Transcript

IN THE SUPREME COURT OF THE UNITED STATES

HARRY P. BEGIER, JR., ETC., Petitioner v. INTERNAL REVENUE SERVICE

No. 89-393

March 27, 1990

The above-entitled matter came on for oral argument before the Supreme Court of the United States at 12:59 a.m.

APPEARANCES:

PAUL J. WINTERHALTER, ESQ., Philadelphia, Pennsylvania; on behalf of the Petitioner.

BRIAN J. MARTIN, ESQ., Assistant to the Solicitor General, Department of Justice, Washington, D.C.; on behalf of the Respondent.

PROCEEDINGS

12:59 p.m.

CHIEF JUSTICE REHNQUIST: We'll hear argument now on No. 89-393, Harry P. Begier v. Internal Revenue Service.

Mr. Winterhalter.

ORAL ARGUMENT OF PAUL J. WINTERHALTER ON BEHALF OF THE PETITIONER

MR. WINTERHALTER: Thank you, Your Honor. Mr. Chief Justice, and may it please the Court:

Good afternoon. The third case before the Court today involves whether a debtor's pre-bankruptcy payment alone from its general operating account for trust fund tax obligations excludes that property from a bankruptcy estate subject to avoidance as preferential transfers under Section 547. For the reasons which I shall present to this Court, I would respectfully present that such transfers are, in fact, avoidable.

The Petitioner in this case is the court-appointed Chapter 11 bankruptcy trustee in the matter of American International Airways. The debtor was a commercial airline carrier that provided scheduled passenger and air cargo service throughout the eastern and central United States.

As a carrier, the debtor had many employees and was required to pay wages to those employees and was further required to withhold taxes from those employees' wages, was required to withhold individual income taxes, the employer's -- the employee's share of Federal Insurance Corporation taxes, and was further required to retain certain excise taxes which it collected from the passengers' tickets.

By the first quarter of 1984, the debtor had become -- had experienced financial difficulties in the payments of its -- of its debt -- of its debts. Similar to many companies in this type of situation, the debtor failed to file and pay its tax returns on a timely basis. The debtor funded only net payroll.

The IRS imposed extraordinary remedies for the enforcement of the collect -- for the enforcement of these taxes. It issued a notice changing the debtor's tax filing requirements from a quarterly basis to a monthly basis. It also required the debtor to make deposits into a certain designated depository.

The debtor followed these guidelines and on April 30th transferred two checks to the government, one out of the specially designated account and the second check in the amount of $734,797 from the debtor's general operating account. The debtor and the IRS agreed to specific application of these funds.

Two further payments were made out of the general operating account just prior to the bankruptcy. One for $200,000, which was applied to 941 withholding taxes and the second in the amount of $11,636 which was applied to Federal unemployment taxes and also to Form 11 taxes for the year 1982.

QUESTION: All the payments you've described, Mr. Winterhalter, were within the preferential period?

MR. WINTERHALTER: That is correct, Your Honor. The debtor's financial difficulties continued, whereby on July 19th, 1984, the debtor filed its petition under Chapter 11. Problems persisted and a trustee was appointed two months later.

During the administration of the bankruptcy proceeding, the trustee instituted this instant action, seeking to avoid the three transfers made out of the debtor's general operating account.

Following a trial, the bankruptcy court ruled that the trustee was entitled to avoid $700,410. The District Court affirmed. On subsequent appeal to the Third Circuit, the United States Court of Appeals for the Third Circuit reversed the bankruptcy court and district court findings.

The Third Circuit, relying principally on the dissenting opinion of the D.C. Circuit in Drabkin v. The District of Columbia, found the ability of the debtor to make the pre-petition payment of withholding taxes regardless of the source of those funds impressed those funds with trust characteristics, removing the property from the debtor's estate.

QUESTION: What particular funds was the court of appeals talking about?

MR. WINTERHALTER: Your Honor, I'm not certain I understand your question. The funds -- the funds which the court of appeals was discussing were the funds that the debtor used to pay the Internal Revenue Service.

QUESTION: Simply money drawn on its general operating account?

MR. WINTERHALTER: That is correct. They were written on a regular check that the -- that the debtor would pay any other creditor.

It is respectfully presented that the holding of the Third Circuit is incorrect and should be reversed. The circuit's reasoning is wrong on four specific points.

First, the court relies on the wrong legislative history to support its contention that Congress intended to preclude the avoidability of tax withholding payments.

QUESTION: Well, what about the language of the statute?

MR. WINTERHALTER: My second point would be that the clear language of the statute --

QUESTION: Well, you had better start with that, hadn't you?

(Laughter.)

MR. WINTERHALTER: I would believe, Your Honor, that the clear language -- the plain wording of the statute expressly requires that for this trust to be created the taxes must be withheld or collected. In this situation, we did not have that situation.

QUESTION: Well, what does it -- doesn't the -- doesn't the law say that these withheld taxes are to be held as a trust fund?

MR. WINTERHALTER: Yes, it does. Section 7501 of the Internal Revenue Code --

QUESTION: Yes.

MR. WINTERHALTER: -- provides that --

QUESTION: Yes.

MR. WINTERHALTER: -- Justice White, provides that any taxes which are collected and withheld shall be held in trust. The wording of the statute -- the plain wording of the statute expressly indicates that the -- expressly indicates and is written in the past tense that the funds must be collected and withheld. There must be some type of segregation. This segregation does not --

QUESTION: Well, it doesn't really say that, does it? It says, the amount of tax so collected or withheld shall be held to be a special fund in trust.

MR. WINTERHALTER: That --

QUESTION: It -- it provides automatically by statute that whatever amount is withheld for these taxes is automatically in trust for the government. Isn't that what it says?

MR. WINTERHALTER: The statute says expressly that, Justice O'Connor. I would represent --

QUESTION: So why does it have to be segregated to comply with the statute?

MR. WINTERHALTER: I would represent to the Court, as has this Court on other occasions, that there must be a trust raised for a trust to be established. There must be something there. If -- here the government suggests that they need do nothing, that payment alone is a sufficient designation to establish this trust. But there is no trust existence.

QUESTION: You're -- you're not now saying that it has to be segregated. You're just saying that it has to exist, that when somebody pays an employee $80 and fails to withhold the $10 or put that aside for the government, there -- there is no $10 to -- for the trust to attach to.

MR. WINTERHALTER: That is exactly correct.

QUESTION: Now, that would be different for a sales tax, I suppose. If you collect a sales tax and it's provided that the sales tax shall be held in trust, you would actually get the sales tax and that could be held in trust.

MR. WINTERHALTER: That is exactly correct.

QUESTION: But with the withholding of -- of wages there's --

MR. WINTERHALTER: The property is --

QUESTION: -- there's nothing to identify.

MR. WINTERHALTER: That is correct.

QUESTION: You just paid him -- paid him 80. You were supposed to put 10 aside, but there is no 10 that we know of that's an identifiable 10.

QUESTION: Well, obviously there was money though, because they paid him.

MR. WINTERHALTER: Yes, there is money. But there is no --

QUESTION: Well, whatever the law says -- that -- that amount is going be held in trust, and the money was there to be held in trust.

MR. WINTERHALTER: Not necessarily so.

QUESTION: Well, it was paid.

MR. WINTERHALTER: Yes, it was paid.

QUESTION: Mr. Winterhalter, let's go back to that second clause of 7501 that Justice O'Connor referred to. The amount of tax so collected or withheld shall be held to be a special fund in trust for the United States. Now, certainly Congress can legislate in a way that says a -- a particular fund shall be treated in a particular way even though under the classic law of trusts there might not be any res, can't it?

MR. WINTERHALTER: Yes, it can. But --

QUESTION: You -- don't you think that's -- might be what it intended here?

MR. WINTERHALTER: No, I do not believe it did. I believe the -- when Congress enacted Section 7501, which was back in 1934, it had contemplated providing some protections for the government in the collection of their taxes. They have provided other statutes which expressly empower the government to enforce its collection efforts. Section 6672 would be an example.

QUESTION: Well, suppose what the company did in this case with respect to monies that was paid from the general account, drew one check to the general account and then immediately -- pardon me -- drew one check from the general check to the special account --

MR. WINTERHALTER: Yes.

QUESTION: -- then a second check special account to the government. Does that create the trust?

MR. WINTERHALTER: Absolutely. I think there is the act of the segregation itself.

QUESTION: And -- and you couldn't set it aside as a preference that putting it in the trust was a preference? I mean, how would that would be any different from the argument you're making now?

MR. WINTERHALTER: Well, I think in the situation which you have raised in your hypothetical, there is the -- there is the designation. There is the creation of the trust res which allows it to come into existence.

There is oftentimes suggested that the normal business operates properly --

QUESTION: But it's not -- it's not a preference to create a trust res?

MR. WINTERHALTER: No, I do not --

QUESTION: But it -- but it -- but it is -- but it is a preference to directly to pay the IRS?

MR. WINTERHALTER: Let me correct that statement.

QUESTION: That -- that doesn't make sense.

MR. WINTERHALTER: I believe that it would be a preference to create a trust res for any party. But I believe under Section 7501 Congress had enacted a provision which gives the IRS special treatment under certain circumstances. And that is when the trust money is properly withheld.

QUESTION: Mr. -- Mr. Winterhalter, it -- it seems to me -- I don't -- I don't understand why you say -- why you say that there has to be a res in order for a trust to be created. But if the statute, as the Chief Justice pointed out -- if it says it shall be created, the Federal Government can make it happen.

I should think that -- that the problem here is not whether it's created, but how you identify it, that when the government says in this statute that it will be a special fund in trust, you don't know what the res is. You don't know whether it's the bank accounts or the corporate -- the corporation's real property or any of the other assets of the corporation.

And, therefore, when it comes to -- to identifying something that -- that is subject to this special privilege, you can't identify it. It isn't that it couldn't be created, it's that it's not identifiable later. Isn't that your -- your point?

MR. WINTERHALTER: My point is, Justice Scalia, that there must be some act, some separation. It does not have to be the deposit into the designated account. It does not have to be the deposit into the approved tax depository in the normal business sense. But there must be something. The -- for the, for the trust to be created, there must be something to set aside. It can't just -- it's not an abstract, as the government suggested in their brief. There must be the creation that the --

QUESTION: It could be created in the abstract, but you can't give it effect in the abstract. Unless you can identify a res, you can't identify the trust corpus.

MR. WINTERHALTER: I don't believe I disagree with that.

QUESTION: But when must it be created? I'm not sure I understand your position on that. Supposing 30 days before bankruptcy they have $1,000 payroll and $200 withholding obligation. They have $1,200 in the bank and they pay $1,000 to the -- to the employees and don't do anything to with the two hundred until after the bankruptcy. Or they pay the 200. Would that be -- would that be a preference?

MR. WINTERHALTER: If they held the 200 in their general operating account?

QUESTION: Yes.

MR. WINTERHALTER: And then paid it directly to the government?

QUESTION: Yeah, a week later, but still within the preference period.

MR. WINTERHALTER: Presuming that the other elements of a preference have been satisfied, I would believe that that -- I would believe that that would be a preference. I believe that's the situation here.

We have funds being used which were in the account, but no connection being made between the $200 in your hypothetical and the $700,000 in this hypothetical which would connect the monies collected with the trust being created.

QUESTION: Other than the fact that they did use the money to pay the government? That's not enough, of course.

MR. WINTERHALTER: That is -- that is correct.

QUESTION: Well, what do they -- they have to put it -- you're -- they have to put in a separate account before the -- in -- in -- before the preference period begins.

MR. WINTERHALTER: I'm -- I'm not saying to create the segregation itself or to create the designation it has to be placed in a separate account. Again, many businesses operate under a three bank account system. They have their general operating account which they collect their revenues. They then have their payroll account and they have their tax account.

They would collect revenues from the normal operation of their business, place them in their -- place them -- place those monies into their general operating account. Use the general operating account to pay their normal expenses, which would include their payroll and their wages. And once they provide gross wages into the payroll account, they then, in turn, would transmit the requisite funds to satisfy the withholding tax obligations. Upon doing that, I think the 7501 would come into effect.

QUESTION: Well, what if the statute -- this clause we've been talking about -- said any paid amount of tax so collected or withheld shall become the property of the United States?

MR. WINTERHALTER: I -- I still don't believe you have reached that threshold of identifying the trust res. There is -- the statute does not say --

QUESTION: But this statute would not have -- the statute I'm talking about says nothing about a trust. It simply says the money that was withheld shall become the property of the United States.

MR. WINTERHALTER: If there has been no withholding, Mr. Chief Justice, I do not believe that the trust -- well, you're -- instead of putting the property in trust, you're creating a statute which would in effect transfer title to the property directly to the government --

QUESTION: Yes.

MR. WINTERHALTER: -- upon the operation of the statute. I'm not certain how that would work, Mr. Chief Justice. I would believe that if -- if Congress specifically enacted that statute and expressly stated such in a statute, then, in fact, that would be controlling.

QUESTION: Well, I -- I have the feeling that the statute Congress did enact is not far different from --

MR. WINTERHALTER: I would respectfully disagree with Your Honor.

QUESTION: I'm sure you do.

(Laughter.)

QUESTION: Mr. Winterhalter, it's -- it's my understanding of trust law that if you declare yourself to be a trustee of a res which is not in existence at the time, but later declare the res, it is effective. That is, if I tell my nephew I am putting in trust $500 for you and in fact I don't, but several weeks later I set aside the $500 and I say this is the -- this is the trust corpus for my nephew, that's effective. So, you can do it later. Right?

MR. WINTERHALTER: I believe that Hornbook trust law would -- would look to the intent to the trustee in that situation.

QUESTION: Well, that's right. But I can do it later.

MR. WINTERHALTER: Yes.

QUESTION: I don't have to do it at the moment that it's created.

MR. WINTERHALTER: Yes. That is correct.

QUESTION: Now why isn't it -- and it's also Hornbook trust law, as I understand it, that you can declare in trust a portion of a fungible account. So you can say $500 of this bank account is held in trust for my nephew.

MR. WINTERHALTER: Yes, you can.

QUESTION: Okay. Now, when you put those principles -- two principles together, why is it not the case that as soon as the corporation wrote out this check to the United States it identified a portion of that bank account as being the trust corpus that was owed to the government before it was transmitted to the government.

MR. WINTERHALTER: You would be talking -- I -- my -- my response to that would be it would not be a trust because you would be transferring title to the funds to the government on that time.

QUESTION: I'm not using it as check. I'm not using it for its conveyance purposes. I'm using it for its declaration of what is the corpus of the trust. As soon as you sign that check you have effectively expressed your intention that this is indeed the portion that belongs to the United States.

MR. WINTERHALTER: What in effect as --

QUESTION: As opposed to my real estate. I agree with you, before that we have no idea what portion of the corporation's assets belong to the United States. We don't know that it was a real estate or whatever and I'm sure the government would use whatever -- whatever was convenient at the time. But once the -- once the corporation signs that check, the corporation has acknowledged a particular corpus.

MR. WINTERHALTER: Mr. Justice Scalia, I would present to you that the trust which is required to be created in order for 7501 to be attached -- to attach, this trust to be created, must relate to the funds collected from employees' wages. If these funds are dissipated -- if the bank account goes down to zero, then you cannot take funds unrelated to the employees' wages and recreate them in a trust. Those funds will never be affected with the trust characteristics if in fact they came from funds which were not generated from employees' wages.

QUESTION: There is no -- there's no -- how do you identify -- look the statute applies not only to -- to funds collected but also to funds withheld. There is no identifiable dollar withheld. When I pay you $80 and withhold $ 10 for Federal income tax, what identifiable dollar is that? It's no identifiable dollar. It is money I have not paid you.

MR. WINTERHALTER: But this is --

QUESTION: So, you have to rely on my declaration of a fund later, it seems to me.

MR. WINTERHALTER: I would respectfully disagree.

QUESTION: That's for a sales tax. Yes. When I get the tax, you say that's it, that's what the trust attached to. But not for a withholding tax. The withholding tax never exists. There -- there is no dollar it -- it ever attaches to. It's just money I do not pay you.

MR. WINTERHALTER: The trust language, Mr. Justice Scalia, under 7501 does not suggest that the trust attaches to monies collected and which should have been collected. It only says that the trust attaches to monies which were collected.

QUESTION: Or withheld.

MR. WINTERHALTER: -- or withheld.

QUESTION: (Inaudible) the problem?

MR. WINTERHALTER: But if we fund only net payroll, if the employer pays only net payroll while the -- the employee takes the advantage of the tax credit, the employer does not pay it. He does not fund gross payroll. He does not withhold the monies.

QUESTION: Well, he withholds by the act of paying the employee only the net, I would think. Withhold means deduct.

MR. WINTERHALTER: Yes. I agree.

QUESTION: So, he is with -- if I -- if I hire you for $100 a week and your gross is $100 and your net is $80, when I pay you $80, I have by definition withheld $20, even though I don't have the $20.

MR. WINTERHALTER: That's correct. But, Mr. Chief Justice, if you don't have the $20, then how can the trust attach to those funds?

QUESTION: Well, if you're looking for something that meets all the requirements of Bogurt on trusts, I agree that it can't. I -- my view is that this statute does not require those.

QUESTION: It cannot attach immediately, but I thought you conceded before that -- that the res does not have to be in existence at the time. You can establish the res later. And why didn't that happen when the check was written, even using Bogurt?

MR. WINTERHALTER: Because there's been no connection between the funds withheld from the employees and the trust funds paid to the government.

QUESTION: There doesn't have to be a connection.

MR. WINTERHALTER: I believe that there does.

QUESTION: The res was created later.

QUESTION: But you acknowledge that you can put it into a special account and that that creates a trust without a preference. And I just don't see how that follows from your argument.

MR. WINTERHALTER: I would represent to Your Honor that if there is the designation -- if you -- if you go through the steps to establish the existence of a trust res --

QUESTION: But -- but why isn't the payment to the government the designation?

MR. WINTERHALTER: Because --

QUESTION: Why -- why is doing something directly less of a designation than doing it indirectly?

MR. WINTERHALTER: Because in the payment to the government you are transferring title to the property. What the government wants to say is allow us to be preferred over every other creditor. We should be preferred. We should have some loophole.

If that is what Congress intended when it enacted the Bankruptcy Code, it should have expressly stated so. But it didn't state that. It stated that the -- that the IRS, that the government was going to be subject to the preference laws. It was going to be subject to the -- a trustee in bankruptcy or the debtor himself from avoiding payments to the government.

QUESTION: Well, the Congress set up a scheme whereby avoidance could be had for items that were property of the debtor. These monies weren't property of the debtor. They were the property of the United States the minute they are withheld. It doesn't belong to the debtor anymore.

MR. WINTERHALTER: I would respectfully disagree.

QUESTION: Well, that's the statutory scheme.

MR. WINTERHALTER: But there is no nexus between the funds collected and the monies paid to the government. There is no -- in this case, there is absolutely no proof that the funds used to pay the Federal Government were those funds collected from the employees' wages.

QUESTION: Well, there is no tracing problem here. Once the check is drawn, that solves that. They've set it aside.

MR. WINTERHALTER: At that time they transfer title. They don't establish the trust. What you are enabling by such a ruling would be for the -- for the principals of the corporation to in effect -- to in effect avoid 6672, 100 percent penalty liability. You are, in effect, carving out an exception that does not exist in the statute -- while it may have existed in the proposed Senate statute, it does not exist in the statute as enacted to allow a debtor corporation to avoid 100 percent penalty payments, to allow the Internal Revenue Service to be preferred over other creditors.

This Court stated in United States v. Whiting Pools that the government should be treated no differently. That -- it stated in United States v. Slodov that there must be a connection -- there must be some nexus when discussing this trust. If the Court finds in favor of the government of today, it would be reversing the principles established by this Court in those two cases. It would be obviating the need for the government to impose any tracing whatsoever. It would just say that the trust arises by operation of law without anything further.

The legislative history -- the statute itself does not describe either way whether the government can or cannot avoid transfers of property. Several courts have attempted to interpret whether Congress intended when enacting the Bankruptcy Code to permit the government to do just this, whether a bankruptcy trustee can avoid a transfers of the government to a governmental authority if the property was properly withheld.

Each of the courts have looked to the statute and said it's not clear and referred to the legislative history. The legislative history was -- as this Court has recognized, was a long time in making. The statute involved 10 years of congressional debate.

QUESTION: This is the Bankruptcy Code you're referring to?

MR. WINTERHALTER: That is correct. That is correct. And this -- that is correct.

The -- when -- when the statute was enacted, the House originally proposed House Resolution 8200. The House resolution was approved by the House Judiciary Committee, voted out of committee and a report was filed. The language in the report is the language referred by the Third Circuit in their opinion. The House bill was sent to the House floor, subject to several amendments and passed. It was then sent to the Senate.

The Senate at the time was considering their own legislation, Senate Bill 2266. Senate Bill 2266 would have specifically authorized -- would have specifically carved out an exception that the government desires today, that preference payments to the government are not avoidable.

The Senate Bill was approved by the Senate Judiciary Committee. What they did, though, is they took -- they tabled the bill, Senate 2266, put their language into House Resolution 8200 and sent it back to the House. Because of the lateness of the term, the two parties -- the -- the managers, the House leader and the Senate leaders, got together and, in lieu of formal committee, came up with this new statute, came up with a -- with a hybrid which imputed parts of the Senate bill and parts of the House bill.

This hybrid bill is reflected in the conference committee report, which is also attached to the legislative history. That -- that language specifically references the fact that the provision in the Senate bill which allowed the government to have the ability to avoid taxes was specifically excluded.

Senator DeConcini's statements stated that Section 547 -- 547(b)(2) of the House amendment adopts a provision contained in the House bill and rejects the alternative contained in the Senate amendment relating to the avoidance of preferential transfers, that is, the payment of a tax claim owing to a government unit.

What in effect this says is that the -- what the Senate proposed and what the government is proposing today was expressly not adopted.

QUESTION: Of course, Congress could have rejected that because it would have extended to state and local government units, too, the way you have expressed it, couldn't it?

MR. WINTERHALTER: That is correct. In Section -- but what Congress did do in enacting the Bankruptcy Code in its final text, it provided under Section 106, which is sovereign immunity section, clear language that the government would be subject to the avoidance of preferential transfers.

In this case, if the Court adopts the position as espoused by the government, you would in effect be overruling what Congress had expressed in the legislative history.

QUESTION: Only as to the extent of trust funds, though. It wouldn't be as to all tax obligations -- corporate -- income tax, for example.

MR. WINTERHALTER: Yes. That is correct. There -- there is a difference in those taxes, Mr. Justice Stevens. The problem, however, is that there was no express exclusion in the statute for the non-avoidability of even trust fund taxes. And certainly Congress was cognizant of that fact by its -- by its protection of those -- by the protection of those taxes in both Section 507, which is the priority section, and Section 523, which is the discharge section.

What Congress said there is that we want to protect both taxes which were collected and which should have been collected.

QUESTION: Well, on that basis it wouldn't do you any good to segregate these funds that you've withheld.

MR. WINTERHALTER: Under the Section 507 or 523 analysis?

QUESTION: Well, I thought you said a while ago if you actually segregated these withheld funds, they would not become property of the estate.

MR. WINTERHALTER: That is correct.

QUESTION: And there could be no avoidance.

MR. WINTERHALTER: That is correct.

QUESTION: Well, but the argument you've just made from that other provision of the law on the preference I would think it would -- I would think that would cover the withheld funds that are segregated also.

MR. WINTERHALTER: Mr. Justice White, under those sections they clearly had contemplated taxes which should have been collected and which were not collected. In the final draft of the -- of the statute as enacted under 547, they did not include this type of reference and in the legislative history they equally did not include such a reference.

Justice Marshall noted in the case in -- in this Court that under 6672 they do in fact recognize taxes which were collected or which should have been collected. Under 547 and 7501 they do not.

If the Court has no further questions, I will reserve my remaining time for rebuttal.

QUESTION: Very well, Mr. Winterhalter.

Mr. Martin.

ORAL ARGUMENT OF BRIAN J. MARTIN ON BEHALF OF THE RESPONDENT

MR. MARTIN: Thank you, Mr. Chief Justice, and may it please the Court:

I'd like to begin where Mr. Winterhalter left off. In fact, Congress did pass the House version of Section 547, the Preference Bill, H.R. 8200. It rejected the Senate version which would have made all tax payments non-avoidable. It did that to reach corporate income taxes, unemployment taxes.

It's plain that taxes held in trust and turned over to the government cannot be a preference. Every court has recognized that. The joint floor statements recognize that. So, the question in this case is whether a trust was created and maybe whether a trust was dissipated.

The petitioner has argued that no trust was ever created. He has not contended that one was created and somehow spent and -- and rendered unavailable. His argument has been that there was withheld taxes placed in a segregated account.

In the first place, it's -- it's plain that taxes were withheld. At trial IRS Forms 940 which detail the amounts of withholding were placed into evidence. And it's roughly about $350,000 withheld each month of -- of the relevant months in questions.

On the question of whether taxes --

QUESTION: May I -- may I interrupt you right there?

MR. MARTIN: Yes.

QUESTION: Those forms proved that that's the amount that should have been --

MR. MARTIN: No.

QUESTION: -- set aside?

MR. MARTIN: No. It's -- it's a statement of these were withheld. It's not --

QUESTION: But where were they withheld? Were they -- could you -- were they actually -- there were actually funds there that were placed in a bank account?

MR. MARTIN: There were no funds placed in a bank account. They were net wages in other words.

QUESTION: I know, but when you have a -- when you file a form that says gross wages X --

MR. MARTIN: Uh-huh.

QUESTION: -- and net wages X minus the tax, that isn't proof that the amount withheld was actually withheld. It's just a proof they filed a piece of paper that said they were doing it.

MR. MARTIN: The filing a piece of paper their identifying it court as genuine, and the document says --

QUESTION: It's genuine.

MR. MARTIN: And it says -- it says we did it. It says we withheld. It doesn't say we were required to withhold it. It said we did withhold it.

QUESTION: Well, withhold means simply not paid.

MR. MARTIN: Exactly.

QUESTION: Well, okay.

QUESTION: That doesn't suggest the existence that they've put a deposit of monies --

MR. MARTIN: Not at all.

QUESTION: -- just that they did not paid that amount.

MR. MARTIN: Not at all. I'm just saying if you had an employer -- not AIA, but another employer who paid -- who paid gross wages, so there was no withholding in the first place, then we would have trouble reaching -- finding a trust under 7501.

QUESTION: Oh, I see.

MR. MARTIN: But when there is a withholding, that's my simple point.

QUESTION: (Inaudible).

MR. MARTIN: Right.

QUESTION: I still don't -- maybe I'm stupid. Say, they have enough money to pay net wages and they file a return that says we withheld the difference between net wages and gross wages. Would that be -- but they actually didn't have any money. They have -- it's a no-asset business. It's a sales operation of some kind, and all the money they had in -- available to them they used to pay net wages, but they filed the return suggesting that we withheld this amount and we recognize an obligation to pay it when we get the money.

MR. MARTIN: There has been a withholding in that case. If --

QUESTION: What has been withheld?

MR. MARTIN: Well, they've have had to pay less -- they've have had to pay less than they would have paid -- they had to reduce -- they cannot pay gross wages. In other words, if they only have enough money, they have to make payroll, and they have to deduct on the forms at least from the paycheck. A person's paycheck -- the stub would say withholding of $105. The government cannot go after that $105 with respect to that taxpayer if there's been that much of a withholding. Maybe the individual would have a claim for wages against its employer.

QUESTION: But there is no asset representing the amount withheld?

MR. MARTIN: Well, that's right. On -- on the books, they didn't have to borrow the money either. Perhaps they could borrow the money if you wanted to find an asset. Withholding is just a deduction from gross wages. That's all it means.

QUESTION: You just mean not paid.

MR. MARTIN: Not paid is all I mean.

QUESTION: All right. So, the trust consists -- the trust res consists of a liability?

(Laughter.)

QUESTION: That's what you've said.

MR. MARTIN: That's basically right. And this is the liability that if the law is followed, will be satisfied usually within about three to five days by a check to the IRS. It wasn't --

QUESTION: You're -- you're not suggesting that in the strict sense of trust law, the filing of a withholding -- a return showing tax withheld creates any sort of a res, are you?

MR. MARTIN: No. No. I -- I'm saying under 7501 whenever a trust is created and the amount of tax withheld -- the amount of tax withheld shall be held to be a special fund in trust for the United States. It's a statutory trust. The trust is created by operation of law. It's in the amount of not paid. It's in the amount of withheld.

QUESTION: Mr. Martin, I'm -- I'm willing to concede that you can create a trust by law. You can just say by law there is a trust.

MR. MARTIN: Right.

QUESTION: But you -- you know, you can't make black white by law. You can't pass a law that makes black white. And what you're trying to do is to enforce a trust and -- and -- and that is an objective reality. You are trying to move on some corpus.

MR. MARTIN: Uh-huh.

QUESTION: And you can't decree the existence of a corpus by law.

MR. MARTIN: I agree.

QUESTION: So, we -- we -- we have to find some corpus to identify for the legal consequences that you want to attach.

MR. MARTIN: I agree.

QUESTION: Now, at -- until the check was written at least, that corpus could have been anything. It could have been the company's plant. It could have been any asset whatever of the company. I wouldn't know how to apply a trust law theory to that kind of a situation.

MR. MARTIN: And with that --

QUESTION: But you -- you would apply it even before the check was written. You -- you would say that somehow you would have a preference on the corporation's assets even before there was any identification.

MR. MARTIN: Yes. I think that we would -- wherever we found -- found in the commingled accounts of the withholder the amount of tax withheld, that that would be the trust.

QUESTION: Wow, boy, that --

QUESTION: We don't have to decide that in this case.

MR. MARTIN: But you don't have to decide that -- fortunately.

(Laughter.)

MR. MARTIN: But let me just -- you know, there is evidence that Congress thought that too in 1978. The joint floor statements addressed the question of commingled accounts and said that the IRS could use reasonable assumptions, with one such assumption being any amount remaining in commingled accounts is the IRS' money.

QUESTION: I -- I assume that what you assert the Federal Government can do by using the device of trust law, you are willing to acknowledge that state governments can do as well.

MR. MARTIN: Absolutely.

QUESTION: So, a state government could say, henceforward, any taxes owed to the state shall be a trust and they would -- they -- they would acquire a preference under bankruptcy law. You think about that for a minute.

MR. MARTIN: If -- if they have a parallel system, sure. I mean, if -- if a trust is created under law, under private instrument, whatever it is, payments of trust funds cannot be preferences because they're not properties of the debtor. That's right.

Let me go back to the question you asked about -- okay, a trust has been created, but how do we know that the payments are payments of trust fund taxes. Well, we know in this case because of the black letter law that a trustee may designate any funds, its personal funds, its corporate funds, whatever it wants to, as trust funds taxes or -- as the trust property. If they wrongfully dissipated the trust, they can restore it with any funds they want.

So when they write a check that clears, as in this case, that's sufficient to identify the -- the trust. And I think that's what Congress contemplated in the House report which this Court has viewed as authoritative of Congress' intent in 1978. When it said, in the House report -- and this is at page 26 of our brief -- that the payment of withholding taxes will not be a preference if they have been properly been held for payment, as they will have been if the debtor is able to make the payments. So, we think that Congress thinks that if the debtor is able to make the payments, if the tax withholder can make the payments, the checks clear, that no further connection is required.

Now, there may be cases if -- where trust fund taxes are not paid over, they file for bankruptcy, when the IRS wants to identify the funds. In that type of case, we would be entitled to use reasonable assumptions. One of the assumptions is that any -- any amounts remaining in commingled accounts are the taxes.

But here we have more than that. We know that there were amounts remaining. The checks cleared. And we also have the identification of the payments as trust fund taxes by the trustee -- in this case, AIA.

QUESTION: What other purpose is 7501 used for? I mean, it -- it seems to me it might be possible to read the first sentence of 7501(a) as -- as its whole purpose is simply to -- to lay the basis for the second sentence. That is, the -- the only reality that this fund has in the world is to enable the assessment, collection and payment in the same manner as the taxes out of which it arose.

MR. MARTIN: Well, that's -- that's not what Congress was doing in '34. Until 1934, this liability was just a tax debt and had to be treated as such. And Congress wanted to -- to say no, once the withholding has occurred, it's our money. There can be no higher secured interest. You know, if it's -- it's secured, creditors can't take the money. It's our money. You can use trust concepts to segregate and collect. I think that's clear.

QUESTION: There was no withholding in 1934. That must have been added later, wasn't it?

MR. MARTIN: Yeah, in '34 -- it dealt with the excise taxes only and said that -- that money was held in trust. It was added -- I think it was '39 or '40. Whenever withholding began is when it was -- 7501 was amended to apply to withholdings in addition to excise taxes.

I think the last sentence of 7501(a) just means that the that the IRS can use the notice and assessment and levy and lien provisions with respect to trust fund obligations if it wants to. And we have to in many cases.

So, just to summarize our position, we think a trust is created when there is a withholding, when -- when net wages are paid. No segregation is required. We can require it under Section 7512 of the Code if there has been a poor performance by the employer. But we don't have to require a segregated account.

QUESTION: Mr. Martin, in -- in the case of the special fund that is created that is a separate earmarked bank account, if the employer coming upon hard times decides to change his mind or its mind and takes the money back, is -- is there some kind of criminal liability?

MR. MARTIN: Yes. Yes. 6672 is the 100 percent penalty provision for every responsible officer, and I think there would be a 100 percent liability there. And there is also a criminal penalty for willfully violating the trust fund obligations. And I think that would fall within that. It's a -- I believe it's a misdemeanor punishable up to one year.

QUESTION: And -- but that -- but that special liability, that special criminal liability doesn't apply if there is simply a failure to earmark funds that are in the general account and those funds would then disappear or what?

MR. MARTIN: It could apply for willful --

QUESTION: If it's a trust in either event --

MR. MARTIN: Right. No, it could apply in this -- in this type of case as well. If -- if -- the IRS policy is to use the 100 percent civil penalty before it would use the criminal penalty. But there are criminal penalties for the failure to turn over the amounts of withholdings to the IRS.

QUESTION: But -- but is the gravamen of the offense the invasion of an identified trust corpus?

MR. MARTIN: No. No. It's not.

QUESTION: In other words, it's just failure to withhold?

MR. MARTIN: Failure to turn -- to deposit --

QUESTION: Failure to deposit.

MR. MARTIN: -- into the U.S. Treasury the amounts of withholding.

If there are no further questions --

QUESTION: Very well, Mr. Martin.

Mr. Winterhalter, do you have rebuttal?

REBUTTAL ARGUMENT OF PAUL J. WINTERHALTER ON BEHALF OF THE PETITIONER

MR. WINTERHALTER: I do, Your Honor.

The government suggested that the record before the bankruptcy court reflected that in fact deposits or tax payments were made and referred to Form 940 returns. Form 940 returns would reflect Federal unemployment tax obligations. That is not at issue in this case.

What is at issue in this case is 941 taxes which would be reflected on the 941 returns. Government Exhibits Number 11 and Number 12, which were attached to the supplemental brief filed with the Third Circuit, clearly indicated that while the tax liability of the debtor corporation was identified, there were no tax deposits made during this time period.

In addition, the record, the joint appendix, which has attached to it a copy of the record, clearly indicates when the Internal Revenue Service, Mr. Alan Zlatkin, the Revenue Officer, was being questioned at the trial, he clearly indicated --

QUESTION: Thank you, Mr. Winterhalter.

MR. WINTERHALTER: Thank you.

CHIEF JUSTICE REHNQUIST: The case is submitted.

(Whereupon, at 1:42 p.m., the case in the above-entitled matter was submitted.)