In the Matter of Avildsen Tools & Machine, Inc., a Delawarecorporation, Debtor-appellant.edward B. Avildsen and Morton Balon, Plaintiffs-appellants, v. United States of America, Defendant-appellee, 794 F.2d 1248 (7th Cir. 1986)

The appellants-taxpayers, Avildsen Tools & Machine, Inc., Edward Avildsen and Morton Balon, two of Avildsen Tools' officers, appeal the district court's order reversing a bankruptcy court decision and imposing a 100 percent assessment penalty, pursuant to 26 U.S.C. § 6672, for failure to pay corporate withholding taxes in violation of 26 U.S.C. § 7501. We affirm.

* The first case in this appeal, No. 84-2739, arose from the United States' appeal of an order of the United States Bankruptcy Court for the Northern District of Illinois finding that the appellants' corporation had made a voluntary payment to the IRS for their delinquent trust fund taxes. The second case, No. 85-1049, is an income tax refund action commenced by the appellants to recover a partially-paid tax assessment under section 6672 of the Internal Revenue Code of 1954. Since the determination of liability is dependent on the resolution of the same issues of fact and law, we consolidated these cases for purposes of appeal.

The record reveals that on July 12, 1977, Avildsen Tools & Machine, Inc. filed a petition for an arrangement under Chapter XI of the Bankruptcy Act of 1898 (formerly 11 U.S.C. § 701 et seq. 1976) (repealed 1978). Immediately after the filing of the bankruptcy petition, the corporation was appointed debtor in possession in order to operate the business during the reorganization. At the time of the bankruptcy petition, the corporation had failed to pay the government the corporate income taxes and the taxes withheld from its employees' paychecks (or "trust fund" taxes) for the 1977 tax year.¹  The government, in order to protect its claim against the corporation, filed a proof of claim with the bankruptcy court for the delinquent taxes. Three years later, after failing to present a viable plan to reorganize the company as a going concern, the officers of the corporation agreed that it would be in the best interest of the corporation to sell all of its assets. The case was not formally converted to a liquidation proceeding since the corporation was to continue as a shell to take advantage of its tax loss carry forward. On July 15, 1980, the corporate assets were sold pursuant to a court order to International Fastner Research Corporation for $2 million. The bankruptcy court confirmed the sale and specifically ordered the corporation to pay one of the corporation's secured creditors and the expenses that the corporation incurred during the time it acted as the debtor in possession of the bankruptcy estate.

On July 22, 1980, pursuant to the court order, the corporation tendered a check for $107,825 to the Internal Revenue Service ("IRS") in partial satisfaction of its prepetition tax liabilities. The check's endorsement stated that the entire amount was to be applied to the outstanding withholding taxes or trust fund taxes due the government. A Ms. Zeh, a special procedures staff technician with the IRS, received the check and applied it in accordance with the endorsement. During the fall of 1980, the corporation's attorney and the IRS negotiated, and eventually agreed to settle, the remaining corporate tax liabilities. The corporation subsequently realized that it did not have sufficient funds available to pay the agreed upon non-trust fund taxes and therefore informed the IRS that it would not pay the agreed upon settlement amount.²  Apparently, the corporation failed to pay the State of Illinois for taxes it incurred after filing its petition for bankruptcy and the parties believed that the funds the corporation previously expended to pay its tax debts to the United States might have to be recovered by the bankruptcy estate and redistributed to the State of Illinois.³  In light of the fact that the government might have to return the funds to the bankruptcy court and its belief that the $107,826 payment was not voluntarily made to the IRS, the district counsel for the IRS, on March 6, 1981, directed its staff to reapply the payment against the non-trust fund taxes due the government and assess a penalty, pursuant to section 6672, against the officers of Avildsen for failure to remit to the government its employees' withholding taxes.⁴ 

Thereafter, the appellants requested and received an order from the bankruptcy court directing the IRS to reapply the payment to the trust fund taxes. See In re Avildsen Tools & Machines, Inc., 30 B.R. 911 (Bankcy.N.D. Ill. 1983). To support its decision, the bankruptcy court, citing our recent decision in Muntwyler v. United States, 703 F.2d 1030 (7th Cir. 1983), held that the corporate payment of taxes to the IRS was voluntarily made and thus the corporation was entitled to direct the IRS to apply the payment against the delinquent trust fund taxes. In re Avildsen Tools & Machine, Inc., 30 B.R. at 918. The bankruptcy court also held that an implied contract arose between the IRS and the taxpayer when the IRS originally agreed to accept a check for repayment of the trust fund taxes and that the IRS was bound by the "terms of that contract." Id. The IRS appealed to the district court. That court reversed the bankruptcy court's decision, finding that since the corporation had made its payment to the IRS during the period of time it was reorganizing under Chapter XI of the Bankruptcy Act the corporation's payment was not voluntary and thus the corporation had no right to direct the application of the payment to the type of liability it chose. In re Matter of Avildsen Tools & Machine, Inc., 54 A.F.T.R.2d (P.H.) 5398 (N.D. Ill. 1984), 40 B.R. 253. The district court also found that there was no binding agreement between the IRS and the taxpayer to apply the payments against the trust fund portion of the delinquent taxes since there was no legal consideration for the alleged agreement. Id.⁵ 

On appeal, the appellants reassert their argument that the payment to the IRS was voluntarily made and thus they could direct the IRS to credit their delinquent trust fund taxes. In the alternative, the appellants argue that the IRS "should be required to apply the debtor's funds pursuant to the conditions under which it accepted them." Finally, the appellants ask this court to award them attorney fees if they are successful in this appeal.

II

In Muntwyler v. United States, 703 F.2d 1030 (7th Cir. 1983), a panel of this court set forth the standard in this circuit for determining when a payment made by the taxpayer to the IRS is to be considered voluntary. The distinction between a voluntary and an involuntary payment is important since " [w]hen a taxpayer makes voluntary payments to the IRS, he has a right to direct the application of payments to whatever type of liability he chooses." Id. at 1032 (citing O'Dell v. United States, 326 F.2d 451, 456 (10th Cir. 1964)). When the payment is involuntary, the IRS's policy is to apply the payment to the non-trust fund taxes due the government. Muntwyler, 703 F.2d at 1032 (citing IRS Policy Statement P-5-60, reprinted in Internal Revenue Manual (CCH) 1305-15). The officers of the corporation, who are responsible for payment of the trust fund taxes, then become personally liable for the shortfall in the payment of the trust fund taxes. See 26 U.S.C. § 6672 (1978). The IRS's policy in applying involuntary payments initially against non-trust fund taxes is consistent with the purposes of section 6672 to encourage those persons charged with the collection of the withholding taxes from employee wages to pay these sums to the government;⁶  this policy is also consistent with the underlying purpose of the Revenue Code to award those taxpayers who voluntarily comply with the tax laws. See Muntwyler, 703 F.2d at 1032. In Muntwyler our court adopted the definition of a voluntary payment contained in Amos v. Commissioner, 47 T.C. 65, 96 (1966): " 'An involuntary payment of Federal taxes means any payment received by agents of the United States as a result of distraint or levy or from a legal proceeding in which the Government is seeking to collect its delinquent taxes or file claim therefor.' " Muntwyler, 703 F.2d at 1032.

In Muntwyler, the company created a common law, non-judicial trust and assigned all of its assets to the trust for the benefit of its creditors. The IRS did not levy upon the property in possession of the trustee for the withholding taxes owed to the government; rather, it filed a claim with a trustee for the taxes due. The trustee sent the IRS a check that was restrictively endorsed noting that the funds were to be applied against the delinquent trust fund taxes; the IRS accepted the check but applied it against the outstanding non-trust fund taxes rather than the outstanding trust fund taxes. Applying the definition of voluntariness recited in the Amos decision, our court held that the IRS's action in merely filing a claim for the taxes with the trustee did not convert the trustee's subsequent payment to the IRS into an involuntary payment and thus the trustee was entitled to direct the IRS to apply its payment to the trust fund portion of the taxes owed to the government. In determining that the mere filing of a claim with the common law trust was insufficient to make the subsequent payment by the taxpayer to the IRS involuntary, the panel in Muntwyler relied on the absence of any court involvement in the filing of the IRS claim:

"The distinction between a voluntary and involuntary payment in Amos and all the other cases is not made on the basis of the presence of administrative action alone,but rather the presence of court action or administration action resulting in an actual seizure of property or money as in a levy."

Id. at 1033 (emphasis added).⁷ 

We do not have to decide whether a payment for delinquent pre-bankruptcy petition taxes made to the government while the corporation is in bankruptcy is voluntary or involuntary since even if we agree that the payment to the government in this case is voluntary, the government was within its rights to reapply the payment since the corporation breached the alleged agreement with the government to settle the amount owed for the delinquent pre-bankruptcy petition taxes. Specifically, in the second part of their brief, the appellants argue that the IRS "should be required to apply the debtors' funds pursuant to the conditions under which it accepted them." Essentially, the appellants argue that a contract arose between the corporation and the IRS when the IRS originally accepted the check and applied the funds consistent with the check's limited, restrictive endorsement directing that the funds be used to pay the trust fund portion of the corporation's delinquent taxes. It is hornbook law that " [i]f the written terms of the draft expressly designate [ ] the purpose for which the payment was made, such designation, upon acceptance of the draft, [becomes] an integral part of the parties' agreement." (Emphasis added). See, e.g., Coastal Plains Development v. Tech-Con Corp., 531 S.W.2d 143 (Ct.Civ.App. Tax 1975); National Bank of Harvey v. Pauly, 280 N.W.2d 85 (N.D.1979); AmJur Bills & Notes Sec. 66 (noting "marginal notations placed on a bill or note at the time of the execution thereof with the intention of making them part of the contract constitute a part of the contract, and must be construed with the body of the instrument to arrive at the true agreement existing between the parties.") However, it is equally true that when one party fails to substantially perform his part of the contract, the other party is not bound by the contractual terms and may rescind the agreement. 4A A. Corbin, Contracts Sec. 1104, at 558, 562-64 (1964); See, e.g., C.G. Caster Co. v. Regan, 88 Ill.App.3d 280, 43 Ill.Dec. 422, 426, 410 N.E.2d 422, 426 (1980) (noting it is well-established that a party "may terminate or rescind a contract because of substantial non-performance or breach by the other party"); Builder's Concrete, etc. v. Fred Faubel & Sons, 58 Ill.App.3d 100, 15 Ill.Dec. 517, 521, 373 N.E.2d 863, 867 (1978) (same); Kampmann v. McInerney, 258 Wis. 432, 46 N.W.2d 205, 207 (1951).

In the instant case, we will accept, for the purpose of argument, the appellant's assertion that an "agreement" arose between the taxpayer and the IRS to apply the corporate funds against the delinquent trust fund taxes when the government accepted the corporation's check with the limited restrictive endorsement. Specifically, Johanna Zeh, an IRS tax technician, accepted the check and applied it according to the terms of the limited endorsement on the check of July 22, 1980.⁸  The appellants then sought to settle the remaining corporate tax liabilities. The appellants sent a letter dated August 29, 1980, to the Tax Division of the Department of Justice offering to pay $12,000 in settlement of the corporation's remaining corporate tax liabilities. Government Exh. A. On October 15, 1980 the government accepted the defendant's offer to settle the remaining tax liabilities for $12,000 upon the condition that the company also agree to pay the government any future tax refunds resulting from the corporations' tax loss carry forwards or carrybacks. Government Exh. B. The corporation accepted the modified settlement offer on October 17, 1980. Government Exh. C. However, on February 17, 1981, Avildsen sent a letter to the IRS repudiating the settlement agreement stating that the corporation was no longer "in the position to pay $12,000 to the government." Government Exh. E.

A settlement of a tax dispute with the IRS requires a closing agreement or compromise. 26 U.S.C. § 7121, 7122.⁹  In this case, the corporation owed the government approximately $170,000 in delinquent, pre-bankruptcy petition taxes consisting of $107,000 in delinquent trust fund taxes and $63,000 in non-trust fund taxes (employer FICA taxes) and penalties. Thus, any agreement to settle the pre-bankruptcy petition taxes would have to encompass the entire $170,000. The corporation presented the $107,000 check in payment of the delinquent trust fund taxes and IRS staff technician Zeh agreed to apply the $107,000 check accordingly. The Tax Division of the Justice Department then agreed to accept $12,000 as a down payment on the non-trust fund delinquent taxes and conditioned the acceptance of this payment as a settlement of the remaining pre-petition tax liabilities upon the promise of the company to pay to the government any future tax refunds arising from the corporation's tax loss carryforwards and carrybacks. If the corporation had paid the $12,000 in settlement of the remaining delinquent prebankruptcy taxes, the corporation would have honored its end of the agreement. The corporation, however, breached this agreement when it notified the Justice Department that it was financially unable to pay the $12,000 and thus to fulfill the terms of the "contract." Because of the corporation's breach of the agreement to settle the corporation's delinquent taxes, the government was entitled to withdraw its acceptance of the alleged terms of the agreement entered into between the corporation and the government and apply the corporation's check as it saw fit in this instance to the non-trust fund portion of the delinquent pre-bankruptcy petition taxes. See Broussard v. United States, 352 F. Supp. 685, 688 (W.D. La. 1972) (taxpayer not entitled to refund for amount payed to government after government rejected compromise agreement since the taxpayer still owed the government the amount due); cf. In re Tom Le Duc Enterprises, Inc., 47 B.R. 900 (D.Mo.1984) (noting that in the absence of a designation or agreement as to how tax payment is to be applied, IRS may apply the payment received against any amount owed). We hold that under the facts of this case a valid agreement settling the corporate pre-petition tax liabilities no longer existed once the corporation failed to fulfill the terms of its agreement with the government, and thus the appellants have no valid basis for claiming that the government is bound by the check's restrictive endorsement.¹⁰ 

The decision of the district court is modified and AFFIRMED, and costs for this appeal are awarded to the government.

RIPPLE, Circuit Judge, concurring.

I agree that the judgment of the district court must be affirmed. In my view, the district court correctly concluded that the tax payment in question, made when the bankruptcy proceeding had been converted to a de facto liquidation, was not voluntary. Muntwyler v. United States, 703 F.2d 1030 (7th Cir. 1983), is not, by its own language, controlling in a situation such as the present one where the available funds are being distributed pursuant to the judicial supervision of a bankruptcy court. Id. at 1033, 1034 n. 2. Since the payment was not voluntary, the corporation had no right to direct its application to the type of liability it chose.