In re Halo Metal Products, Inc.

• Decision Date: 12 December 1969
• Docket Number: No. 17608.,17608.
• Parties: In the Matter of HALO METAL PRODUCTS, INC., an Illinois Corporation. UNITED STATES of America, Appellant, v. William L. RANDALL, Trustee, Bankrupt, Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

419 F.2d 1068 (1969)

In the Matter of HALO METAL PRODUCTS, INC., an Illinois Corporation.

UNITED STATES of America, Appellant, v. William L. RANDALL, Trustee, Bankrupt, Appellee.

No. 17608.

United States Court of Appeals Seventh Circuit.

December 12, 1969.

Thomas A. Foran, U. S. Atty., Chicago, Ill., Lee A. Jackson, Appellate Section, Tax Division, Karl Schmeidler, Crombie J. D. Garrett, Attorneys, U. S. Department of Justice, Washington, D. C., Johnnie M. Walters, Asst. Atty. Gen., Eugene Robinson, Asst. U. S. Atty., of counsel, for appellant.

Kevin J. Gillogly, Chicago, Ill., for appellee.

Before HASTINGS and KNOCH, Senior Circuit Judges, and DILLIN, District Judge.^*

HASTINGS, Senior Circuit Judge.

The district court affirmed an order of the referee in bankruptcy refusing to declare a trust in favor of the United States for income and social security taxes withheld from employees' wages by the bankrupt while acting as a debtor-in-possession under an arrangement proceeding pursuant to Chapter XI of the Bankruptcy Act, 11 U.S.C.A. § 701 et seq. The United States appealed. We affirm.

Halo Metal Products, Inc., filed a petition for an arrangement under Chapter XI on August 18, 1967. On August 20, 1967, orders were entered allowing the debtor to remain in possession and requiring it to file monthly reports, to keep separate books and records of its operation as of August 18, 1967, to set up separate bank accounts for its general, payroll, and tax indebtedness, and to make appropriate disbursements therefrom.

While operating its business as a debtor-in-possession, Halo failed to file regular reports, failed to properly set up the separate bank accounts, failed to deposit in the tax account amounts withheld from employee wages as income and social security taxes, and failed to make payment of such taxes.

On November 22, 1967, Halo was adjudged a bankrupt. Pursuant to court order, its physical assets were sold.

The United States filed a petition in the bankruptcy proceeding for an order imposing a trust in its favor on $1,075.02 of the bankrupt's estate and ordering payment to it of such amount prior to payment of the costs of administration. This amount represents the income and social security taxes withheld by the debtor-in-possession which were not paid over to the United States.

The United States contends such a trust is imposed by Section 7501(a) of the Internal Revenue Code of 1954, which provides:

"General Rule. — Whenever any person is required to collect or withhold any internal revenue tax from any other person and to pay over such tax to the United States, the amount of tax so collected or withheld shall be held to be a special fund in trust for the United States. The amount of such fund shall be assessed, collected, and paid in the same manner and subject to the same provisions and limitations (including penalties) as are applicable with respect to the taxes from which such fund arose."

It is well settled that, absent such a trust, taxes incurred during a Chapter XI arrangement enjoy only a pro rata first priority with all other administrative expenses under Section 64a (1) of the Bankruptcy Act, 11 U.S.C.A. § 104(a) (1).¹ See, e. g., Missouri v. Earhart, 8 Cir., 111 F.2d 992, 995 (1940) and cases cited therein.

The fund created by the sale of the bankrupt's physical assets is the only substantial asset of the estate and exceeds the Government's tax claim by a mere few hundred dollars. It is thus clear that if the Government is given a super priority under its trust fund theory, the claims for other administrative expenses will not be paid.

Three federal courts of appeal have accepted the Government's trust fund theory in cases presenting factual situations essentially identical to that before us.

The Second Circuit's decision in City of New York v. Rassner, 2 Cir., 127 F.2d 703 (1942), is the first, and still leading, case supporting the Government's position. It involved city sales taxes and a state statute making sellers trustees of such taxes for the city upon their collection. The court noted that a beneficiary must trace funds where mingling takes place prior to bankruptcy, but held tracing was unnecessary where a debtor-in-possession acting as an officer of the bankruptcy court mingled trust funds. The court reasoned that "if we hold that the city must now trace the funds, we state in effect that any beneficiary of a trust which is handled by an officer of a bankruptcy court must always protect himself by petitioning in advance for proper administration of the trust. Thus stated, it can be seen that we would be condoning improper action by a trustee so long as he could successfully get away with it. As a court of equity, a bankruptcy court can hardly proceed on this assumption. It is the duty of the bankruptcy court in distributing an estate to do so equitably." 127 F.2d at 706. (Footnote omitted.)

The court there recognized that "of course, an overriding policy of the Bankruptcy Act could prevent preferred satisfaction of even trust claims." Id. However, it concluded that no such policy was reflected by "the generalities of § 64, subd. a(1)." Id., at 707.

Rassner was followed by the Ninth Circuit in United States v. Sampsell, 9 Cir., 193 F.2d 154 (1951), and by the Sixth Circuit in Hercules Service Parts Corp. v. United States, 6 Cir., 202 F.2d 938 (1953). Both cases involved federal income and social security withholding taxes and the predecessor statute to Section 7501(a).

The Second Circuit reaffirmed Rassner and applied it to federal taxes in In re Airline-Arista Printing Corp., 156 F.Supp. 403 (S.D.N.Y.1957) aff'd per curiam, 2 Cir., 267 F.2d 333 (1959). It held that the 1952 amendment to Section 64a(1)² granting priority to costs and expenses of an ensuing bankruptcy proceeding over costs and expenses of a superseded arrangement did not reflect a new "overriding policy of the Bankruptcy Act" which would compel a reversal of the Rassner rule.

With deference and for reasons hereinafter set out, we are unable to follow the Rassner line of decisions. We hold that the United States is not entitled to a super priority by virtue of Section 7501(a) of the Internal Revenue Code.

The Third Circuit has noted that the tax trust fund created by the first sentence of Section 7501(a) is limited by the second sentence of that section. "Thus, though such collections are considered by law to be held in trust, that trust is subject to the same limitations as are the taxes from which the trust arose. Here, that limitation is the structure of the Bankruptcy Act * * *." In re Connecticut Motor Lines, Inc., 3 Cir., 336 F.2d 96, 107-108 (1964).³

The Supreme Court, since the Rassner precedent, has recognized that the second sentence of Section 7501(a) may impose bankruptcy-created limitations on the tax trust fund imposed by the first sentence. In Nicholas v. United States, 384 U.S. 678, 86 S.Ct. 1674, 16 L.Ed.2d 853 (1966), the Court held that the United States was not entitled to post-bankruptcy interest on withholding taxes which accrued while the debtor was in possession under Chapter XI, but which were not paid until after the adjudication of bankruptcy. The Court then continued:

"We find no merit in the Government\'s alternative suggestion that the interest on two of the taxes here in question — those withheld from the wages of employees and those collected from the patrons of the cabaret — constitutes a trust fund over which the United States has an absolute priority under § 7501(a) of the Internal Revenue Code. * * * The second sentence of § 7501(a) specifically provides that interest on such a trust fund is collectible in the same manner as the taxes from which the fund arose. Since we have already determined that no interest on any of the taxes here in question accrues beyond the period of the arrangement proceeding, no interest could accumulate on a trust fund composed of the withholding and cabaret taxes." 384 U.S. at 690-691, 86 S.Ct. at 1683-1684. (Footnotes omitted.)

The District Court of Colorado has applied this reasoning to the identical issue before us. It held "the second sentence of § 7501(a) means that the trust fund mentioned in the first sentence is nevertheless subject to the provisions of § 64(a) of the Bankruptcy Act which establishes a priority for all expenses of administration including taxes. So construed there is no conflict between § 7501(a) and § 64(a) * * *." In re Green, 264 F.Supp. 849, 851 (1967).

We are persuaded that this construction is correct. It gives effect to both Congressional enactments. On the one hand, it preserves the tax trust arrangement and thus leaves available to the Government certain favorable collection procedures. The legislative history of Section 7501(a) confirms this was the major goal of its enactment. The Senate Committee Report, S.Rep.No. 558, 73d Cong., 2d Sess., p. 53, noted:

"Under existing law the liability of the person collecting and withholding the taxes to pay over the amount is merely a debt, and he cannot be treated as a trustee or proceeded against by distraint. Section 7501(a) * * * impresses the amount of taxes withheld or collected with a trust and makes applicable for the enforcement of the Government\'s claim the administrative provisions for assessment and collection of taxes."

The Conference Report, H.Conf.Rep.No. 1385, 73d Cong., 2d Sess., p. 32, reflected the same purpose:

"This amendment impresses taxes collected or withheld with a trust in favor of the United States and makes applicable for the enforcement of the Government\'s claim the administrative provisions applying to the assessment, collection, and payment of taxes."

On the other hand, this construction makes collection of the trust fund in bankruptcy situations subject to the usual bankruptcy priority rules and thus honors the policy decision of Congress reflected in Section 64 as to the relative merit of various claims upon the bankrupt...