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Payroll firm can’t recoup clients’ money paid to IRS

FirstPay trustee sought millions paid within 90 days of Chapter 7 filing

The trustee for a bankrupt and scandal-ridden Silver Spring payroll processing company cannot recover nearly $28 million it paid on behalf of clients to the Internal Revenue Service in the 90 days prior to declaring bankruptcy, a federal appeals court has ruled.

FirstPay Inc. trustee Michael G. Wolff had sought the money as FirstPay Inc.’s estate seeks to recoup its losses in an 11-year-old involuntary bankruptcy.

The 4th U.S. Circuit Court of Appeals held that a Bankruptcy Code provision permitting bankrupt debtors to recover money paid within 90 days before filing does not apply to money held in trust and paid on clients’ behalf.

The debtor can recoup such payments only if the money constitutes “an interest of the debtor” —which the client funds here were not, the 4th Circuit said, in affirming lower court rulings.

The case arose in 2003, when FirstPay creditors forced the company to file a Chapter 7 petition amid allegations its owner, Mark Rothman, had skimmed about $11 million in clients’ funds it was contractually obligated to pay the IRS on their behalf. The missing funds were discovered only after Rothman’s death earlier that year.

Noting the company’s sordid history, the 4th Circuit on Friday made special mention of FirstPay clients who paid the company money that was never transferred to the IRS, as provided for under contract.

“We do not know how FirstPay decided which clients’ taxes it would pay and which it would not, and we regret that some of the clients remain liable to the IRS for tax payments they had entrusted funds to FirstPay to make,” Senior Judge Andre M. Davis wrote for the unanimous panel.

“But the employers assumed the risk of FirstPay’s mishandling of their funds when they selected the firm for vital payroll processing and tax reporting services,” Davis added. “We recognize that the government has made efforts to minimize distress to those employers who remain liable for taxes by, for instance, waiving otherwise applicable penalties and other measures. We expect that responsible government officials will continue to proceed with sensitivity to the realities of this painful situation in which these businesses find themselves.”

Applying Maryland trust law, the 4th Circuit concluded that the nearly $28 million paid within the 90-day period was not FirstPay’s property, but the company’s clients.

“All of the elements of a valid, express trust are satisfied in this case,” Davis wrote.

Wolff’s attorney, Jeffrey M. Orenstein, did not return telephone and email messages Monday seeking comments on the decision and whether an appeal is in the offing.

Wolff initially filed a complaint against the U.S. government in 2005, arguing that FirstPay was owed the $27,816,992.50 in payroll taxes it had paid to the IRS in the 90 days prior to filing for bankruptcy.

The U.S. Bankruptcy and, later, the U.S. District Court agreed with Wolff, saying the government had essentially conceded the company’s payment of client funds to the IRS on behalf of clients was a transfer of FirstPay’s own interest in property. But in August 2010, the 4th Circuit said the government made no such concession and remanded the case.

On remand, the U.S. Bankruptcy and District Courts concluded the money paid to the IRS was not FirstPay’s and thus not recoverable under the 90-day pre-filing provision.

On Friday, the 4th Circuit agreed.

Judges Diana G. Motz and Albert Diaz joined Davis’ published opinion in Wolff v. United States of America, No. 13-2116.