeals. United States Court of Appeals (2nd Circuit)

480 F.2d 184 (1973)

In re FREEDOMLAND, INC., Bankrupt.

Nos. 427, 804, 805, Dockets 72-1546, 72-1551, 72-1716.

United States Court of Appeals, Second Circuit.

Argued March 15, 1973.

Decided June 8, 1973.

Howard Karasik, New York City, for appellant Otte, Trustee in Bankruptcy of Freedomland, Inc.

Susan Freiman, Asst. U. S. Atty. (Whitney North Seymour, Jr., U. S. Atty., S. D. N. Y., on the brief), for appellant United States.

Samuel J. Warms, New York City (Norman Redlich, Corp. Counsel for City of New York, New York City, Raymond Herzog, Cedarhurst, N. Y., and Cornelius F. Roche, New York City, of counsel), for appellant New York City.

Before HAYS, MULLIGAN and OAKES, Circuit Judges.

OAKES, Circuit Judge:

This case presents the esoteric, but nevertheless highly practical, issue of how withholding on wages earned before bankruptcy is to be handled in bankruptcy. Involved are both the income tax laws, silent in this regard as to the effect of bankruptcy, and the bankruptcy laws, silent as to the status of moneys withheld and indeed inarticulate as to the category of priority within which withholding taxes on previously earned wages fit. The problems presented in winding a tortuous path between two inexact sets of statutes in these two different areas of law as to withholdings claimed due the United States are further complicated by virtue of a claim for income tax withholdings by the City of New York on a statute enacted after the wages were earned but before any payments on their account to the wage earners have been made by the bankruptcy trustee.

Freedomland, Inc., filed an arrangement petition under Chapter XI of the Bankruptcy Act on September 15, 1964, and was adjudicated a bankrupt on August 30, 1965. During the statutory period for filing claims, 413 claims of $600 or less, totaling approximately $80,000, were filed by former employees of Freedomland on account of wages earned before the filing of the Chapter XI petition. 11 U.S.C. § 93. No claims for withholding, social security or related taxes were filed either by the United States or the City of New York during the statutory filing period or otherwise.¹ The trustee, on November 7, 1969, moved the referee for an order authorizing payment to the wage claimants without withholding income, social security or other taxes and an order specifically declaring that he was not required (1) to make any such payments to any governmental body; (2) to prepare, distribute or file wage and tax statements for the employees or as an employer; or (3) to pay any penalties. The referee, Edward J. Ryan, was apparently much taken with the criticism by a fellow referee of United States v. Fogarty, 164 F.2d 26 (8th Cir. 1947), which held that a trustee must withhold income and social security taxes and that the taxes were payable as an administration expense entitled to first priority.² Referee Ryan accordingly on January 27, 1971, granted the trustee's petition on all counts, holding that "compliance with withholding and reporting requirements of tax authorities is utterly inconsistent with the spirit and the letter of the Bankruptcy Act," particularly the policy in favor of "efficient, expeditious economic administration of bankrupt estates."

The district court took evidence on the question what administrative burdens were imposed by the requirement that taxes were to be withheld, paid over and duly accounted for by the bankruptcy trustee. The district court noted (as the referee had previously) a bankruptcy practice in the Southern District of New York, concurred in by IRS, of deducting 25 per cent of gross wage claims, covering both income and social security taxes, and paying it in one check to the Director of Internal Revenue without allocation to the various individual taxpayers. Further evidence indicated that a junior accountant or clerk with payroll records could make the 25 per cent calculations quite readily and could also fill out forms 941 and W-3 for the Government and forms W-2 for the individual employees respectively. On the basis of this evidence the district court, in an opinion printed at 341 F.Supp. 647 (S.D.N.Y.1972), reversed the referee's order that the trustee was not required to withhold taxes or file the necessary forms. The court then went on to hold, relying upon In re Connecticut Motor Lines, Inc., 336 F.2d 96 (3rd Cir. 1964), that withholdings were not "expenses of administration" as held in United States v. Fogarty, supra, but rather were entitled only to a fourth priority as taxes "legally due and owing" to the United States by the bankrupt. Bankruptcy Act § 64(a)(4), 11 U.S.C. § 104(a)(4). In reaching this decision, the court also referred to In re International Match Corp., 79 F.2d 203 (2d Cir.), cert. denied sub nom. Delaware v. Irving Trust Co., 296 U.S. 652, 56 S.Ct. 368, 80 L.Ed. 464 (1935), for the proposition that "before a tax could be found to be legally due and owing by the bankrupt . . . enough must have been known about the basis of the tax to make the tax computable or `knowable' before bankruptcy, although not collectible until after adjudication." 341 F.Supp. at 656. As to the City of New York's claim, the district court held that since the City tax was not even enacted until 1966³ there were no taxes that could be said to be legally due and owing to it in September, 1964, when the Chapter XI proceeding was filed, and hence the City had no claim, under In re International Match Corp., supra. For the reasons which we state hereafter, we agree with the district court insofar as it required withholding and filing the prescribed forms, but disagree as to the order of priority assigned by it to withholdings, as well as to its treatment of the claim of the City of New York.

The first issue is whether a bankruptcy trustee must withhold under federal income tax law. The Internal Revenue Code of 1954, § 3401(a) defines "wages" as "all remuneration . . . for services performed by an employee for his employer . . . ." Were we to face this question afresh, an argument might be made that payments made by a bankruptcy trustee for wages earned before bankruptcy are really wage claim distributions. For example, as pointed out to us by the trustee, a solvent employer required to pay a judgment for disputed wages earned might not be paying "wages." Cf. Rev.Rul. 55-520, 1955 Int.Rev.Bull. No. 2 at 393-94 (compromise settlement for cancellation of employment contract not wages for withholding or FICA); Rev.Rul. 69-136, 1969 Int.Rev.Bull. No. 1 at 252-53 (sums paid former employees while in military service not wages). Further, it could be advanced that the bankruptcy trustee is not an "employer" since he has no "right to control and direct," 26 C.F.R. § 31.3401(c)-1(b), the "individual performing services," 26 C.F.R. § 31.-3401(c)-1(a), that is, the wage claimant. See In re Park Brewing Co., 48 F. Supp. 750 (W.D.Mich.1942). But see Int.Rev.Code of 1954, § 3401(d)(1) (defining "employer" as "the person having control of the payment of . . . wages . . . ." emphasis supplied);⁴ Educational Fund of the Electrical Industry v. United States, 426 F.2d 1053 (2d Cir. 1970) (payments to union members attending school which under collective bargaining agreement derived from employers but were paid out by union trust denominated as "educational fund" constituted "wages" for withholding, and educational fund held to constitute "employer" under § 3401(d)(1)).

We are not writing on a clean slate, however. United States v. Fogarty, supra, decided in the Eighth Circuit has been followed first in the Sixth, United States v. Curtis, 178 F.2d 268 (6th Cir. 1949), cert. denied, 339 U.S. 965, 70 S. Ct. 1001, 94 L.Ed. 1374 (1950), and then in the Ninth Circuits on this point. Lines v. State Department of Employment, 242 F.2d 201 (9th Cir.), rehearing denied with opinion, 246 F.2d 70, cert. denied, 355 U.S. 857, 78 S.Ct. 86, 2 L.Ed.2d 64 (1957). See also In re Connecticut Motor Lines, Inc., 217 F.Supp. 330 (E.D.Pa.), supplemented 223 F. Supp. 189 (1963), rev'd on other grounds, 336 F.2d 96 (3rd Cir. 1964). While Fogarty and its fellows have been criticized sharply by writers in the bankruptcy field,⁵ there is no decision of any court outstanding to the contrary on the point of necessity of withholding.

Indeed, as was found below, until it was decided to make a test case of this one — and we are appalled that almost nine years elapsed from the time the wages were earned until the case came to us⁶ — the bankruptcy trustees, at least in the Southern District of New York, managed perfectly well with the rough deduction of 25 per cent and remittance of that sum to the Director. The trustee's and referee's parade of horribles relating to computations, employment of accountants, completion of forms, etc., was quite deflated by the court below in its findings,⁷ and especially its conclusion that "Compliance with such requirements adds only slightly to the trustee's inescapable task and cost of verifying each claim before payment." 341 F.Supp. at 654. The result in Fogarty at least has the virtue that wage earners themselves do not have the job of determining their individual FICA taxes or figuring how to report them so as to obtain full social security credit therefor.

It may be that a dust cloth will be needed to wipe the cobwebs away from the files in which the wage and payroll records for the quarter in question are stored, now that so much time has gone by, but the amount of effort required on the trustee's part in a bankruptcy matter involving the sums that this one does is relatively small, even though 413 wage claimants are involved. That effort probably doesn't begin to match that which will be required of a conscientious trustee to track down the present addresses of the former employees so that they may receive their long overdue wages in the mail, effort which could largely have been avoided had distributions been made when they first could...