If a business customer wants to use our bank to pay its employees through ACH transactions, could we be liable for the customer’s payroll taxes if they overdraw their account with us when initiating payroll payments? We are not providing any payroll processing services. The customer would calculate the wages and tax withholdings on its own and use our online system to make payroll payments via ACH.

Yes, we believe that your bank might face potential liability for honoring a customer’s overdraft in order to permit the customer to cover wages, provided that your bank is deemed to have knowledge that the employer lacked the intent or ability pay its payroll taxes. However, this issue has not been settled in Illinois; we recommend consulting with bank counsel before entering into an arrangement where your bank may honor overdrafts for a customer to cover its payroll obligations.

The Internal Revenue Code provides that if a bank supplies funds to an employer to pay wages, and knows that employer does not intend to or will not be able to cover payroll taxes on those wages, the lender is liable for the taxes and interest from date they were due.

While we are not aware of any courts in Illinois that have applied this provision to overdrafts, federal appellate courts outside of Illinois have determined that honoring an overdraft to cover payroll may constitute “supplying funds” within the scope of this provision. In one case, the court identified a number of factors for determining a bank’s liability for honoring an overdraft, such as the account agreement, the frequency, amount and duration of overdrafts, and the bank’s overdraft approval procedure — all of which must be evaluated to determine if the bank had the requisite knowledge of the employer’s lack of intent or ability pay the taxes.

For resources related to our guidance, please see:

Internal Revenue Code, 26 USC 3505(b) (“If a lender, surety, or other person supplies funds to or for the account of an employer for the specific purpose of paying wages of the employees of such employer, with actual notice or knowledge (within the meaning of section 6323(i)(1)) that such employer does not intend to or will not be able to make timely payment or deposit of the amounts of tax required by this subtitle to be deducted and withheld by such employer from such wages, such lender, surety, or other person shall be liable in his own person and estate to the United States in a sum equal to the taxes (together with interest) which are not paid over to the United States by such employer with respect to such wages. However, the liability of such lender, surety, or other person shall be limited to an amount equal to 25 percent of the amount so supplied to or for the account of such employer for such purpose.”)
IRS Rules, 26 CFR 31.3505-1(b)(1) (“A lender, surety, or other person who (i) Advances funds to or for the account of an employer for the specific purpose of paying wages of the employees of that employer, and (ii) At the time the funds are advanced, has 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, make timely payment or deposit of the amounts of tax required by subtitle C of the Code to be deducted and withheld by the employer from those wages, shall be liable in his own person and estate for payment to the United States of an amount equal to the sum of the taxes . . . and interest from the due date of the employer's return relating to such taxes. . . .”)
U.S. v. First Nat. Bank of Circle, 652 F.2d 882, 889 (9th Cir. 1981) (“Under the proper circumstances, honoring of overdrafts may constitute a method for supplying funds within the reach of Section 3505(b). Whether the overdrafts in this case result in liability for withholding taxes on the Bank’s part depends on whether the evidence establishes that by honoring the overdrafts, the Bank ‘supplie(d) funds . . . for the specific purpose of paying wages . . . with actual notice or knowledge . . . that such employer does not intend to or will not be able to make timely payment or deposit of the . . . tax.’ A trial is required for the resolution of that issue. The following relevant factors among others should be considered by the court in making its determination: (1) The agreements and understandings between the parties with respect to the honoring and repayment of overdrafts; (2) The frequency, amount and duration of overdrafts; (3) The purposes for which the funds obtained by overdrafts were used; (4) The procedures for approval of overdrafts by bank officials; (5) The transactions between the Bank and other participating banks with respect to overdrafts; and (6) The documentary record relating to the overdrafts.”)