Not-for-profit entities are not immune from the business cycles, risk of lawsuits and other threats to solvency. Managing the collapse of an organization has always required diligence, but recent IRS enforcement initiatives and a recent District Court decision have made these situations even more troublesome. During the wind-down of a failed organization, there has generally been no personal liability for managers who have chosen to pay some vendors over others (except for certain limited statutory exceptions such as trust fund taxes). In the not-for-profit world, the policy encourages community leaders to volunteer to serve on boards. While the Internal Revenue Code’s lien priority and personal liability limitations have created some comfort and certainty, there has long been a hidden weapon in the government’s arsenal that has rarely left its holster. The Federal Insolvency Statute, 31 U.S.C. § 3713, is a rarely invoked but potentially devastating collection tool. The statute creates liability for responsible persons of insolvent companies who direct payment to unsecured creditors while obligations to the U.S. government are left unpaid.
The statute has not been materially changed since it was enacted in 1797. The statute does not differentiate between legitimate business expenses, expenses necessary to preserve going concern value, the expenses necessary to preserve the liquidation value of organization and fraudulent transfers. The plain meaning of the statute is very harsh. If any creditor is paid while the government remains unpaid, the individuals directing the payment may be held liable to the government to the extent of the payments. For instance, an executive director or board member who approves payroll and expense payments of $1 million in order to keep an organization operating while he finds a buyer or works on a bankruptcy solution could be liable for the $1 million in payments made for ordinary and necessary operating expenses. Responsible officers are generally only pursued for the trust fund portion of employment taxes. The corporate side of employment taxes, income taxes and other government claims have not been assessed against the business owners or its managers. Statute 26 U.S.C. § 6672 creates personal liability for owners, employees and agents who: (1) are deemed to be responsible for the collection and payment of withholding taxes, and (2) willfully fail to remit the withheld money to the government.
The theory behind the liability is that the money was collected from employees on behalf of the government, and the failure to pay the withheld funds is akin to conversion. An employee who becomes a target of a responsible person assessment bears the burden of disproving liability by a preponderance of the evidence. The targets of responsible owner liability claims include owners, directors, managers, accountants and even payroll agents. This statute often encourages managers of distressed organizations to keep trust fund payments current while corporate liabilities are not paid. It also gives them some comfort that their efforts to preserve going concern value or provide for an orderly liquidation when a large tax liability cannot be paid will not lead to personal liability, so long as the trust fund taxes are kept current during their supervision.
The limited liability for business tax liabilities is now in doubt after a recent Indianapolis District Court decision. In United States v. Sperry1, the Court held that under 31 U.S.C. § 3713, the government could recover non-trust fund employment taxes to the extent that the company remitted payments to the company’s unsecured creditors. The facts in Sperry are common to many failed businesses and notfor- profit organizations. Sperry owned Monroe County Title Company (MCTC). In June 2008, the company suffered substantial revenue losses from which it could not recover. It closed in February 2010. In the 31 months that the business floundered, Sperry paid operating expenses of the company, salaries, personal expenses, his salary and some debts which he personally guaranteed. He failed to pay employment taxes and was personally assessed for the trust portion of this liability. He paid the trust fund liability and was then sued by the government to recover the non-trust fund taxes under the Federal Insolvency Statute.
The District Court held that where a representative of an insolvent business enterprise exercises his authority to pay anyone before the government, that representative can be held personally responsible for the amounts paid (up to the amount due the government). If more courts follow the Sperry analysis and application of 31 U.S.C. § 3713, the structured wind-down of organizations outside of bankruptcy may pose unreasonable risk for managers, directors and liquidation agents. The current best practice of liquidation agents has historically included deferring payment of old tax debt to ensure that current taxes, wages and other essential operating expenses are paid to preserve the value of the entity for the benefit of all creditors, including the government. Under the holding in Sperry, the liquidation agent cannot spend the first dollar toward asset preservation unless there is sufficient cash on hand to pay the tax debt in full. The statute, as applied in Sperry, leaves no room for payment of insurance, security and utilities necessary to prevent complete loss of the corporation’s assets or even the accounting services necessary to allow the government to assess an accurate claim.