Third-party liability for withholding taxes under Sec. 3505.

• Author: Zimmerman, John C.

Employers faced with financial difficulties may try to cut corners to maintain positive cash flow. It is not unusual for financially troubled employers to attempt to improve their cash position by failing to remit withholding taxes or to delay remittance until their finances improve. Alternatively, an employer may attempt to secure payroll financing from a third-party lender. The third party may be a bank, general contractor supplying a subcontractor, manufacturer financing a supplier, a wholesaler financing a manufacturer or a surety.

However, even if a third party provides payroll financing, it is still possible that the employer will not remit payroll taxes. The overall effect of failing to remit payroll taxes is that the employer is illegally borrowing these funds. It is also possible that the third-party lender may directly finance the payroll but fail to remit withholding taxes.

Congress's first attempt to deal with this problem was to enact Sec. 6672, which imposes a 100% penalty on certain "responsible persons" who willfully fail to pay over employee FICA and income taxes and thus become liable for 100% of the tax due. Nevertheless, a common practice of payroll lending before 1966 was for a third party to engage in net payroll financing. The lender would advance an employer enough to meet only the net payroll; withholding taxes were not advanced. At the time, only the employer could be be held liable for payroll taxes. Thus, no action could be taken against the lender for payroll taxes. Attempting to collect from the employer could be fruitless because it was likely to be without financing resources. To prevent net payroll financing Congress enacted Sec. 3505 in 1966.(1)

Sec. 3505 addresses direct payment of employee wages by third parties and indirect payments in the form of loans to the employer. The section applies only to liability for payment of the employee portion (FICA and income tax) of the payroll tax. Liability is not imposed for the employer portion.(2)

Sec. 3505(a) provides that if a lender, surety or other person who is not the employer directly pays an employee or group of employees employed by one or more employers, the third party will be liable "in a sum equal to the taxes (together with interest)" for amounts required to be deducted from wages. Liability is also imposed on the lender if the wages are paid to the employee's agent.

Sec. 3505(b) is more narrow in scope. It provides that when a lender, surety or other person supplies funds to or for the account of the employer for the specific purpose of paying employee wages, the third party will be liable "in a sum equal to the taxes (together with interest)" for amounts required to be deducted from wages. However, the third party must have actual notice or knowledge (within the meaning of Sec. 6323(i)(1) that the employer does not intend to withhold on the wages. Also, the liability of the third party is limited to 25% of the amount supplied to or for the employer's account.

Example 1: Lender L advances $100,000 to an employer for the specific purpose of paying only net wages. L knows that the employer will not be able to deduct and withhold the employment taxes. Withholding taxes not remitted amount to $26,000. The lender liability is limited to $25,0000 plus interest.(3)

L will be liable for up to 25% on only those wages supplied to an employer, not for unsupplied wages.

Example 2: Lender L loans employer E $15,000 for the specific purpose of paying $20,000 in net wages to E's employees. L knows that E will not be able to deduct and withhold the employment taxes. The total withholding liability is $4,500. The limitation is $3,750 ($15,000 X 0.25). However, E is liable for only $3,375 ($4,500 X ($15,000 / $20,000), plus interest.(4)

Sec. 3505(a) is a strict liability statute. It will be imposed regardless of whether the third party directly paying wages is aware of the withholding requirement or is financially able to withhold.(5) Thus, most of the litigation involving the statute concerns Sec. 3505(b).

This article will discuss the application of Sec. 3505(b); analyze the case law in this area, which tends to side with the IRS; and offer planning points on how to avoid the Sec. 3505 liability.

Working Capital Loans

Sec. 3505(b) does not apply to an ordinary working capital loan even if the party supplying the funds knows that part of the funds will be used for wage payments in the ordinary course of business. Under Regs. Sec. 31.3505-1 (b)(3), an ordinary working capital loan is a loan "made to enable the borrower to meet current obligations as they arise." The funds supplier is not required to determine the specific use of an ordinary working capital loan or the employer's ability to withhold the necessary employee taxes. However, Sec. 3505(b) will apply if the funds provider has actual notice or knowledge within the meaning of Sec. 6323(i)(1) at the time of the loan that the funds, or a portion of the funds, are to be used specifically to pay net wages. An agreement that states that funds are being provided as a working capital loan will not allow the lender to escape liability if it has actual notice or knowledge that withholding taxes will not be paid.

In Fidelity Bank, N.A.,(6) the lender granted a $1 million revolving credit line to CDI, a construction company. The money was used for construction and working capital. CDI experienced financial difficulties and had to shut down its operation in 1973. Shortly thereafter it was able to resume its operation and Fidelity agreed to provide additional funds even when CDI was overdrawn on its credit line. Fidelity asked CDI to close its payroll account at another bank and have all payroll checks paid through its general account with Fidelity. The word "payroll" was prominently displayed on the checks, which were initialed and approved by a bank officer.

CDI continued to have financial difficulties and Fidelity foreclosed on its assets. Fidelity also refused to honor unprocessed checks. Fidelity asserted that it was not liable under Sec. 3505(b) because its line of credit constituted an ordinary working capital loan. The court rejected this characterization because payroll checks were approved and initialed by a bank officer: "Although the overdrafts were secured by the agreements relating to the general credit line, the bank, through [its officer] knew it was supplying funds specifically for wages."(7) The court noted that when CDI closed its payroll account with another bank, Fidelity "had to know that without loans from it CDI would unable to pay taxes due."

In Intercontinental Industries, Inc.(8) (INI), a parent company was financing the operations of its subsidiary, Prebuilt, through a general account kept by Prebuilt at its bank. Prebuilt also received funds from sources not connected with INI. Prebuilt experienced financial difficulties and went bankrupt. During the period of financial difficulty Prebuilt failed to pay withholding taxes. INI not only knew of this decision but made it a condition of further financing.

INI argued that it was not liable under Sec. 3505(b) because the government failed to show that it gave specific amounts to Prebuilt for the specific purpose of paying wages. INI also argued that Prebuilt was receiving funds from other sources and all funds were going into a general account. The...