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Octc=er 19, 1981

Mr. :·iarc Paiva

~amilton Taft & COffi?any
1255 Post Street
San Francisco, CA 94109

Re: Charac:erization of Funds ~ichheld by Employer

'E'or Tax Payments

Dear Marc:

Per your request, this letter Q1SCUSSes the characteri-

zation of funds withheld by employers from employee pay
checks in satisfaction of federal and sta~e income taxes,
Social Security taxes, and state ~nemployment insurance '.
taxes. This letter is limited to a discussion of the In-
ternal Revenue Code ("I.R.C."), t~e California Revenue and
Taxation Code ("Cal. Rev. & Tax. Code"), ;:he California
Unemployment Insurance Code ("Cal. U. Com. Code"), and the
general responsibilities and duties of a trustee as reflected
in the California Civil Code ("Cal. Civ. Code").

An employer is required to withhold from the wages of

employees amounts in respect of federal income taxes (I.R.C.
§ 3402], Social Security taxes [I.R.C. § 3102], state income
taxes [Cal. U. Corn. Code § 13020], and state unemployment
insurance "taxes [Cal. U. Com. Code § 986]. The employer is
liable for the deduction and witr.holding of taxes. I.R.C. 5
3403: Cal. U. Corn. Code § 13021.

Characterization of Withheld Funds

Funds that are withheld or collected as income tax or

Social Security Tax are to be held by the employer as " a
special f:..1nd in trust for the United States." LR.C. § 750l.
u.s ..... Hill, 368 F.2d 617,66-2 ::.S.T.C. ~[9736 at 87382 (5th
:-: :'. r c ? ..= ':
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2i.~., 1966~. ="...!~ds Lhat are .....'l.-:::~eld cr :::: __ ~cr:ed as s~ate

inco~e c~x 3re ~o be held by ~~e employer aE "3 special fund
in tr'Jsc for the S't'ate ot Cali=ornia rCcl. -,:. Com .. Cocie §
ll

13070]; '..."hile :~nds withheld 2.5 unemcl~vmen~ :'nsurance tax

.:i r e t 0 be \.; i t h he 1 d "i n t r L1 st.
IICal . - U • - Ca ~ . :: 0 d e § 9 8 6 • The
duty to keep Withheld taxes as a trust arises as the taxes
are withheld from wages regardless of the or~scribed dace for
~ayment to the government and does not termi~ate until the
taxes are paid over. ';stleforc ' I . U.S., 75-1 U.S .T.C. I! 9464
( D. ~1 i nn. 1975).

During the ?eriod the funds are held i~ trust, the person
holding the f~ndsassumes, with a few except~ons discussed
~elow, the duties and resDonsibilities of a ~rustee as such
duties and responsibiliti~s are mandated under common law.
~arsh v. Home Federal Savinas & Loan Assn, 66 Cal. App. 3d
674, 136 Cal. Rptr. 180 (4th D.C.A. 1977). In general, a
trustee is a fiduciary and is bound to act in the highest
good faith toward his beneficiary, must make full disclosure
of material facts, must not acquire any adverse interest, and
must not use his position to gain any advantage over the
beneficiary or to make any special ~rofit. Cal. Civ. Code §§
2228-2233. A trustee normally should not ~ingle trust
property with his own, but if he do.es willfully mingle the
trust funds with property of his own, he is absolutely liable
for their safety and for the value of thei~ use. Cal. Civ.
Code §§ 2236.

A trustee has a general duty to invest funds for the

benefit of the beneficiaries, but he must account over to the
beneficiaries any interest earned. Cal. eiv. Code § 2262.
In investing, reinvesting, or otherwise managing trust property,
a trustee must exercise the judgment and care which people of
prudence, discretion, and intelligence exercise in the management
of their own affairs. Cal. eiv. Code § 2261. California law
provides a-fairly liberal description of the type of investment
a prudent person would make, including every kind of property,
real, personal, or mixed, and every kind of investment which
a prudent person might enter into. Id.

Notwithstandin~ the foregoing, the parties to the trust

may alter or waive any of the standard pro~isions and duties.
Rest. 2d, Trusts § 216. It is possible for the parties to a
trust arrangement to authorize commingling of funds, to authorize
the trustee to retain any income rrom the trust assets, and
.' : r. ~·1 arc r' 2 V i..J
>: tobe r .2 9, : 9S1
?age Three

:0 consent ~o various ki~ds of investmen~s. The ~ase G[

:·;acsh Va HOi7le Federal Savir.qs &. Loan Assn. I 66 C::. ';?p . .,)0
6 7 4 , 1 36 Cal.. R~ t: r--:. 1 8 0 (4 t h D. C .. rl.. 1 9' 7 7), i spa =- tic u 1 a t 1 Y
instructive. At issue in Marsh was the proprie~~ and
:egality or ':he lIimpoundll or llreserve" accounts :::.lstomar-ily
required by savings and loan 2ssocia~ions and ba~Ks in
connection with residential ~ortgages to insure ~ayment of
~axes and insurance.. The suit was a class action seeking
general and punitive damages and seeking an acco~nting of
interest on the impound accounts, which were customarily held
~ithout interest.

The Court first determined that the impound accounts

~onstituted trusts, not escrOws. It then considered in
detail the nature of a trust and the duties of a trustee,
observing that the beneficiary of ' the trust may ~aive the
right to any income and may authorize the commingling of
Eunds. Thus, the Court noted that the deed of trust authorizing
the impound account stated specifically that the payments by
the plaintiff would be held by Home Federal "in its general
fund without interest," and concluded that the parties had
agreed that the trustees could commingle and use the trust
funds, but did not have to account for any interest earned.
9.

The statute and cases indicate that the trust funds

created by I.R.C. § 7501, Cal. U. Com. Code § 986, and Cal.
U. Com. Code § 13070 are subject to some modification of the
general rule. Thus, although normally a trustee must segregate
the assets of a trust and not commingle the assecs with his
personal funds, see Cal. eiv. Code § 2236, it is not generally
required that the-Iunds withheld for taxes be held separately
from the general accounts of the corporation or chat they be
deposited in a separate bank account, Slodov v. ~.S., 436
U.S. 238, 78-1 U.S.T.C. ,[ 9447 at 84,206 (1978); Newsome v.
U.S., 431 F.2d 742, 70-2 U.S.T.e. ~ 9504 at 84,1~9 (5th Cir.
1970). The Treasury or the Franchise Tax Board, as the case
may be, may specially require that withheld taxes be put into
separate accounts, however, in the event the employer has
failed previously to make appropriate deposits, payments, or
returns for such taxes, I.R.C. § 7512; Cal. Rev .. & Tax. Code
5 18492.

Furthermore, there is nothing in the statute or any

regulation or case with which we are acquainted to imply that
the government is entitled to any additional interest on the
trust funds doring the period such funds are held in trust.
Thus, it would follow that if an employer decided to forego
interest on the trust funds, he, too, could do so.
:·1 r. :·1.3 r c ? a \. i 3-
Oc tobe r :2 9, 1981
?age four

~ole of Co11ec~ing Ager.~

The foregoing discussion has considered the situation of

an emclover. There does noe appear to be any case law, regula-
tion, or statute dealing wit~ an :~dependent agent who actually
pays over the taxes to the sovernment. The funds presumably
are still trust funds, and che holder of those funds still
bears the responsibilities of a trustee. Presumably, however,
the collecting agent may use the f~nds in the same manner as
the employer ~ight have, ana is noe required, insofar as the
Internal Revenue Service or the Franchise Tax Board are
concerned, to segregate the =unds from the general fund of
the collecting agent.

Penalties

The normal penalty for a breach of fiduciary duty by a

trustee is the amount of the loss to the beneficiary. A simi-
lar penalty is imposed by I.R.C. § 6672 or Cal. Rev. & Tax.
Code § 18815: any person required to collect, account for,
and pay over withholding taxes who willfully fails to collect,
account for, or pay over such tax, is liable for a penalty
equal to the total amount of the tax evaded, not collected,
not accounted for, or paid over. ~

The test is " w illfullness." Basicallv, "willfullness"

does not require anintent to deprive the government of its
taxes, Newsome v. U.S., suora, 70-2 U.S.T.C. at 84,151, but
can be evidenced merely by use of the withheld funds for any
other corporate purpose, regardless of any expectation that
adequate funds would be available at the due date for the
taxes. WavchofE v. U.S., 79-2 U.S.T.C • • 9602 at 88,195
(S.D. Tex. 1979). Any person who voluntarily and consciously
risks the withheld taxes in the operation of a corporation is
subject to liability under I.R.C. § 6672 (Cal. Rev. & Tax.
Code § 18815) if subsequently the corporation is unable to
remit the withheld taxes. ~ewsome v. U.S., supra.

In addition to the civil penalties, however, there are

also ciminal penalties. I.~.C. § 7202 provides that any
person required to collect, account for, and pay over any tax
who willfUlly fails to collect, account for, or pay over such
tax shall be guilty of a felony and, upon conviction thereof,
shall be fined not more than S10,000, or imprisoned not more
:·lr. :·larc Pa'.'.:..3
October 29, :981
?age Five

than five years. o~ both, together with the costs of prosecu-

tion. Cal. Kev. & Tax. Code § 19408 imposes a fine of nat
mOre than $2,000 or imprisonment [no staeed maximuml, or both
for the similar offense. Although the penalties under these
sections have been imposed only rarely and only in particularly
egregious situations, there is considerable need to be con-
cerned about the potential criminal penalties as well.

If you have any questions or comments.concerning the

foregoing, please do not hesitate to contact us.

t;;jY,
~id L. Kimpert

DLK/aw

..