“It Wasn’t My Fault”
When a business is successful and there are profits to share, the owners of the business get along well enough. As revenues fall off, however, while costs often remain steady or even increase, the owners will sometimes choose to “defer” the payment of so-called “trust fund” taxes in order to satisfy business expenses instead, in the hope of keeping the business afloat until it can turn the proverbial corner.
Of course, that corner turns into a spiral, the business fails, and the IRS seeks to collect the unpaid trust fund taxes from those persons in the business who were responsible for collecting and remitting the taxes. There may be several individuals to whom the IRS will look for payment, and it is not unusual to find erstwhile partners blaming one another and pointing fingers so as to deflect responsibility onto anyone but themselves. It is amazing what some people will do to avoid responsibility for the taxes owed by their business.
The U.S. Tax Court recently considered what can only be described as an especially egregious case of finger-pointing by former partners, coupled with what can most generously be described as incompetence by the IRS, that resulted in the IRS’s exoneration of those persons who were actually responsible for the unpaid taxes, and that almost ended with the assessment of those taxes against a truly innocent party.
Let’s Go Into Business
Partner and Taxpayer’s spouse (“Spouse”) formed Corp. to purchase and operate the Business. Partner and Spouse agreed they would be equal owners of Corp. but, because Spouse worked full-time at another job and had little time to participate in the Business, Partner would be the president of Corp. and would oversee its operations – indeed, Partner was the only person listed in Corp.’s articles of incorporation as an officer and director – while Spouse would be a passive investor. For family and medical reasons, Taxpayer was unable to devote much effort to the Business.
Shortly after Partner and Spouse began engaging in preliminary business matters, Partner was unexpectedly called out of state, and most of the pre-opening responsibilities fell upon Spouse. Because of his busy schedule, Spouse asked Taxpayer to carry out some of those responsibilities.
Upon his return, Partner and Spouse conducted interviews and hired new employees. Taxpayer was not involved in the interviewing and hiring process.
Spouse, Partner, and the new employees then underwent training related to the Business. Taxpayer did not attend the training.
During this pre-opening training phase, Partner contacted Taxpayer and asked her to retain the services of a payroll company so the new employees could be paid. Taxpayer engaged the services of a payroll company (“Pay-Co”) that, in addition to preparing employee paychecks and determining payroll tax liability, would debit the Business’s bank account; directly deposit Federal payroll taxes; and electronically file Forms 941.
Partner also directed Taxpayer to open a corporate bank account on behalf of Corp. She opened an account at Bank, and was identified as someone having signatory authority on the account.
After the Business opened, it was run primarily by Partner and a key employee (“Employee”). Partner carried out his role as president of the corporation, and was heavily involved in the initial hiring and structuring of the Business. Partner indicated that he “drove all aspects of building business from the ground up, . . ., hired, trained, and supervised staff . . ., while managing . . . costs.”
Partner oversaw the day-to-day operations of the Business and, when he was not physically present, was in constant contact with Employee, with whom he discussed daily business dealings. Partner also monitored the Business’s bank balances and determined when it was appropriate for the Business to borrow money.
Employee was the general manager of the Business and was responsible for carrying out the day-to-day business operations. He managed the employees, paid creditors, and oversaw purchases from vendors. He was responsible for hiring, training, and firing personnel, purchasing, inventory, sales strategies and yield management, reviewing financial statements, product mix, budgeting, forecasting revenues and expenses, and management of individual department managers/supervisors. Employee was also Pay-Co’s main contact, and maintained control over the payroll process.
Taxpayer did not have a significant role at the Business. While she was directed to establish the Business’ bank account and to contract with Pay-Co during the pre-opening phase of the business, she became decidedly less involved once the Business was operational. Taxpayer’s main responsibilities were delivering checks, relaying electronic bank account balances to Employee, and delivering the Business’s mail that was sent to her private mailbox. Taxpayer occasionally transferred funds to and from the corporate bank account at the direction of Partner or Spouse. She also issued checks at the direction of Partner or Spouse for some of the Business’s recurring monthly expenses. During the periods at issue Taxpayer signed roughly 4% of the non-payroll checks.
Taxpayer made no operational decisions. Indeed, she did not have the proper education, training, or experience to hold a management position at the Business.
Employee maintained control over the payroll process. He was responsible for compiling the payroll information and transmitting this information directly to Pay-Co every week. Because of the quick turnaround between providing the weekly payroll information to Pay-Co and payday at the Business, it was necessary for Pay-Co to hand-deliver the payroll checks by courier.
Because the Business had no business location at the time Pay-Co was first contracted, the payroll checks were initially delivered to Spouse’s and Taxpayer’s home address. Later, once the Business formally opened, Pay-Co began delivering the payroll checks directly to the business location. However, because employees were rarely onsite to receive the payroll checks at the time of delivery, the parties reverted to having the checks delivered to Spouse’s and Taxpayer’s residence.
Upon delivery of the payroll checks, Taxpayer was directed by Partner to sign the checks and deliver them to the business premises. It was usually necessary for Taxpayer to sign the checks because Employee was usually off on payday, and there was no one else onsite available to sign the checks. Taxpayer was not responsible for and did not review statements included in the Pay-Co package. Taxpayer signed about 81% of the payroll checks.
The Business Fails
Within a year of opening, the Business was losing money.
As a result of several bounced checks, vendors began to lose faith in the Business’s ability to pay its bills, and many demanded cash on delivery or certified checks.
Employee began to pay creditors by first using cash received from daily operations. When the Business’s cash balance was exhausted, he would resort to using standard checks or certified checks. The owners limited the number of checks available to Employee at any one time, in an effort to rein in his spending.
Eventually, the account at Bank was frozen. At that point, Partner directed Taxpayer to open a new bank account, with Second Bank. Before opening the account, a bank employee instructed Taxpayer to indicate she held some form of corporate office on the commercial signature card and on a form titled “Bank Resolution by Corporation”. Taxpayer handwrote “sec” next to her signature on the signature card, and she signed the Resolution as Corp.’s secretary even though she was never actually secretary for Corp.
Shortly thereafter, Pay-Co tried to withdraw $X for taxes from the account at Second Bank. The electronic withdrawals were rejected.
Pay-Co then scaled back its services to Corp., limiting them to producing payroll checks and reference copies of Forms 941. The payroll checks continued to be debited from the Second Bank account. However, Pay-Co did not debit the payroll tax portion from the account, make payroll deposits on the Business’s behalf, or file Forms 941. Taxpayer was unaware these services had been canceled.
The IRS Comes A-Knocking
Corp. finally stopped operating the Business and, within a couple of months, the IRS visited the office of Corp.’s CPA.
CPA informed Spouse and Taxpayer that a representative of the IRS had visited his office investigating unpaid payroll taxes. This was the first time Spouse and Taxpayer had knowledge that Federal payroll deposits had not been made for various quarters and that Forms 941 remained unfiled.
The IRS originally investigated Corp., but expanded its investigation to include Partner, Employee, and Taxpayer. After conducting its investigation, the IRS recommended assessing the Trust Fund Recovery Penalty (“TFRP”) against Partner, Employee, and Taxpayer.
The IRS eventually assessed the TFRP against Taxpayer as a “responsible person.” However, both Partner and Employee somehow successfully contested the IRS’s efforts to assess the penalty against them.
Taxpayer challenged the IRS’s determination, which was sustained by an IRS Appeals officer. Taxpayer then filed a petition with the Tax Court.
Trust Fund Recovery Penalties
Employers have a duty to withhold income and employment taxes from their employees’ wages. These withheld funds are often referred to as “trust fund taxes” because the Code characterizes such withholdings as “a special fund [held] in trust for the United States.” Employees generally are allowed a credit against their tax liability for the amount of taxes withheld from their wages, regardless of whether the employer actually remits the funds to the IRS. Therefore, when net wages are paid to an employee and the employer does not pay over the withheld funds, the IRS has no recourse against the employees for their payments and may collect only from the employer.
The Code provides a collection tool allowing the IRS to impose penalties on certain persons who fail to withhold and/or pay over trust fund taxes. The penalty is equal to the total amount of the tax that was withheld but not paid over, and is imposed on any “person” required to collect, truthfully account for, or pay over any tax withheld who willfully fails to do so.
The term “person” is often taken to mean a “responsible person” and includes an officer or employee of a corporation who, as such, is under a duty to collect, account for, or pay over the withheld tax. Therefore, liability for a TFRP is imposed only on (1) a responsible person who (2) willfully fails to collect, account for, or pay over the withheld tax.
The Court addressed whether Taxpayer was a responsible person. A “responsible person,” it explained, is any person required to collect, account for, or pay over withheld taxes. Whether someone is a responsible person is a “matter of status, duty and authority, not knowledge.” Indicia of responsibility include “the holding of corporate office, control over financial affairs, the authority to disburse corporate funds, stock ownership, and the ability to hire and fire employees.”
The IRS argued that Taxpayer possessed all the recognized indicia of responsibility and was, therefore, a responsible person. The IRS further asserted that Taxpayer exercised substantial financial control over Corp., and that at all times Taxpayer was a de facto officer of the corporation because she opened two corporate bank accounts, had signatory authority on both accounts, and signed checks on behalf of the corporation.
Taxpayer argued that she lacked decision-making authority and did not exercise significant control over corporate affairs. She further asserted that despite her signatory authority, she was not a responsible person because she had a limited role in the Business’s payroll process and merely signed payroll checks for the convenience of the corporation.
Taxpayer claimed that Partner and Employee were responsible for running the corporation day-to-day, and that her duties were ministerial.
The Court’s Analysis
The Court agreed with Taxpayer and found that the preponderance of the evidence showed that her role was ministerial and that she lacked decision-making authority. Accordingly, the Court held that Taxpayer was not a responsible person.
Responsibility, the Court stated, is a matter of status, duty, and authority. “In considering the individual’s status, duty, and authority, the test is one of substance.” In other words, the focus of the inquiry does not involve a mechanical application of any particular list of factors. The inquiry must focus on actual authority to control, not on trivial duties.
The Court determined that Taxpayer lacked the authority to control the financial affairs of the Business, including the disbursement of Corp.’s funds. Notwithstanding Taxpayer’s signatory authority and her spousal relationship to one of Corp.’s owners, the substance of her position was largely ministerial and she lacked actual authority.
According to the Court, the “credible” testimony and the documentary evidence introduced at trial demonstrated that Partner and Employee exercised control over the financial affairs of Corp., and that Taxpayer served only support functions. The Court commented that the testimony of Partner and Employee regarding Taxpayer was not credible.
The Court Reprimands the IRS
Interestingly, the Court noted that it was, in fact, puzzled that Partner, the president of the corporation and a hands-on owner, and Employee, the day-to-day manager, successfully “evaded” – the Court’s word – any personal liability for TFRP.
The Court observed that the IRS went to great lengths to characterize Taxpayer as a savvy business person whose actions and prior work experience made her a de facto director and officer. On the basis of the record, the Court could not make such a finding.
It was clear, the Court stated, that Taxpayer was not an officer, director, owner, or employee of Corp. at any time. With the exception of a few weeks during the preopening phase, Taxpayer had no involvement in the day-to-day affairs of the corporation. She usually visited the corporation only once a week (on payday), for less than an hour each time. The record also showed that there were times that she did not visit the business for periods of several months.
The IRS had determined that Taxpayer was a responsible person during the pre-opening phase (1) because of her alleged status as secretary of the corporation, and (2) because she signed checks.
However, the Court determined that the IRS did not conduct a thorough investigation.
Additionally, Taxpayer had no authority to hire and fire employees of the corporation. She had no responsibility to oversee or ensure the payment of payroll taxes on its behalf. She was not its bookkeeper or accountant. She did not reconcile the bank statements.
Even though she wrote and signed roughly 4% of the non-payroll checks to pay some of the corporation’s recurring operating expenses, such as rent, she was merely doing so at the direction of others and for the convenience of the corporation.
Moreover, even though Taxpayer signed most of the payroll checks prepared by Pay-Co, the duty was ministerial and done only for the convenience of the corporation. She had no duty to, and did not, oversee the employees, collect payroll information, compile payroll information, or remit the payroll information to Pay-Co on behalf of Corp.
Accordingly, because Taxpayer did not hold corporate office, did not control financial affairs, had no ownership interest, had no authority to hire and fire employees, and otherwise had little or no decision-making power beyond some ministerial duties, the Court found that she was not a responsible person.
Beware of Fair-Weather Partners
How could the IRS have absolved Partner and Employee while continuing to pursue Taxpayer in the above case? Might securing the testimony of the absolved parties have had anything to do with the IRS’s actions? Perhaps. Might their legal representatives have been more competent than Taxpayer’s? Maybe. In any case, the Court was right to be puzzled.
How can a taxpayer in a closely held business protect himself from a similar scenario? Unfortunately, there is no completely fail-safe way to do so – a resourceful “bad guy” will likely find a way or two to circumvent, at least in part, the obstacles to his evasion scheme.
A good place to start would be at the beginning. The passive investor should educate himself – what kind of activity will expose him to liability as a responsible person. During the initial phase of a business, it would behoove the passive investor to insist that each participant’s role within the business be described and documented.
A well-drafted shareholders’ agreement and by-laws would go a long way, as would accurate and timely recorded directors’ and shareholders’ minutes.
Finally, the investor should consider memorializing any activity undertaken on behalf of the business, including its nature and extent, and who requested his participation and under what circumstances.
It is not a perfect strategy, and may be resisted by others, but that in itself should be a wake-up call.