In re Calabrese, No. 11-3793; Third Circuit; opinion by Hardiman, U.S.C.J.; filed July 20, 2012. Before Judges McKee and Hardiman and Jones, District Judge, sitting by designation. On appeal from the District of New Jersey. [Sat below: Judge Hillman.] DDS No. 42-8-7424 [20 pp.]

Appellant Michael Calabrese operated “Don’s What a Bagel Inc.,” which filed for reorganization under Chapter 11 of the Bankruptcy Code. After failing to confirm a reorganization plan, the bankruptcy was converted to Chapter 7. Calabrese also filed a bankruptcy petition under Chapter 13.

As proprietor of a restaurant, Calabrese was required by New Jersey law to collect sales tax from his customers. The New Jersey Division of Taxation filed several secured proofs of claim in his individual bankruptcy. He successfully moved to have the claims reclassified as unsecured. New Jersey then filed amended proofs of claim alleging that he owes $63,437.19 in taxes collected from 2003 to 2009. The bankruptcy court held the taxes are trust fund taxes under 11 U.S.C. § 507(a)(8)(C), which are never dischargeable, not excise taxes under § 507(a)(8)(E), which are nondischargeable if they are less than three years old, as measured from the date of the bankruptcy petition. The District Court affirmed.

Held: Because sales taxes collected by a retailer never become the property of the retailer, it retains those funds in trust for the state. Accordingly, Calabrese’s sales-tax obligation is subject to 11 U.S.C. § 507(a)(8)(C) and is not dischargeable.

The court says that § 507(a)(8) is susceptible to two applications to a sales tax owed by a third party and held by a debtor. Although neither (C) nor (E) is unclear, both may be read to apply to this kind of tax since, under New Jersey law, the tax is “required to be collected or withheld” and Calabrese “is liable for the tax in whatever capacity,” and the tax is an “excise tax” that is “a tax imposed on the manufacture, sale, or use of goods,” Black’s Law Dictionary 646 (9th ed. 2009). Thus, (a)(8) contains two clear but contradictory instructions that necessitate extratextual analysis to adjudicate this dispute.

Congress enacted the first version of what is now § 507(a)(8) as part of the Bankruptcy Reform Act of 1978. The House bill proposed a subsection (C) covering “taxes required to be withheld from wages, salaries, commissions, dividends, interest, or other payments that were paid by the debtor,” which would be dischargeable after two years, and a subsection (E) allowing for the discharge of excise taxes after one year. The Senate bill prohibited the discharge of “taxes required to be collected or withheld” regardless of age, and provided no priority for excise taxes.

The two chambers informally negotiated an agreement to compromise. In the process, Congress drafted several pieces of legislative history that suggest different views on how taxes like the one at issue should be prioritized, including a joint statement explaining various provisions of the compromise.

Also, the courts of appeals for the Second, Seventh, and Ninth circuits have considered the issue presented here. The court reviews those decisions, which, after analysis of the legislative history, all concluded that a sales tax paid by a third party is a trust fund tax under (C), not an excise tax under (E).

The court looks to the legislative history and says it reveals that the two chambers had different views on the dischargeability of various tax obligations. Through compromise, the House received its excise-tax prioritization, while the Senate received a broad trust-fund-tax priority, along with somewhat longer nondischargeability periods. Looking only to how the text of the bills impacted the statute, the court says it cannot determine where the third-party tax should fall, because each chamber inserted the provision that it had believed at one time would cover such a tax. It also hesitates to base its decision on the Senate and House reports that predated the compromise, or on 19th century bankruptcy law.

It says the joint statement is a reliable manifestation of the Legislature’s purpose, but concludes that its passing mention of sales taxes is of little importance because those words, when used alone, typically refer to taxes owed by the purchaser to the government, not to the third-party variety at issue here.

Faced with an ambiguous statute and an indefinite legislative history, the court turns to public policy and says these considerations cut both ways. Two broad purposes of the bankruptcy scheme are to give the debtor a new financial start and to keep creditors on an equal playing field. However, the incentives for a potential debtor like Calabrese would be quite perverse if, when he sees his business take a turn for the worse, he knows he might obtain a discharge of his debt if he refuses to turn over to the state sales taxes collected from third parties. The court concludes that the second consideration weighs more heavily.

It also finds it significant that third-party sales taxes resemble trust fund taxes more than other sales taxes even though the source of taxation is a sales transaction, i.e., they are not owed by the debtor, but are merely held by him on behalf of the party that owes the tax until transferred to the taxing authority. Using similar reasoning, Begier v. IRS, 496 U.S. 53, 64 n.5 (1990), concluded that taxes withheld by an employer under the Federal Insurance Contributions Act, 26 U.S.C. § 3102(a), are held in trust for the IRS even when improperly comingled with the employer’s general operating funds. The underlying principle — that the debtor is responsible for money in which he never had an equitable interest — is applicable here.

The court also notes that its decision is consistent with New Jersey’s treatment of its sales tax. That the Tax Court of New Jersey has recognized its sales tax is a trust fund tax when held by a business owner for the customer validates the court’s construction of § 507(a)(8).

For debtor-appellant — Nicholas S. Herron (Seymour Wasserstrum). For defendant-appellee — Ramanjit K. Chawla, Marlene G. Brown and Marikae G. Toye, Office of Attorney General of New Jersey. For trustee Isabel C. Balboa — Office of U.S. Trustee.