Most taxpayers readily accept that they may be liable for various taxes based on, among other things, their income, the goods they buy and the wages they pay to their employees. On the other hand, the average person would cringe at the thought of being held responsible for tax obligations generated by the activities of an unaffiliated third-party. Commercial lenders, however, are routinely faced with this possibility when lending to distressed borrowers, yet many may not know such potential liability exists under the Internal Revenue Code (and has since the mid-1960s).
Pursuant to Section 3505(b) of the Internal Revenue Code, if a lender advances funds to a borrower for the specific purpose of paying such borrower’s employees, the lender may be held liable to the United States for such borrower’s employment taxes if the advance is made with the actual notice or knowledge that the borrower does not intend to or will not be able to make timely payment or deposit of such taxes. The lender’s overall liability will be capped at 25% of all funds disbursed to the borrower for payroll purposes, but the thought of incurring any penalty while funding a distressed borrower is likely to be unsettling at best.
As is often the case with tax analysis, the devil is in the details and whether the two primary requirements for liability – that the loan be specifically for payroll and that the lender have actual notice or knowledge of the borrower’s inability or intent not to pay – are met will depend on the specific facts at hand. For example, where the parties have an express agreement that the lender will fund a borrower’s payroll, a specific purpose can easily be found. The water becomes murky, however, when a general working capital line (which is normally exempted) allows funds to be earmarked for payroll purposes or when a lender knows that substantially all of a borrower’s general working capital expenses consist of salaries and wages. With respect to the second requirement, the statute does not require a lender to actively patrol the use of all loan funds, but notice or knowledge will include the situation where an individual loan officer is actually aware that a borrower will be unable to pay its employment taxes even if there are no broader warning signs.
In order to minimize exposure to potential lender liability under Section 3505(b), a lender should consider (i) educating its loan officers regarding Section 3505, (ii) including provisions in their loan documentation that allow the lender to make direct payments of payroll taxes and add such payments to the loan balance, (iii) requiring a borrower to use a third-party payroll services company that will ensure the proper payment of all withholding taxes, (iv) requiring a borrower to execute an appropriate Form 8821 to permit the lender to directly monitor or inspect the borrower’s confidential tax information, and (v) documenting the assurances received from a distressed borrower regarding its timely payment of all payroll taxes.