Surety's Interest Page3

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Extended consideration and analysis has been given to cases similar to the one here in several of the cited cases and little purpose would be served by extensively reviewing said authorities. For a compilation of applicable authorities and legal theories see Wolverine Ins. Co. v. Phillips, supra.

The United States relies on the cases of Phoenix Indemnity Co. v. Earle, 9 Cir., 218 Fed. (2d) 645 [55-1USTC ¶9179]; and U. S. v. R. F. Ball Const. Co., 355 U. S. 587, 78 S. Ct. 442 [58-1 USTC ¶9327]. It appears that the result in the first cited case was controlled by the sovereign character of the United States and the provisions of the Bankruptcy Act, neither of which factors are material in this case. In the Ball case the fund in question was admittedly property of the delinquent taxpayer and the only question was whether the interest of the claimant was perfected as against the tax lien of the United States .

A number of cases involving the same questions as is presently before the Court have been decided since the decision in the Ball case and it did not control the results,Aetna Cas. & Sur. Co. v. U. S. A., supra; Wolverine Ins. Co. v. Phillips, supra; Central Sur. & Ins. Co. v. Martin Infante Co., supra.

In accordance herewith, the plaintiff, General Insurance Company of America , is entitled to the said sum heretofore deposited with the Clerk of the Court in the sum of $11,834.08.

Counsel for the plaintiff shall prepare Findings of Fact, Conclusions of Law, and a Proposed Judgment, serve copies of the same on counsel for the defendant and submit the originals to the Court.

 

 

[58-2 USTC ¶9778]Charles W. Berry Houses, Aetna Casualty & Surety Company, Respondent v. United States of America, Appellant, and Horticultural Service, Inc., et al., Defendants, and another action (Lester W. Patterson Houses)

State of New York Court of Appeals, No. 75, 4 NY2d 639, 4/30/58

[1939 Code Sec. 3670--similar to 1954 Code Sec. 6321]

Tax lien: Fund withheld from contractor: Effect of state law.--Tax liens were asserted against funds withheld from a contractor who had not paid for labor and materials. Under New York law, a contractor who defaults in payment of laborers and materialmen has no right to and no property interest in the withheld funds. Since the contracts involved required payment of claims for labor and material as a condition precedent to the contractor's right to payment, there was not a substantial performance which would entitle the contractor to the funds. Consequently, the Federal tax liens did not attach to any of the withheld funds and the surety which performed under its bonds and completed the contracts was entitled to the funds. The Appellate Division erroneously awarded the Government $331 on the grounds that one tax assessment list had been received before the execution of one bond.

Paul W. Williams, United States Attorney, Foley Square, New York, N. Y., John S. Clark, for United States of America. M. Carl Levine, Morgulas & Foreman, 521 Fifth Avenue, New York, N. Y., Albert Foreman, for Aetna Casualty & Surety Co. Irving Wise, 299 Broadway, New York, N. Y., for New York City Housing Authority.

Opinion

CONWAY, Chief Judge:

In these two actions both the plaintiff Aetna Casualty & Surety Company and the defendant United States assert liens against two funds which the N. Y. City Housing Authority holds as the balance due under two contracts for the landscaping of two public housing projects. This case was tried on stipulated facts. Horticultural Service Inc. entered into two contracts with the Authority, one on October 28, 1949 to landscape the Charles W. Berry project, and the other on January 24, 1950 to landscape the Lester W. Patterson project. Under these contracts Horticultural was required to procure bonds to secure the performance of the contracts and the payment of laborers, materialmen etc. Aetna, as surety, issued these Performance and Payment Bonds, those for the Berry project being issued on November 29, 1949 , and those for the Patterson project on February 6, 1950 . Applications for Contract Bond and Agreement of Indemnity, executed on the same respective dates, made Aetna the subrogee and assignee of all of Horticultural's rights to any monies due or to become due from the Authority under the contracts, should Horticultural default in its performance of the contracts thereby requiring Aetna to perform under its bond. Horticultural entered into performance of the work but was unable to complete it because it lacked sufficient funds. Consequently, Aetna performed under its bonds and made large expenditures in payment of materialmen, subcontractors, and the wages of Horticultural's laborers. Aetna 's expenditures on the Patterson project, commencing on March 19, 1951, totalled $38,288.98. However, it received payments of $5,990, leaving a present loss to Aetna on the Patterson project of $32,298.98. Aetna's expenditures on the Berry project, commencing on April 12, 1951, totalled $28,469.18 which represents the present loss since no payments were received. It will immediately be seen that Aetna's losses exceed the total unpaid contract balance presently held by the Authority which amounts to $9,444.02 on the Berry project, and $1,860.75 on the Patterson project.

[Tax Liens]

Opposed to Aetna 's claims on these funds are the tax liens presently asserted by the federal government which arose out of Horticultural's failure to turn over to the government the Withholding and Employment taxes which it collected from its workers. All except one of the tax assessment lists were received by the Collector of Internal Revenue subsequent to Aetna 's issuance of its bonds. One, in the sum of $331.30, was received on December 12, 1949, subsequent to the execution of the Berry bonds, but prior to the Patterson bonds. It may be noted that it was this asserted tax lien only for which the Appellate Division rendered judgment for the United States . While all but one of the tax assessment lists were received by the Collector subsequent to Aetna's execution of its bonds, the amount of the assessment lists received prior to Aetna's performance under its bonds exceeded the sums presently held by the Authority. Tax liens, of course, arise upon the receipt by the Collector of the assessment list (26 U. S. C. §3671), but they attach only to "property and rights to property" belonging to the taxpayer (26 U. S. C. §3670).

[Issue]

The crucial issue in this case is whether Horticultural had any interest in the funds presently held by the Authority to which a tax lien could attach. As far as Horticultural's contractual rights to these funds are concerned, each contract provided that "[a]s a condition precedent to his right to any partial payment the Contractor must, as requested, submit to the Authority proof satisfactory to the Authority that the Contractor is meeting his obligations to the Subcontractors, Materialmen, and workmen promptly." [section 5(c)]. The Authority was authorized to retain 10% of each estimated partial payment, as "retained percentages", until final completion of the work. [section 5(e)]. Partial payments could be withheld or reduced at the Authority's option if it felt the work was not progressing satisfactorily [section 5(g)]. As a "condition precedent" to final payment, Horticultural was obligated to furnish proof of payment to all subcontractors, materialmen, laborers, etc., until which time it was provided "[t]he Final Payment payable to the contractor shall not become due." [section 6(a)]. It was provided also that "[b]efore Final Payment or any retained percentages shall become due and payable, the Contractor must also, if required, obtain and furnish written consent of his sureties to such payment." (Ibid.) If the work were not performed in accordance with the contract, or if Horticultural failed to pay its subcontractors, materialmen, laborers etc., the Authority was entitled under the contract to withhold out any payment, final or otherwise, such sums as it deemed ample to satisfy such claims [Section 7(a)]. The net effect of these provisions was to condition Horticultural's right to any payment, partial or final, upon the full and faithful performance of its contract obligations to do the work and pay its laborers, materialmen, subcontractors etc.

The federal tax lien is assertable only to the extent of Horticultural's interest, if any, in the funds retained by the Authority. The parties agree that the basic question presented here is whether Horticultural had any interest in the funds, presently held by the Authority, to which the federal tax liens could attach. The United States contends that this issue presents a question of federal law, and that under that law Horticultural did have an interest. Aetna, on the other hand, argues that this is a matter of state law, and that under the law of the State of New York Horticultural had no such interest.

In Fidelity & Deposit Co. v. N. Y. City Housing Authority, 241 Fed. (2d) 142 (1957) [57-1 USTC ¶9410], the Second Circuit Court of Appeals said: "Section 3670 imposes a tax lien on 'all property and rights to property' of a defaulting taxpayer. In adopting this legislation, the Congress did not create property interests on which a lien might be imposed; there is no suggestion that it authorized the federal courts to do so." ( Id. at 144). Accordingly, that court held that the existence of a property interest "is solely a question of state law." (Ibid.) Citing this case, the United States Supreme Court held, on June 9th, 1958, in United States v. Bess, 26 U. S. Law Week 4381: "Third. We must now decide whether Mr. Bess possessed in his lifetime, within the meaning of §3670, any 'property' or 'rights to property' in the insurance policies to which the perfected lien for the 1946 taxes might attach. Since §3670 creates no property rights but merely attaches consequences, federally defined, to rights created under state law, Fidelity & Deposit Co. v. New York City Housing Authority, 241 Fed. (2d) 142, 144 [57-1 USTC ¶9410], we must look first to Mr. Bess' right in the policies as defined ( Id. at 4382).

[State Law]

Thus, whether Horticultural had any interest in the funds held by the Authority is to be determined by New York law. The case of U. S. Fidelity & Guaranty Co. v. Triborough Bridge Authority, 297 N. Y. 31 [47-2 USTC ¶9327], is dispositive of this question. In that case we held that a surety who performs under its bond upon the contractor's default has an equitable lien upon the funds held by the owner, and that this lien arises upon execution of the bond although it does not become enforceable until the surety suffers a loss by making payments pursuant to its obligation under the bond. In so holding we went on to say: "In addition, it is, of course, settled that intervenor's rights to the moneys held by defendant Authority can be no greater than those which its taxpayer--the contractor--had. (Karno-Smith Co. v. Maloney, 112 Fed. (2d) 690, 692 [40-2 USTC ¶9533]; Internal Revenue Code, §3670; U. S. Code, tit. 26, §3670). Here the contractor's rights to the fund were clearly subordinate to the right of defendant Authority--and, by subrogation, of plaintiff--to withhold and apply those moneys to the payment of unsatisfied claims for labor and materials. So long as such claims were outstanding and unpaid and so long as defendant Authority had the right to withhold and apply, the contractor had no rights to the fund, and consequently, had no property interest therein upon which intervenor could place a lien." ( Id. at 37). (Italics added). The law of the Triborough case, followed in other cases, is well-settled law. (See Scarsdale Nat. Bank & Trust Co. v. United States Fidelity & Guaranty Co., 264 N. Y. 159, 163-164; U. S. Casualty Co. v. Met Contracting Corp., 158 N. Y. S. 2d 117; Lumbermans Mut. Cas. Co. of Ill. v. Great Atl. Constr. Corp., 158 N. Y. S. 2d 115; Fidelity & Deposit Co. of Md. v. N. Y. City Hous. Auth., supra at 144, 146; Vincent v. P. R. Matthews, 126 Fed. Supp. 102 [54-2 USTC ¶9658]; Alabama-Tennessee Nat. Gas Co. v. Lehman-Hoge & Scott, 122 Fed. Supp. 314 [54-2 USTC ¶9519]; Royal Indemnity Co. v. United States, 93 Fed. Supp. 891, 899; In Re Cummins Constr. Corp., 81 Fed. Supp. 193, 196-197). The net effect of these cases is that Horticultural had no interest in the funds presently held by the Authority to which the tax lien could attach. Consequently, inasmuch as Aetna's losses far exceed the funds held by the Authority, it was entitled to recover the full unpaid balance of the contract price--(1) $9,444.02 on the Berry project, and (2) $1,860.75 on the Patterson project. The United States is entitled to nothing out of these funds.

[Conclusion]

The award by the Appellate Division of $331.30 to the United States suggests the conclusion that that court felt Horticultural did have an interest in these funds, and therefore the tax assessment list received prior to the execution of the Patterson bond created a lien in favor of the United States for $331.30 upon the unpaid balance of the Patterson contract price. This, as explained above, was error. Consequently, the judgment in Action No. 1 should be affirmed, and the judgment in Action No. 2 should be modified so as to increase the judgment in favor of plaintiff Aetna Casualty & Surety Company by $331.30 and, as so modified, affirmed.

In Action No. 1:

Judgment affirmed, without costs. All concur.

In Action No. 2:

Judgment modified in accordance with the opinion herein and, as so modified, affirmed, with costs to the plaintiff Aetna . All concur.

 

 

[58-1 USTC ¶9350]Fidelity and Deposit Company of Maryland , Plaintiff v. New York City Housing Authority, Caruso-Sturcey Corporation, Arnold Lewis, as Assignee of Caruso-Sturcey Corporation, People of the State of New York and United States of America, Defendants

U. S. District Court, So. Dist. N. Y., Civ. 93-145, 157 FSupp 87, 12/4/57

[1939 Code Sec. 3670--substantially unchanged in 1954 Code Sec. 6321]

Tax liens: Fund withheld from contractor: Surety's lien: Effect of New York law.--State and Federal tax liens were asserted against a fund withheld from a contractor who had not paid for labor and materials. Reversing the District Court, the Appellate Court held in an earlier opinion that state law governed the nature of the contractor's interest. Under New York law, a contractor who defaults in payment of laborers and materialmen has no right to and no property interest in the withheld funds. On remand, the District Court held that the tax liens against the contractor did not attach to the withheld funds. It held that the surety which had paid the laborers and materialmen had an equitable lien upon the withheld funds.

Maurice, McNamee & Dart, 149 Broadway, New York 6, N. Y. (Stewart Maurice, of counsel), for plaintiff. Louis J. Lefkowitz, Attorney General, State of New York, 80 Centre Street, New York 13, N. Y. (Samuel Backlar, Assistant Attorney General, of counsel), for People of the State of New York. Paul W. Williams, United States Attorney, Southern District of New York, United States Court House, Foley Square, New York 7, N. Y. (John S. Clark, Assistant United States Attorney, of counsel), for United States of America.

Opinion

DIMOCK, District Judge:

Plaintiff moves for summary judgment.

[Facts]

The suit is one by Fidelity and Deposit Company of Maryland , surety on the bond of Caruso-Sturcey Corporation, a building contractor, to recover the sum of $46,392.51 from defendant New York City Housing Authority, hereinafter referred to as the owner. That sum is the amount equal to the unpaid balance of the contract price for heating and ventilating work that the contractor agreed to do for the owner. Plaintiff, as surety on the contract, paid laborers and materialmen whom the contractor in breach of its contract had failed to pay. The amount paid by the surety was in excess of the amount unpaid under the contract and plaintiff seeks to apply the unpaid amount in reduction of its claim. Taxes are due from the contractor both to the United States of America and the State of New York and both asserted liens upon the contractor's claim against the owner.

The case was tried before me and I held, 140 Fed. Supp. 298 [56-2 USTC ¶9761], that federal law applied, citing United States v. Kings County Iron Works, Inc., 2 Cir., 224 Fed. (2d) 232, 235 [55-2 USTC ¶9536]. Accordingly I applied United States v. Munsey Trust Co., 332 U. S. 234, as I interpreted it, and held that the Government had a paramount lien upon the contractor's claim. Judgment for the Government was entered.

On appeal the Court of Appeals reversed the judgment, 241 Fed. (2d) 142 [57-1 USTC ¶9410], holding that the nature of the interest of the contractor, as distinguished from the priority of the Government, was to be determined by the law of the State of New York . The Court, p. 145, said that the Kings County Iron Works case did no more than hold that state-law classification of a right as a trust did not preclude its classification as a lien upon federal inquiry into its nature. The court therefore applied New York law as expressed in U. S. Fidelity & Guaranty Co. v. Triborough Bridge Authority, 297 N. Y. 31 [47-2 USTC ¶9327], and held that the owner had no property right in the unpaid portion of the purchase price to which any lien of the Government could attach. The case was therefore remanded.

Plaintiff, instead of seeking a new trial, has moved for summary judgment. This procedure is quite proper since there is no dispute as to the facts.

The Government, though held by the Court of Appeals to be without right as lienor upon any property right of the contractor, is still in the field asserting a priority over the surety. I must therefore determine the respective rights of the parties and, to do that, I must determine what law governs.

The Court of Appeals in its opinion in this case said, p. 145:

"These cases make it perfectly clear that : (1) the classification of state created rights and (2) the weighing of relative priorities under Section 3670, are both matters of federal law. But here we are concerned with the question of whether or not a contractual right exists and that we hold is a matter of state law only."

From this I conclude that in determining whether a right exists I must look to state law if its creation would be within state competence and federal law if its creation would be within federal competence. Then, in classifying a state created right according to its true nature, for purposes of resolution of competing state and federal claims, I am not bound by the name that the state law applies to it but must apply federal law. Finally, I must apply federal law in determining the relative priority of a federally created right, on the one hand, and state created rights on the other.

[Surety's Lien]

Any right which the surety in this case may have to the withheld funds is state created. The New York State case of U. S. Fidelity & Guaranty Co. v. Triborough Bridge Authority, 297 N. Y. 31, supra, as an alternative ground undiscussed by our Court of Appeals in reversing, held that the surety, in a case such as this, obtains an equitable lien upon the withheld funds. I believe that United States v. Munsey Trust Co., 332 U. S. 234, supra, holds to the contrary, but, even so, it does not purport to declare the law of the State of New York . ^*

It is thus established that the surety has an equitable lien on the withheld funds. It is also established that the Government has no lien on any right of its debtor, the contractor, and no one has suggested any other avenue through which the Government could reach the withheld funds. Since the Government has no interest in the withheld funds, no question arises either as to the true nature of the surety's equitable lien thereon or as to the relative priority of interests of the surety and the Government therein.

The Government suggests that an appeal to the Court of Appeals of the State of New York is now pending from the judgment of the Appellate Division in Aetna Casualty & Surety Co. v. Horticultural Service, Inc., 2 A. D. 2d 963, a case which followed the ruling in the Triborough case, and that I ought to withhold decision until a final determination of that appeal. As a general proposition I am loath to dealy the enforcement of the rights of litigants in anticipation of a possible change in controlling law. In this case, moreover, it would serve no purpose, since substantially the same result can be obtained by the taking of an appeal from my present determination and keeping it pending until the determination of the Horticultural Service appeal by the State Court of Appeals.

[Judgment]

Judgment is awarded plaintiff against the New York City Housing Authority for $46,392.51, and the claims of all other parties are dismissed.

With respect to the time for appeal counsel will please note the provisions of Rule 58 F. R. Civ. P.

^* Evidently its effect must be limited to cases like it where government contracts are concerned and where consequently a general federal common law rather than the law of a specific state is applied. Priebe & Sons v. United States , 332 U. S. 407, 411.

 

 

[57-1 USTC ¶9410]Fidelity and Deposit Company of Maryland , Plaintiff-Appellant v. New York City Housing Authority, Caruso-Sturcey Corporation, Arnold Lewis, as assignee of Caruso-Sturcey Corporation, People of the State of New York, Defendants, and United States of America, Defendant-Appellee

(CA-2), U. S. Court of Appeals, 2nd Circuit, Docket No. 24196, 241 F2d 142, 2/8/57, Reversing and remanding the decision of the District Court, 56-2 USTC ¶9761, 140 F. Supp. 298

[1939 Code Sec. 3670--substantially unchanged in 1954 Code Sec. 6321]

Tax lien on fund withheld from contractor: Effect of state law.--A tax lien was asserted against a fund withheld from a contractor who had not paid for labor and materials. Under the applicable New York law, a contractor who defaults in payment of laborers and materialmen has no right to the withheld funds and no property interest. Such local law must be recognized for federal tax purposes. Under 1939 Code Sec. 3670, the courts have authority to determine whether state-created interests are choate or inchoate; the existence of the interests to be federally classified, however, is solely a question of state law. Since the contract required payment of claims for labor and material as a condition precedent to the contractor's right to payment, there was not a substantial performance which would entitle the contractor to the withheld fund. Payment of the claims by surety did not satisfy this condition.

Maurice, McNamee & Dart , New York City (Stewart Maurice, Rob ert F. Dart, New York City , of counsel), for plaintiff-appellant. Paul W. Williams, United States Attorney, New York City (Arthur B. Kramer, Miriam R. Goldman, Assistant United States Attorneys, New York City, of counsel), for defendant-appellee.

Before SWAN, MEDINA and WATERMAN, Circuit Judges.

MEDINA , Circuit Judge:

This case was tried below [56-2 USTC ¶9761, 140 Fed. Supp. 298] on an agreed statement of facts. Caruso-Sturcey Corporation contracted on June 21, 1949 with the New York City Housing Authority to install heating and ventilating facilities on a housing project. The contract required Caruso to give a performance bond, not involved in this litigation, and a payment bond for laborers and materialmen. This the contractor did when it executed the bonds on July 11, 1949 with Fidelity and Deposit Company of Maryland .

When the heating and ventilating facilities had been installed and accepted by the owner on March 1, 1952 , there was an unpaid balance on the contract, amounting to $46,392.31. The principal claimants to this fund are Fidelity, which had made payments for labor and materials aggregating $75,650.09, from December 11, 1950 through November 13, 1951, as required by its bond, on Caruso's failure to make such payments when due, and the United States by reason of tax liens, for withholding taxes retained by Caruso from the wages of its employees, but not remitted. The tax assessments run from April 11, 1950 through September 12, 1951; and the total of these is $47,639.68.

On September 14, 1951, Caruso made an assignment for the benefit of creditors, pursuant to the provisions of the New York Debtor and Creditor law, to defendant Arnold Lewis; and there is a subsidiary claim of the defendant State of New York arising out of certain corporation and franchise taxes owing by Caruso.

In form the suit is one by Fidelity in equity against the Housing Authority to recover the fund. Caruso's assignee filed an answer containing a counterclaim but failed to appear at the trial. The State of New York asserted its claim against the fund for taxes. The United States pleaded a claim to the fund under Section 3670 of the Internal Revenue Code of 1939, 26 U. S. C., Section 3670. ¹

The fund was awarded by the court below to the United States on the theory that the defaulting taxpayer Caruso, under its contract, had a conditional right to the fund, that this right was a "right to property" within the meaning of Section 3670, and that the United States thus had a valid tax lien on the entire fund. As the tax lien thus found to exist would take superiority over any claim by Fidelity, it became unnecessary for the court otherwise to pass upon the nature and sufficiency of Fidelity's claim. Nor was consideration given to the claim of the State of New York , for the same reason. As we have concluded that there were no rights of Caruso upon which the government tax lien could attach, there must be a new trial in which all the issues raised by the pleadings and not yet disposed of may be adjudicated, including the rights of the State of New York, although the appeal to this court is by Fidelity alone.

[Contractor's Right to Withheld Fund]

The first issue to be considered is whether the defaulting taxpayer under its contract had a conditional right to the withheld fund. The contract was made and performed in New York . The New York Court of Appeals has had occasion to consider a similar contract that also required as a condition precedent to payment proof that the contractor had satisfied claims of materialmen and laborers. "So long as such claims were outstanding and so long as [the owner] had the right to withhold and apply," it held, "the contractor had no rights to the fund and, consequently, no property interest therein upon which [the United States] could place a lien.' United States Fidelity & Guarantee Co. v. Triborough Bridge Authority, 297 N. Y. 31, 37 [47-2 USTC ¶9327]. And again: "A failure by the contractor to pay for labor and material was just as much a failure to perform and carry out the terms of the contract as an abandonment of the work would have been." Ibid. p. 36.

For the highest court of the State of New York , in short, a failure to pay laborers and materialmen is a breach of contract and a contractor who fails to make such payments has no right under the contract. This decision, if binding here, disposes of the holding below: without a finding that the defaulting taxpayer has some right that may be classified as a "right to property," there can be no federal tax lien. But is it binding here?

[Effect of State Law]

Section 3670 imposes a tax lien on "all property and rights to property" of a defaulting taxpayer. In adopting this legislation, the Congress did not create property interests on which a lien might be imposed; there is no suggestion that it authorized the federal courts to do so. On the contrary, it took for granted here, as it normally does in the tax law, the vital existence of state laws creating and maintaining various interests. The statute was fashioned to require the courts to determine for federal purposes whether those state-created interests are "property" or "rights to property." That classification of interests is a federal question; the existence of the interests to be federally classified, however, is solely a question of state law.

This distinction was formulated by the Supreme Court in Morgan v. Commissioner, 309 U. S. 78, 80 [40-1 USTC ¶9210], which also involved the tax law. "State law," the court explained, "creates legal interests and rights. The federal revenue acts designate what interests or rights, so created, shall be taxed. Our duty is to ascertain the meaning of the words used to specify the thing taxed. If it is found in a given case that an interest or right created by local law was the object to be taxed, the federal law must prevail no matter what name is given to the interest or right by state law."

This distinction has not been discarded in the Supreme Court decisions under Sections 3670 and 3671. In none of those cases was there any doubt that a federal tax lien had attached to "property or rights to property"; nor for that matter was there any question under state law as to whether the party against whom the federal government asserted a tax lien had some interest in the disputed property. The question was solely one of priorities between two existing claims.

Thus, in United States v. Security Trust and Savings Bank, 340 U. S. 47 [50-2 USTC ¶9492], the court held "inchoate" an attachment lien that had been thought by the state courts, applying the state doctrine of relating a judgment lien back to the time of the attachment lien, to have been perfected. In United States v. Acri, 348 U. S. 211 [55-1 USTC ¶9138], the court exercised a similarly independent judgment in disregarding for federal purposes a state holding that an attachment is "execution in advance." In these and in other cases cited in the footnote, ² the issue was one of priorities under a federal statute; in disposing of this issue, the Supreme Court held itself free to disregard for federal purposes the state determination as to whether the right the state had created was "choate."

Nor was this distinction discarded in our decision in United States v. Kings County Iron Works, 224 Fed. (2d) 232 [55-2 USTC ¶9536]. The facts in that case, as in the one before us, were not disputed. It was admitted that the taxpayer-contractor owed money to the United States for unpaid taxes, that he also owed money to his subcontractor for services performed, and that he was owed money (having performed his promises under a contract) by the owner. The issue was whether the New York Lien Law that classified a reserve fund for workers and materialmen as a "trust," precluded a federal inquiry into the nature of the right thus created. The court held for federal purposes that it did not, that the right admittedly created by state law was for the purposes of Section 3670 a "lien" rather than a "trust," that peculiar local conditions were responsible for the differences in vocabulary. The court did not inquire whether the state had created a right. It assumed that it did and was concerned with the "relative priority of a federal tax lien and a mechanic's lien under state law." United States v. Kings County Iron Works, supra, at 234.

These cases make it perfectly clear that: (1) the classification of state-created rights and (2) the weighing of relative priorities under Section 3670, are both matters of federal law. But here we are concerned with the question of whether or not a contractual right exists and that we hold is a matter of state law only. F. H. McGraw & Co. v. Sherman Plastering Co., 60 Fed. Supp. 504, 511-512 (per Hincks, D. J.). Under the authority of Triborough Bridge Authority, supra, we are constrained to rule that Caruso was left with no contractual right; and, accordingly, we have nothing to "classify."

[Government's Arguments]

The government, citing no New York cases, tries to spell out a right to the withheld fund in two ways. First, it claims that the contractor could have sued for the fund after satisfactorily installing the heating facilities on a theory of substantial performance, even though the contractor failed to satisfy the claims for labor and material. This argument is not persuasive. The contract carefully requires satisfaction of those claims as a condition precedent to partial payment no less than to final payment. Thus, Section 5(c) provides:

"As a condition precedent to his right to any partial payment, the Contractor must, as requested, submit to the Authority proof satisfactory to the Authority that the Contractor is meeting his obligations to the Subcontractors, Materialmen, and workmen promptly. The Contractor's monthly requisitions must be accompanied by his affidavit showing the amounts previously paid for Work executed by such Subcontractors or materials furnished by such Materialmen, and the amounts remaining unpaid and owing to any such persons, setting forth therein the names of the persons whose claims are unpaid and the amount due to each and, if required, must also be accompanied by affidavits from all Subcontractors and Materialmen, containing this information."

And Section 6 provides:

"The Contractor shall, as a condition precedent to final payment, furnish to the Authority a detailed sworn statement of all liens, claims and demands, just and unjust, of Subcontractors, Materialmen, laborers, other employees, and third persons, then outstanding or which he has reason to believe may thereafter be made on account of the Work or performance thereof. The Final Payment payable to the Contractor shall not become due, however, until the Contractor shall deliver to the Authority all releases required by the Authority from all such claims and demands arising out of any Work done pursuant to the Contract * * *."

We do not understand how the New York courts, or any courts for that matter, could find justification for holding, in the face of so carefully drawn a contract, that a failure to satisfy these condition is "insubstantial." Jacob & Youngs v. Kent, 230 N. Y. 239; Dauchey v. Drake, 85 N. Y. 407; Spence v. Ham, 163 N. Y. 220; Cassino v. Yacevich, 261 App. Div. 685; Gompert v. Healey, 149 App. Div. 198.

The second theory assumes, as it were, that the contractor might not be able to recover on a claim of substantial performance. "Caruso might agree to waive its claim to the fund unless it paid all laborers and materialmen," the argument goes, "but it could not waive the Government's interest; for purposes of federal taxation, Caruso continued to have an interest in the fund despite any agreement to give laborers and materialmen a preferred and divesting interest."

This statement begs the very question it is designed to answer. Of course, if the government has an interest in the funds, Caruso by agreement could not waive it. The problem, however, is whether Caruso has, without prior payment of laborers and materialmen, the enforceable interest in the fund to which a tax lien might attach. By the terms of the contract, he does not.

The government advances one other reason for holding that Caruso has a right to the withheld fund under the contract. The terms of the contract, it urges, do not specifically require that the contractor pay the laborers and materialmen; it requires only that they somehow be paid. Here, they were paid (by the surety) and the condition precedent to payment was thus satisfied.

While perhaps superficially plausible, this construction of the contract is not convincing. Section 3 of the contract requires the contractor to "furnish all labor and materials" needed to comply with the contract. Section 5(c) declares that "As a condition precedent to partial payment, the Contractor must, as requested, submit to the Authority proof * * * that the Contractor is meeting his obligations to the Subcontractors, Materialmen and workmen promptly." Section 20 declares that "The Contractor * * * shall promptly pay all amounts due for services rendered, work performed and materials and equipment supplied * * *." This terminology indicates that while the ultimate aim of the Authority may have been to secure prompt payment for laborers and materialmen, it required contractually as a condition precedent to payment that the contractor do so.

We are satisfied, then that under Triborough Bridge Authority, supra, recently cited as controlling authority by the New York Appellate Division in Aetna Casualty & Surety Co. v. Horticultural Service, Inc., -- N. Y. Supp. --, reported in N. Y. L. J., Dec. 12, 1956 (Nos. 10544-10545) [56-1 USTC ¶9548], the taxpayer-contractor had no right to the withheld fund. Of necessity, it follows that it had no "right to property" to which a federal tax lien might attach and the government's claim must fail.

Reversed and remanded.

¹ Section 3670. Property subject to lien.

If any person liable to pay any tax neglects or refuses to pay the same after demand, the amount * * * shall be a lien in favor of the United States upon all property and rights to property, whether real or personal, belonging to such person.

² On the "inchoate" character of the lien: United States v. White Bear Brewing Co., 350 U. S. 1010 (1956) [56-1 USTC ¶9440], petition for rehearing den., 351 U. S. 958 (Mechanic's Lien); United States v. Colotta, 350 U. S. 808 (1955) (Mechanic's Lien) [55-2 USTC ¶9680]; United States v. Scovil, 348 U. S. 208[218] (1955) (landlord's distress lien) [55-1 USTC ¶9137]; United States v. Liverpool & London Ins. Co., 348 U. S. 215 (1955) (garnishment) [55-1 USTC ¶9136]; United States v. City of New Britain, 347 U. S. 81 (1954) (city tax lien) [54-1 USTC ¶9191]. See also, United States v. Gilbert Associates, 345 U. S. 361 (1953) (ad valorem tax held "judgment" under state law, but not for federal purposes) [53-1 USTC ¶9291].

 

 

[60-1 USTC ¶9413]The Atlantic Refining Company v. Continental Casualty Company, Joseph M. Smith, and Greensburg Concrete Block Company, Defendants, and United States of America, Intervenor

U. S. District Court, West. Dist. Pa., Civil Action No. 15185, 183 FSupp 478, 4/8/60

[1954 Code Secs. 6321-6323]

Tax liens: Funds withheld under construction contract: Surety's rights.--A lien for taxes did not attach to funds withheld from the tax-delinquent contractor under a construction contract which provided that final payment would be made only after the contractor showed that there were no liens for unpaid claims for labor and material, which the contractor was unable to do. The surety on the contractor's bond was subrogated to the rights of the person for whom the work was being done, not to the rights of the contractor (which would be subject to the tax lien), and, under the terms of the contract and bond, was not liable to the United States for withholding and social security taxes attributable to the construction performed under the contract.

Rob ert A. Rundle, of Wright & Rundle, Frick Building , Pittsburgh 19, Pa. , for plaintiff. J. M. McCandless, 304 Ross Street , Pittsburgh 19, Pa. , for defendant.

Opinion and Order

Opinion

MARSH, District Judge:

The facts as disclosed by the pleadings and stipulated by the parties, except as hereinafter specified, are adopted by the court as if found pursuant to Rule 52, Fed. R. Civ. P.

Atlantic Refining Company, hereinafter called the Owner, on November 8, 1954 , and May 16, 1955 entered into two no-lien construction contracts with Joseph M. Smith, hereinafter referred to as Contractor, to furnish labor and materials for the construction of two service stations located, respectively, in Mt. Pleasant , Westmoreland County , Pennsylvania , and Connellsville, Fayette County , Pennsylvania . The contracts were filed of record in the respective counties before visible commencement of work was begun on the ground. A construction and payment bond furnished by Continental Casualty Company, hereinafter referred to as Surety, accompanied each contract.

The Contractor completed the construction of the service stations but failed to pay certain materialmen on each job. As of November, 1956, the balance withheld by the Owner on the contract price was $6,027.68 for the Mt. Pleasant station and $6,626.26 for the Connellsville station, or a total of $12,653.94.

[Claims to Withheld Funds]

Previously, the United States Internal Revenue Service served on Owner notice of levy and demand for certain taxes owned by the Contractor, assessed in July and December of 1955 and noticed and filed of record on October 28, 1955 and December 30, 1955 . The total amount of the assessments was $11,632.06, plus interest, of which sum $1,114.81 was incurred by the Contractor in erecting the two service stations aforementioned.

Greensburg Concrete Block Company, a judgment creditor of the Contractor, served a writ of attachment execution on the Owner, as garnishee, attaching the fund allegedly due to the Contractor to satisfy its judgment of $737.65, with interest and costs.

The Surety claimed the balances withheld on the contract prices by reason of its liability on the bonds to unpaid materialmen.

Faced with these conflicting claims, the Owner on November 15, 1956 filed a "Complaint for Interpleader and Declaratory Relief" against the United States , the Surety Company, Greensburg Concrete Block Company, and the Contractor, and thereupon paid $12,653.94 into the registry of this court.

A default judgment was entered against Contractor Smith and Greensburg Concrete Block Company for failure to appear, answer or plead, and the Owner was discharged from any claim that they might assert against the funds paid into court.

[Tax Liens]

The complaint was dismissed as to the United States , and the United States was permited to intervene as a party plaintiff. The government's complaint in intervention alleges that the Contractor is indebted to it for certain withholding and F. I. C. A. taxes in the sum of $11,632.06, plus interest, and claims by virtue of the 1955 assessments that it has a prior lien on the fund allegedly due to the Contractor from the Owner. Hence, it demands the funds paid into court by Owner.

By amendment to its complaint, the government also sues the Surety directly on the bonds for all withholding and F. I. C. A. taxes due it from the Contractor in the sum of $11,632.06, plus interest. This suit, however, is pressed only for the sum of $1,114.81, plus interest, that amount being the withholding and F. I. C. A. taxes incurred by the Contractor in the construction of the service stations at Mt. Pleasant and Connellsville (see government's brief, pp. 32-34).

[Surety's Claim]

After the fund was paid into court, the Surety paid claims of materialmen on the Mt. Pleasant station in the sum of $6,004.51, leaving a balance of $23.17 unclaimed except by the United States . The Surety paid claims of materialmen on the Connellsville station in the sum of $12,285.53. The Surety took assignments from the materialmen which it paid.

The Surety presses its claim on the following grounds:

(1) The Contractor had no property or property interest in the fund upon which the government liens might attach.

(2) The Surety is subrogated to the rights of the Owner and materialmen in the fund created by the contract between the Owner and the Contractor.

(3) The Surety is entitled to the fund under equitable assignments given by the Contratcor to the Surety at the time of the execution of the bonds. ¹

In my opinion the Surety is entitled to the fund on the first ground, and on the second ground, i.e., because it is subrogated to the rights of the Owner. It is, therefore, unnecessary to discuss the third ground, although I am of the opinion that the Surety's contentions with respect to the effect of its equitable assignments would not succeed against the federal liens. ²

The provisions of the contracts between the Owner and the Contractor are identical except for description of work and prices.

The pertinent provisions thereof are as follows:

(1) "Contractor shall, during the progress of the work, pay all valid charges of all his sub-contractors and other persons furnishing labor and/or materials in the performance or prosecution of the work . . . when and as such charges become payable and in their full amount."

(2) "When the contract has been completed, the Contractor shall deliver to the Owner a full Release of Liens signed by himself and all sub-contractors and other persons who have furnished any materials, labor, or both, in the performance of the contract or prosecution of the work. . . . Such release, with accompanying affidavits, shall be in such form as the Owner may require and its presentation to Owner shall constitute a representation by Contractor that all sub-contractors . . . have joined in the proper execution thereof as having been paid. . . . Until such releases and affidavits are delivered properly executed, the final schedule of payments may be withheld."

(3) "WAIVER OF LIENS AND CLAIMS: . . . In the event that notice is given of any claim . . . which is chargeable to the Contractor . . . the Owner shall have the right to retain out of any payment then due, or to become due, an amount sufficient to completely indemnify the Owner against such claim. . . . In the event of . . . [the Contractor's] failure to have such claims . . . paid . . . the Owner shall have the right to take such action as is necessary to have the same done, charging the cost thereof . . . to the Contractor."

(4) "The Owner shall retain ten percent (10%) pending completion of the job and full compliance with the contract. . . . The final payment shall be made within thirty (30) days after final test and acceptance of the work, provided the Contractor shall have submitted to the Owner a satisfactory Release of Liens showing that all claims and bills for labor and material have been met and paid as hereinbefore provided."

The surety bonds are identical in their material provisions. Each contract was incorporated by reference in the accompanying bond.

Each bond was conditioned upon faithful performance of the contract and upon prompt payment of all just charges for labor and material furnished by Contractor.

No release of liens was furnished the Owner by the Contractor with respect to either job as required by both contracts. The Owner withheld the balances due on the contract prices and interpleaded the claimants thereto.

The Contractor Does Not Have Any Property or Rights to Property in the Withheld Balances of the Contract Prices Upon Which the Liens for Federal Taxes Might Attach

The United States bases its claim to the fund on §§ 6321 and 6322 of the Internal Revenue Code of 1954. ³ As therein provided "if any person liable to pay any tax neglects or refuses to pay same after demand, the amount . . . shall be a lien in favor of the United States upon all property and rights to property . . . belonging to such person."

It was held in United States v. Bess, 357 U. S. 51, 55 (1958) [58-2 USTC ¶9595] that ". . . §3670 [now 26 U. S. C. §6321] creates no property rights but merely attaches consequences, federally defined, to rights created under state law", citing Fidelity & Deposit Co. v. New York City Housing Authority, 241 F. 2d 142, 144 (2nd Cir. 1957) [57-1 USTC ¶9410]. As stated in Morgan v. Commissioner, 309 U. S. 78, 80 (1940) [40-1 USTC ¶9210]: "State law creates legal interests and rights."

As of the dates the federal liens were assessed (1955), the Contractor was not entitled to received any money under the terms of the contract, for the Contractor owed materialmen on both jobs. On the Mt. Pleasant job the unpaid amount was practically equivalent to the amount withheld by the Owner, and on the Connellsville job the amount was substantially in excess of the amount withheld.

[Contractor's Rights Under State Law]

It must now be determined under the Pennsylvania law whether the Contractor had any "property" or "rights to property" in the balances withheld from the Owner and paid by it into court. Cf. Central Surety and Insurance Corp. v. Martin Infante Co., 272 F. 2d 231 (3rd Cir. 1959) [59-2 USTC ¶9736].

It is a general principle that a material failure of performance by one party to a contract not justified by the conduct of the other discharges the latter's duty to give the agreed exchange. Sections 274 and 275, Restatement, Contracts, with which Pennsylvania law is in accord; Wright v. Barber, 270 Pa. 186, 113 Atl. 200 (1921); City of Farrell v. H. Platt Co., 142 Pa. Super. 242, 15 A. 2d 718; vol. 8 P. L. E. §301; Sum. Pa. Jur. Contracts, §498; cf. vol. 4, Corbin on Contracts, §901. Also in accord are cases in other jurisdictions involving contracts providing for the payment of labor and materialmen as a prerequisite for payment of the contract price. Central Surety & Insurance Corp. v. Martin Infante Co., supra; Fidelity & Deposit Co. v. New York City Housing Auth., supra; United States Fidelity & Guaranty Co. v. United States, 201 F. 2d 118 (10th Cir. 1952) [53-1 USTC ¶9249]; Wolverine Insurance Co. v. Phillips, 165 F. Supp. 335 (N. D. Iowa W. D. 1958) [58-2 USTC ¶9765]; United States Fidelity and Guaranty Co. v. Miller, 143 F. Supp. 941 (W. D. N. C. 1956) [56-2 USTC ¶9930]; Scott v. Zion Evangelical Lutheran Church, 75 S. D. 559, 70 N. W. 2d 326 (1955) [55-2 USTC ¶9669]; United States Fidelity & Guaranty Co. v. Triborough Bridge Authority, 297 N. Y. 31, 36-37, 74 N. E. 2d 226, 228 (1947) [47-2 USTC ¶9327].

In the cited cases it was held that the tax liens of the United States did not attach to the withheld funds; and the sureties and, in one case, the materialmen, won the money. In at least four of the cases, it seems that the contractors had completed or substantially completed the work for the owners, ⁴ the contractual breach being their failure to pay materialmen.

Therefore, I am of the opinion that a failure by the Contractor here to pay for labor and materials is just as much a failure to perform and carry out the terms of the contract as an abandonment of the work would have been.

Since the Contractor failed to pay the materialmen in amounts almost equal to or in excess of the balances withheld on the contract prices, express promises of the Contractor to the Owner to pay materialmen were materially breached by these substantial failures. Consequently, except for $23.17, the Contractor had no right of property in the balances withheld by the Owner; he could "not get" the withheld balances, Lancaster County Nat. Bank's Appeal, 304 Pa. 437, 155 Atl. 859; he had "no rights whatever" to the said balances, Prairie State Bank v. United States, 164 U. S. 227 (1896).

In Lancaster County Nat. Bank's Appeal, supra, the construction contract, as here, required the contractor to pay the materialmen. Being a contract for public work, it was, as here, in effect, a no-lien contract. On page 861 (155 Atl.), it was stated:

"[A]s it [the assignee of the contractor] was claiming the right to receive a sum payable to the contractor under the terms of the contract, it was bound to take notice also of the fact that the contractor could not get the semifinal estimate, which is the one in controversy here, until and unless all 'claims for labor and materials [incurred in the performance of the contract] have been satisfactorily settled,' . . .." (Italics supplied.)

Likewise, in Prairie State Bank v. United States, supra, with which it has been declared the Pennsylvania law is "in harmoney", Sundheim v. School District, 311 Pa. 90, 166 Atl. 365 (1933), it was stated at page 232:

"A great deal of confusion has arisen in the case by treating . . . [the surety] as subrogated merely 'in the rights of . . . [the contractor]' in the fund, which, in effect, was saying that he was subrogated to no rights whatever." (Italics supplied.)

Thus when perfected in 1955, the lien of the government's taxes bound a contingent right of the Contractor to receive the balance of the contract prices if, but only if, he substantially performed his direct contractual obligations to the Owner to pay the materialmen. After his material breaches, the Contractor's contingent right never ripened into a "right to property" which he could enforce or on which the federal tax liens could attach.

It is ". . . well settled that the lien of federal taxes extends only to property in which the taxpayer has an interest." United States v. Burgo, 175 F. 2d 196, 198 (3rd Cir. 1949) [49-1 USTC ¶9307]. "Since the government's rights under Sections 6321 and 6322 can rise no higher than the rights of the taxpayer, there was nothing of Infante's [the contractor's] to be levied upon." Central Surety and Insurance Corp. v. Martin Infante Co., supra, at pages 234-235.

Adapting Mr. Justice Brennan's statement in United States v. Bess, supra, at pp. 55, 56, it would be anomalous to view as "property" subject to lien, money never within the Contractor's reach to enjoy.

In the instant case, I conclude that the Contractor had no "property" or "right to property" in the withheld balances which the Owner paid into court, and, therefore, there was nothing to which the government's lien could attach.

The Surety Is Subrogated to the Rights of the Owner in the Withheld Balances

Having determined that the United States does not have a lien on the withheld balances, it seems certain that the Surety is entitled to recover the fund paid into court.

However, the government strenuously argues that in no-lien contracts where the work is completed by the Contractor, the Surety cannot be subrogated to the rights of the materialmen or the Owner, but only to the rights of the Contractor, which rights, of course, are subject to the government's tax liens. I am of the opinion that under Pennsylvania law the Surety can be, and is, subrogated to the rights of the Owner, and is thus entitled to the fund in which the Contractor, as shown, has no property rights.

It is established in Pennsylvania that upon elementary principles a surety is entitled to assert the equitable doctrine of subrogation to funds in the hands of the owner where there is a direct contractual obligation to the owner, as a party to the contract, binding upon the contractor and the surety to pay materialmen when the contractor breaches the contract by failing to pay the materialmen. In such circumstances, the surety is entitled to be subrogated to the rights of the owner in the retained balances. Subrogation arises from the owner's right to have the original contract performed according to its terms. When the surety pays the materialmen, it stands in the position of a surety who not only has completed the contractual obligations of the defaulting contractor, but also has carried out the equitable obligations of the owner to see that the materialmen are paid. Sundheim v. School District, supra. (Compare with similar cases in other jurisdictions, see footnote 4.)

In Henningsen v. United States Fidelity & Guaranty Co., 208 U. S. 404, 411 (1907), where the contractor promised the owner to pay materialmen, it was held that the surety was "entitled to assert the equitable doctrine of subrogation", citing Prairie State Bank v. United States, supra. And in Lancaster County No. Bank's Appeal, supra, at page 861 (Atl.), "under precisely similar circumstances" to those in Hinningsen, the Pennsylvania Supreme Court said: "With this statement of the law we are in complete accord. . . ." (page 862 Atl.).

In Sundheim v. School District , supra, at pp. 367-368 (Atl.), the Supreme Court of Pennsylvania stated:

"Consequently, when the contractor fails to pay labor and materialmen, it is tantamount to a breach of its contract with the United States [the owner]. . . . When this occurs and the surety pays the labor and materialmen, it stands in the position of a surety completing a contractual obligation of a defaulting contractor and performing an equitable duty to the United States . It [the surety] is therefore entitled to subrogation to the rights of the United States in the fund. Subrogation does not arise through the contractor, but from the government's [the owner's] rights. Prairie State Nat. Bank v. U. S. , 164 U. S. 227, 17 S. Ct. 142, 41 L. Ed. 412; Henningsen v. U. S. Fid. & Guar. Co. of Baltimore, 208 U. S. 404, 28 S. Ct. 389, 52 L. Ed. 547; In re Scofield Co. (C. C. A.) 215 F. 45. In Pennsylvania, where our statutes and the facts coincide with the cases decided by the federal courts, we are in harmony with those decisions as illustrated by Lancaster County National Bank's Appeal, 304 Pa. 437, 155 A. 859, 861." (Italics supplied.)

In Prairie State Bank v. United States , supra, at pages 232-233, it was stated:

"Hitchcock's [the surety's] right of subrogation, when it became capable of enforcement, was a right to resort to the securities and remedies which the creditor (the United States) [the owner] was capable of asserting against its debtor Sundberg & Company [the contractors], had the security not satisfied the obligation of the contractors, and one of such remedies was the right based upon the original contract to appropriate the ten percent retained in its hands. . . . The right of Hitchcock to subrogation, therefore, would clearly entitle him when, as surety, he fulfilled the obligation of Sundberg & Company [the contractors], to the government [owner], to be substituted to the rights which the United States [owner], might have asserted against this fund." (Italics supplied.)

In Henningsen v. United States Fidelity & Guaranty Co., supra, at page 410, it was stated:

"It [the surety] paid the laborers and materialmen and thus released the contractor from his obligations to them, and to the same extent released the Government from all equitable obligations to see that the laborers and supply men were paid." (Italics supplied.)

That the owner-promissee has equitable obligations and rights in a donee beneficiary contract, as a promise to pay materialmen seems to be, ⁵ is pretty well established. Restatement, Contracts, §138; Burnet v. Wells, 289 U. S. 670, 679-680 [3 USTC ¶1108]; Cove IRR. Dist. v. American Surety Co. of New York , 42 F. 2d 957 (9th Cir. 1930); Williston on Contracts, rev. ed., §§ 358, 359; Corbin, Contracts, vol. 4, §812.

Thus, Henningsen v. United States, supra, and Prairie State Bank v. United States, supra, pointed to in the Pennsylvania cases (Lancaster and Sundheim) as exemplifying the federal law with which Pennsylvania is in accord, clearly hold that in no-lien construction contracts, ⁶ the owner has an equitable obligation to see that the materialmen are paid, and when the surety has paid them, the surety is subrogated to the rights of the owner in the withheld balances as of the date of the original contract.

The rationale of the foregoing principles is well expressed in Corbin on Contracts, vol. 4, §901, pp. 609, 610, from which the following extracts are taken:

"If the surety claims by subrogation, his claim is not a 'latent equity' for the reason that he is being put into the position of the obligated owner, none of whose defenses and counterclaims can be described as 'latent'.

"The owner, in such a case as the above, is both an obligor and an obligee. His duty to pay is accompanied by a right to the performance promised in exchange for his money; his duty to pay is conditional upon performance by the builder. . . . In so far as the building contractor has not performed his part of the agreed exchange, he has no right to payment by the owner; and his assignee [lien creditor] has none. In so far as the agreed exchange has been performed at the surety's expense, under the compulsion of the surety bond, it has seemed fair and just to give to him that part of the payment that is dedicated to the agreed exchange; and it has seemed unjust to let either the contractor or his assignee [lien creditor] profit by the performance rendered under compulsion by the surety. This is the doctrine of subrogation of the surety to the position of the creditor. For, again be it noted, although the owner is a debtor (obligor) as to the promised payment, he is a creditor (obligee) as to full performance by the building contractor, and deferred payments are retained by him as security for such performance. . . .

"So, when the surety performs any of the contractor's duties to the owner, he is subrogated to the owner's right and securities against the principal contractor; and among these are included the deferred payments and retained percentages in the owner's hands."

The contracts, sub judice, are explicit in providing that the final schedule of payments may be withheld from the Contractor (promisor) until proof satisfactory to the Owner (promisee) is delivered, in order to show the Owner that all claims of laborers and materialmen (beneficiaries) have been paid by the Contractor as promised. ⁷ Because no such proof was ever submitted and substantial amounts were due to materialmen, the Owner did withheld final payments. Thereupon the withheld balances became collateral security for the Owner and ultimately for the Surety when it performed its obligations under the bonds and paid the materialmen. Prairie State Bank v. United States , supra. I hold that the Surety is entitled to the fund.

Payment by the Owner of the Withheld Balances Into Court Does Not Constitute a Waiver of the Surety's Right of Subrogation

The government argues that when the Owner paid the withheld balances into court, it waived its right to withhold them and the Contractor's property rights to same were reinstated and hence the federal liens attach. I do not agree.

In Lancaster County Nat. Bank's Appeal, supra, at page 861 (Atl.), it is stated:

". . . [T]he surety had an equity to insist that the secretary of the department 'withhold the payment of any semifinal or final estimate' until these claims were paid, as by the contract itself he said he would do, and on the faith of which provision, inter alia, the surety executed the bond. Derby v. United States Fidelity & Guaranty Co., 87 Or. 34, 169 P. 500; Canton Exchange Bank v. Yazoo County , 144 Miss. 579, 109 So. 1."

Cf. Sum. Pa. Jur., Surety & Guarantor, §139.

The Owner, when it actually withheld the balances and paid them into court, waived any defenses it had aaginst the claimants, ⁸ but it could not waive any right that the Surety might have to the withheld balances which are the security for the Contractor's performance. Interpleader does not affect the rights of the claimants or the merits of their respective claims inter se. Moore 's Federal Practice, 2d ed., vol. 3, ¶22.07, pp. 3021-3022.

The Surety upon payment of the materialmen was entitled to insist that the withheld balances remain as its security, ⁹ and their payment into court by the Owner, the plaintiff in interpleader, did not divest the funds of their character as security. They did not ipso facto become the property of the Contractor.

The United States Cannot Recover From Surety Unpaid Taxes of the Contractor Incurred in the Performance of Work Under the Contracts at Bar

It remains to be determined whether or not the government is entitled to a judgment against Surety in the sum of $1,114.81, plus interest, being the withholding and social security taxes attributable to the construction of the Mt. Pleasant and Connellsville service stations which the Contractor failed to pay.

In may opinion the claim should be denied.

It seems to be established that withholding and social security taxes due to the government from the Contractor are owing as taxes and not as wages. United States v. Crosland Const. Co., 217 F. 2d 275 (4th Cir. 1954) [58-1 USTC ¶9112]; Westover v. William Simpson Const. Co., 209 F. 2d 908 (9th Cir. 1954) [54-1 USTC ¶49,022]; United States v. Zschach Const. Co., 209 F. 2d 347 (10th Cir. 1954) [54-2 USTC ¶9164].

The pertinent portion of both contracts is as follows:

"With respect to all persons at any time employed by or