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Lender Liability for a Debtor's Unpaid Withholding
By: John E. Burrus, Esq.

Most lenders are probably aware that it is risky to assume complete control of a defaulted business debtor. One of the greatest risks is the potential for the debtor’s unpaid withholding under Internal Revenue Code §6672, which imposes liability for the full amount of the withholding tax on a person required to collect and pay over income and social security taxes of an employee. The IRS has not often been successful in imposing liability on a lender under this section since lenders seldom assume the degree of control over the debtor necessary for liability to arise. One court has suggested that application of this section requires that a lender assume virtually total control over a debtor’s funds and over decisions of which creditors are to be paid and which are not.

The IRS has been more successful in imposing liability on lenders under another code section. Section 3505 deals directly with the liability of lenders (among others) for unpaid withholding and imposes that liability in two situations:

• Where the lender pays payroll directly to a debtor’s employees; and
• Where the lender indirectly pays payroll by loaning money for this specific purpose and, in addition, has “actual” knowledge that the debtor will not or cannot pay withholding.

Under the first situation a lender may be liable for the full amount of taxes owed. Under the second, the lender’s liability is limited to 25% of the amount loaned for payroll purposes. Under this second alternative the liability of lenders has been recognized even for honoring overdrafts for payroll when circumstances indicated that certain bank officers had reason to know that the withholding taxes would not be paid.

The regulations adopted under §3505 state that an ordinary operating line-of-credit is not sufficient to impose liability under this section even if the lender knows that some portion of the line will be used for payroll. However, the reported cases make it unclear how far this regulation can actually be relied on. If bank officers become aware of facts indicating that withholding taxes will not be paid, care should be taken in how any workout arrangement is structured to protect the bank, as far as possible, from direct liability for those taxes.

Contact John E. Burrus at jeb@bsblaywers.com

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