January 2019 Edition
by Jordan R. Pavlus, Esq., Byrne, Costello & Pickard, P.C.
It has long been known that a statutory system whereby construction funds are to be held in “trust” for beneficiaries is favorable to subcontractors. There are many reasons for this, but the crux behind it is that payments received by general contractors do not actually belong to them; they are trust funds to be paid to trust fund beneficiaries before they are applied for any other purpose. This can be absolutely critical when a subcontractor is seeking to enforce its right to payment. However, it can also be critical when a taxing authority is attempting to collect funds from a general contractor, but the subcontractor is also owed monies for work performed for that same general contractor on a construction project.
Perhaps this scenario sounds familiar, a general contractor is having some financial difficulties. Payments to the subcontractor start out late, then stop altogether. The subcontractor learns that the general contractor is being pursued by the Internal Revenue Service for unpaid taxes and that the IRS has issued a notice of levy to various parties who may be holding funds which are owed to the general contractor. As between the IRS and the subcontractor, who has a right to those construction funds?
The court in Kemper Insurance Companies v. State of New York, 70 A.D.3d 192 (3rd Dept. 2009) decided that precise issue. The underlying construction matter involved the reconstruction of a roadway. The general contractor posted payment and performance bonds for the project. Ultimately the State of New York declared the contractor in default and terminated it from the project. Id at 193. Thereafter, the surety agreed to complete the project in accordance with the performance bond. At the time of the termination, New York State was holding $579,779.68 which was due or to become due to the general contractor on the project.
Subsequent to the surety taking over the project, the IRS issued a notice of levy to New York State for tax obligations owed by the general contractor. Approximately seven months later, the IRS issued a second notice of levy. In response to the second notice of levy, the NYS Comptroller issued a payment of $579,779.68 to the IRS, using funds from the road reconstruction project. The Comptroller did not inquire whether the tax obligations in the notice of levy arose from the road reconstruction project. The surety was not advised of the notices of levy or payment from the NYS Comptroller to the IRS. Id at 194.
The surety completed the project and satisfied all of its obligations in accordance with the performance bond and thereafter sought payment from the State of New York. The sums paid to the surety did not include those paid to the IRS and were thus insufficient to complete the work and cover payment to the surety’s laborer’s, suppliers and others under the payment bond, thereby causing the surety to incur a loss.
The surety took the position that the State of New York had wrongfully diverted the contract funds and breached the takeover agreement entered into pursuant to the performance bond.
In analyzing the matter, the court noted that under the Internal Revenue Code, any person in possession of property that is subject to a federal tax levy and not subject to attachment or execution under judicial process must surrender the property to the IRS upon demand. Id at 195. Refusing to honor a levy may result in being held liable to the United States for damages and a penalty. On the other hand, a person in possession of property subject to levy who honors a federal tax levy is discharged from liability to the delinquent taxpayer and any other person. Id.
However, like many areas of the law, there are exceptions to the rule. Immunity from liability is not absolute. A person who surrenders property to the IRS which is not subject to levy is not relieved of liability to a third party who has an interest in the property. 26 C.F.R. 301.6332-1[c].
The surety argued that the regulatory exception to immunity applied to New York State because the general contractor had no interest in the funds when they were turned over to the IRS and because New York State failed to make a good faith inquiry.
In its analysis, the court dealt with the interplay of federal tax laws and state property rights. It noted “[f]ederal laws do not themselves create property rights; instead, they attach consequences to property rights created by state laws. For this reason, in applying federal tax laws, state law controls in determining the nature of the legal interest which the taxpayer had in the property.” Id at 195-196 (internal citations and quotations omitted).
Turning to New York State property rights, the court noted that all funds under the roadway reconstruction project were subject to a statutory trust imposed by Article 3A of the Lien Law, which arose automatically upon execution of the contract. The trust res consists of not only funds received, but also the right to receive funds in the future, including prospective payments contingent on future performance. Id at 196.
Based upon those state property rights, the court held that because the general contractor had no apparent interest in the construction trust funds at the time when the funds were turned over to the IRS, New York State was liable for diverting those construction trust funds to the IRS.
Kemper Insurance is an important case because it can be applied equally to any state which has a statutory construction trust funds scheme. If the IRS issues a notice of levy for a general contractor and construction trust funds are paid to the IRS, instead of trust fund beneficiary subcontractors, the party who sent those funds to the IRS could be liable for a diversion of trust funds. Furthermore, a direct action may be brought against the IRS in federal district court to recover project funds (see 26 USC 7426).
Jordan R. Pavlus, Esq., leads the construction practice at Byrne, Costello & Pickard, P.C., Syracuse, N.Y. He focuses his practice on all facets of construction law, including subcontract drafting and negotiation, performance and payment bonds, mediation, arbitration and litigation. Pavlus regularly advises clients on the nuances associated with construction law, including bond claims, lien law, prompt payment law, and a broad variety of issues faced in the commercial construction field. He has served as lead counsel in numerous multi-million-dollar actions and multi-week arbitrations. Pavlus is a frequent lecturer on construction related issues. He can be reached at (315) 474-6448 or firstname.lastname@example.org.