The opinion of the court was delivered by: BRYAN
This is a petition to review an order of the referee in bankruptcy which granted priority to the costs and expenses of administration incurred in the present bankruptcy proceeding over the claim of the District Director of Internal Revenue for the Lower Manhattan District for income and social security taxes withheld by the debtor in possession in a superseded proceeding for arrangement under Chapter XI of the Bankruptcy Act, 11 U.S.C.A. § 701 et seq.
The facts may be briefly summarized as follows:
On May 26, 1954 Airline-Arista Printing Corp., the bankrupt, filed a petition for arrangement in this district under Chapter XI. The debtor was continued in possession and transacted business, pursuant to court order, until September 17, 1954 when it was adjudicated a bankrupt. During this period the debtor in possession withheld Federal income and social security taxes from the wages paid to its employees in the amount of $ 294.41. The amounts so withheld were not segregated by the debtor in possession and no special fund to cover them was established, although on June 1, 1954 the referee had entered an order directing the debtor in possession to separate these funds and hold them in a separate bank account. At all times the debtor in possession had assets of a value greater than the amount of the taxes which it had withheld and these assets came into the hands of the trustee. However, when bankruptcy ensued there remained only $ 34.83 on deposit in the debtor's general checking account.
Upon adjudication a trustee was appointed who took possession of the assets and proceeded to administer and liquidate the estate. The District Director duly filed a claim in the amount of $ 294.41 for the taxes withheld by the debtor in possession, claiming that such taxes constituted a trust fund for the United States under Sections 7501, 3102(a) and 3402(a) of the Internal Revenue Code, 26 U.S.C., which should be turned over to the Government. The trustee's final report showed that he had on hand the sum of $ 554.44. The unpaid expenses incurred in administration and liquidation after bankruptcy, including compensation to the trustee, his attorneys, the appraiser, the official stenographer and the clerk's fees for the referee's salary and expense funds exceeded the sum in the trustee's hands.
The trustee moved before the referee for an order directing that the costs and expenses of administration incurred in the bankruptcy proceeding be paid in advance of the unpaid costs and expenses of administration in the superseded Chapter XI proceeding. The District Director answered asserting that the withheld taxes constituted a trust res in favor of the United States, that the assets in the hands of the trustee were impressed with trust in the amount withheld, and that his claim should be paid in full prior to the costs and expenses of bankruptcy administration.
The learned referee held that the taxes withheld by the debtor were unpaid costs and expenses of the arrangement proceeding and nothing more, and that therefore the costs and expenses of bankruptcy administration should be paid in advance of the claim of the Director for such taxes, pursuant to the 1952 amendment to Section 64, sub. a(1) of the Bankruptcy Act, 11 U.S.C.A. § 104, sub. a(1), granting priority to costs and expenses of an ensuing bankruptcy proceeding over costs and expenses of a superseded arrangement proceeding.
This appears to be the first time that the question of the effect of the 1952 amendment upon the Government's right to priority payment of federal taxes withheld by a debtor in possession in a superseded arrangement proceeding over administration expenses in an ensuing bankruptcy proceeding has been before this court. While the amounts involved here are small the question is of some importance in the administration of bankrupt estates.
Prior to the 1952 amendment of Section 64, sub. a(1) it was the rule that taxes withheld by a debtor in possession in a superseded arrangement or reorganization proceeding constituted a trust res in favor of the taxing authority even though the money collected was not kept in a separate fund and could not be traced. Assets coming into the hands of the trustee were held to be impressed with a trust in favor of the Government in the amount of the withheld taxes which were given priority of payment over all administration expenses and other claims enumerated in Section 64, sub. a(1). City of New York v. Rassner, 2 Cir., 127 F.2d 703; Hercules Service Parts Corp. v. United States, 6 Cir., 202 F.2d 938; United States v. Sampsell, 9 Cir., 193 F.2d 154.
In the Rassner case the Court of Appeals for this Circuit held that the City of New York was entitled to restitution of City sales taxes collected by a debtor in possession in a superseded Chapter XI proceeding from any funds of the estate in the trustee's hands ahead even of expenses of administration, though such taxes were not segregated and were not traceable. This was because the vendor-debtor in possession was made a trustee of sales taxes collected under the City sales tax law
and the City was the beneficiary of such trust. Circuit Judge Clark, writing for the Court, said (127 F.2d at page 705):
'* * * When the petition was filed and the debtor continued operation, it acted as an officer of the bankruptcy court. Bankruptcy Act, §§ 342, 343, 11 U.S.C.A. §§ 742, 743. It was subject 'at all times to the control of the court.' § 342. And in operating the business it had to have 'authorization by and subject to the control of the court.' When the debtor was displaced by the bankruptcy trustee, there was no break in the continuity in relationship, for the order of adjudication related back and the original petition for an arrangement became the vital date. Bankruptcy Act, § 302, 11 U.S.C.A. § 702; cf. Lockhart v. Garden City Bank & Trust Co., 2 Cir., 116 F.2d 658, 660. The trustee in bankruptcy, so far as outsiders are concerned, must proceed subject to any claims available against the debtor in possession.'
He went on to say that a tracing of the funds withheld should not be required since it was the duty of the Bankruptcy Court in distributing an estate to do so equitably, and, as 'a proper part of equitable administration,' the court must protect a beneficiary of a trust whose funds have been misappropriated by its officer to the benefit of the estate.
United States v. Sampsell, supra, applied the same rule to social security and income taxes withheld by the debtor in possession in a superseded Chapter XI proceeding. Hercules Service Parts Corp. v. United States, supra, made the same holding with respect to income and social security taxes withheld by a debtor in possession in a superseded Chapter X proceeding. These cases followed the reasoning of the Rassner case.
The referee was of the view that these cases are no longer the law since Section 64, sub. a(1) was amended in 1952 by adding the following proviso:
'Provided, however, That where an order is entered in a proceeding under any chapter of this Act directing that bankruptcy be proceeded with, the costs and expenses of administration incurred in the ensuing bankruptcy proceeding shall have priority in advance of payment of the unpaid costs and expenses of administration, including the allowance provided for in such chapter, ...