When You Fund Someone Else's Payroll: Lender, Surety and Contractor Liability Under IRC 3505

Construction projects stall when a subcontractor cannot make payroll. Lenders get asked to fund "just this one" payroll. Investors and parent companies prop up a struggling subsidiary. In each case, someone other than the employer puts money into the employees' hands.

IRC 3505 makes that someone potentially liable for the withholding taxes the employer never paid over. It is a different tool from the Trust Fund Recovery Penalty, with different rules and a different collection process.

Two Kinds of Liability

Section 3505(a): paying wages directly

Section 3505(a) says that if a lender, surety or other person, who is not the employer, pays wages directly to employees of one or more employers, or to an agent on their behalf, that person is liable in its own person and estate for the taxes, with interest, required to be deducted and withheld from those wages.

IRM 5.17.7.3.1 explains who the "other person" usually is. It includes anyone similar to a lender or surety who pays another's employees out of its own funds, and the most common example is a prime or general contractor that, by necessity or contract, pays net wages directly to a struggling subcontractor's employees to keep them on the job. The IRM notes that section 3505(a) does not apply to someone acting only as agent of the employer or of the employees, citing the examples in Treasury Regulation 31.3505-1(c).

The IRM also warns that the IRS and courts look at substance. Direct payment of net wages may be found even when a subterfuge, like a special payroll account funded and controlled by the contractor, is used to disguise it.

Section 3505(b): supplying funds

Section 3505(b) covers the lender that does not write the paychecks but provides the money. A lender, surety or other person that supplies funds to or for an employer for the specific purpose of paying wages, with actual notice or knowledge, within the meaning of section 6323(i)(1), that the employer does not intend to or will not be able to timely pay or deposit the withholding, is liable for the unpaid withholding on those wages, with interest.

There is a cap. The statute limits the liability to 25 percent of the amount supplied for that purpose. IRM 5.17.7.3.2 says the 25 percent limit includes accrued interest and gives an example: a lender that advanced $100,000 for net wages can be sued for up to $25,000, even if the employer's assessed withholding plus interest is higher.

Who Counts as a Supplier of Funds

IRM 5.17.7.3.2 lists examples the IRS treats as section 3505(b) persons:

• a prime or general contractor that supplies funds directly to a subcontractor to meet net payroll, knowing the subcontractor cannot pay its withholding taxes;
• a shareholder, including a parent company, that makes a capital contribution or direct loan, or puts up collateral for a third-party loan, to be used to pay net wages; and
• a bank that honors a customer-employer's overdrafts for payroll checks.

The Two Conditions for 3505(b)

IRM 5.17.7.3.2 says both of these must exist:

1. The funds were for wages. The supplier must know the funds are to be used for wages. The IRM says this does not include an ordinary working capital loan made to meet current obligations generally. But it adds that if the lender has actual notice or knowledge when advancing an ordinary loan that some of it will pay net wages, section 3505(b) applies regardless of what the written agreement says, citing Treasury Regulation 31.3505-1(b)(3).
2. Actual notice or knowledge of non-payment. The supplier must have actual notice or knowledge, when the funds are advanced, that the employer does not intend to, or will not be able to, timely pay or deposit the withholding. The IRM says the burden of establishing actual notice or knowledge is on the government. It also states the IRS position that knowledge of the supplier's agent is imputed to the supplier, even if the agent concealed it.

When Knowledge Counts

Timing of knowledge is central under section 3505(b). The statute looks at whether the supplier had actual notice or knowledge when the funds were supplied. IRM 5.17.7.3.2 explains that a lender has actual notice or knowledge of a fact from the time it is brought to the lender's attention, or would have been brought to its attention if the organization had exercised due diligence. A lender that funded payroll for months before learning of the problem is in a different position for those earlier advances than for the ones made after the warning signs appeared.

What Is and Is Not Covered

Under IRM 5.17.7.3.1, section 3505(a) liability extends to withheld income tax under section 3402, withheld employee FICA under section 3102, and withheld railroad retirement tax under section 3202. It does not extend to the employer's share of employment taxes or to penalties imposed on the employer. IRM 5.17.7.3.2 says the same about penalties under section 3505(b).

The employer remains responsible. The IRM says the employer still must file Form 941 and meet its other obligations. Under section 3505(c), amounts paid by the third party are credited against the employer's liability, and the IRM adds that the employer's payments reduce the third party's liability too.

How the IRS Collects

This is a key difference from the Trust Fund Recovery Penalty. IRM 5.17.7.3.3 says that under both section 3505(a) and (b), if the third party does not voluntarily pay, the government may collect only by a court proceeding. The suit must be brought within 10 years after the assessment against the employer. The IRM also states the IRS position that it is not required to give the third party notice and demand before suing.

By contrast, the TFRP can be assessed and collected administratively. The IRM notes that section 6672 has advantages over section 3505, such as the ability to assess and collect administratively, and tells Revenue Officers not to overlook it. That matters because a lender, surety or contractor can also be a responsible person under section 6672 if it controlled the employer's finances. IRM 5.7.3.4.1 lists surety lenders and other persons outside the delinquent business among potentially responsible persons.

Sureties on Federal Construction Projects

There is a separate rule for performance bonds on federal construction. IRM 5.17.7.4 explains that under the Miller Act, 40 U.S.C. 3131, every performance bond on a federal construction project must guarantee payment of federal payroll taxes required to be collected, deducted or withheld from wages by the contractor. The IRM describes strict timing: the government must notify the surety within 90 days after the contractor actually files a return for the period, or within 180 days after the return was due if not timely filed, and must sue within one year after timely notice.

Practical Guidance

For general contractors

• If you must pay a subcontractor's workers to keep a job moving, recognize you may be stepping into section 3505.
• Consider paying gross wages and depositing the withholding yourself, or confirming deposits before releasing funds.
• Document what you knew about the subcontractor's tax compliance when you paid.

For lenders and investors

• Know the purpose of each advance. Funds earmarked for payroll are what section 3505(b) targets.
• If you learn a borrower is not depositing withholding, understand that later payroll funding is made with that knowledge.
• Remember that your agents' knowledge may be imputed to you under the IRS's position.

For the employer

None of this relieves the employer or its responsible persons. The IRS collects the withholding only once in total, but it may pursue the employer, the responsible persons and a section 3505 party in parallel. See our multiple responsible persons guide for how credits work among them.

For more on the firm's payroll tax practice, see the main site's payroll tax page.

Paying someone else's payroll can feel like a rescue. Under section 3505, it can also be an assumption of their tax problem. Know which one you are signing up for. Call (813) 229-7100. Let's talk.