“You Mess with the Bull . . .”
An often-explored theme of this blog is the frequency with which similarly situated business taxpayers, facing the same set of economic circumstances, and presented with the same set of choices, will knowingly repeat the “mistakes” made by countless taxpayers before them.[i] They will choose a course of action that violates the spirit, if not the letter, of the tax law.
Rational behavior? Does the answer depend upon the taxpayer’s appetite for risk-taking? Being an entrepreneur necessarily involves some exposure to risk. However, there is a difference between the calculated risk that an intelligent business owner takes, on the one hand, and the risk that comes with tweaking the nose of the IRS, on the other.
“ . . . You get the Horns”
For example, many business owners (and former owners) have regretted certain choices regarding their withholding tax obligations.
In order to assist the IRS in the collection of those taxes that are imposed on an employee’s wages, employers generally must withhold from their employees’ wages the federal income, social security, and Medicare taxes owing by such employees on account of such wages. These taxes are called “trust fund” taxes because employers actually hold the employee’s money in trust until making a federal tax deposit of the amounts withheld.
Trust Fund Penalty
The amounts withheld must be paid over to the IRS (“deposited”) in accordance with the applicable deposit schedule. To encourage the prompt payment by employers of the withheld income and employment taxes, the Code provides for the so-called trust fund recovery penalty (“TFRP”) under which a person who is responsible for withholding, accounting for, or depositing or paying these taxes, and who willfully fails to do so, can be held personally liable for a penalty equal to the full amount of the unpaid trust fund tax, plus interest.
Thus, if an employer fails to collect the appropriate amount of tax (for example, as result of having misclassified employees as independent contractors) or collects the tax but fails to remit it, and the unpaid trust fund taxes cannot be immediately collected from the business, the TFRP map be applied to the responsible persons.
It should be noted that the employer’s business does not need to have ceased operating in order for the TFRP to be assessed. Indeed, it may be that, in some cases, a business has survived only because the withheld taxes have not been remitted to the IRS but have, instead, been used to pay other expenses of the business.
In many other cases, however, the imposition of the TFRP plus interest has led to the demise of the business. Although this result may seem harsh, it is probably the correct outcome from an economic perspective. A business that cannot survive on its own should not be able to divert withheld tax amounts toward its own private use.[ii]
A Recent Example
Taxpayer formed LLC with his deceased business partner, Dead Guy[iii]. Each was a fifty-percent owner of LLC, and they were the company’s only officers. LLC’s operating agreement gave them joint managerial control of the company and prohibited either one from engaging in major financial transactions without the other’s approval. Taxpayer’s title was “managing member.” He oversaw LLC’s office operations, and Dead Guy oversaw LLC’s field operations.
Both Taxpayer and Dead Guy had signing authority on LLC’s bank accounts. Taxpayer frequently signed checks, including payroll checks, during the years at issue. LLC had a stamp of Taxpayer’s signature, and Taxpayer regularly directed the employee who handled payroll to issue checks with his signature to employees and creditors. Taxpayer admitted that he decided which bills to pay if there were insufficient funds to pay them all. LLC also had an outside accountant, CPA, who prepared LLC’s corporate income and employment tax returns. Once CPA prepared the returns, he reviewed them with Taxpayer and Dead Guy before filing.
During the years at issue, LLC did not fully pay its federal payroll taxes. Taxpayer was aware that employers are required to withhold income and social security taxes from their employees’ wages. He also became aware at some point during this time period that LLC owed taxes.
Taxpayer said that he first learned that the payroll taxes were not being paid when an IRS agent came to LLC’s office. Taxpayer then tried to work with the IRS to pay the delinquent taxes. CPA corroborated that Taxpayer was kept apprised of LLC’s ongoing tax struggles.
Following an administrative investigation, the IRS determined that both Taxpayer and Dead Guy were “responsible persons” who had willfully failed to pay over the trust fund taxes. It assessed trust fund recovery penalties against both of them.
Trust fund taxes are amounts withheld for income and social security tax and remitted to the IRS.
During the pendency of their case before the District Court, Dead Guy, well, died, and was dismissed as a defendant.[iv] The case proceeded against Taxpayer, and the IRS sought a judgment against Taxpayer for the unpaid balance of the amounts assessed against him. The parties filed cross-motions for summary judgment on the issues of: (i) whether Taxpayer was a person responsible for paying over the trust fund portion of LLC’s payroll taxes; and (ii) whether Taxpayer willfully failed to pay over those taxes.
The Courts Speak
The District Court concluded that Taxpayer was a responsible person because he was a fifty-percent owner, one of only two officers, he had check-signing authority, and he exercised his power to pay LLC’s bills and sign paychecks. The Court further determined that Taxpayer learned during the years at issue that the taxes were not being paid, and that he received regular updates on communications with the IRS regarding the delinquencies. The Court concluded that he was willful because he paid other creditors after having actual knowledge that the payroll taxes were not being paid, and because he acted with reckless disregard for whether the taxes were being paid.
In opposition to the IRS’s motion for summary judgment, Taxpayer claimed – contrary to his deposition testimony! – that he had not been aware of the delinquencies. The District Court disregarded this declaration because “conclusory, self-serving affidavits are insufficient to withstand a motion for summary judgment.”
The District Court granted the IRS’s motion, and Taxpayer appealed the decision to the Court of Appeals for the Third Circuit.
The Code provides that any person required to pay over trust fund taxes who “willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof” will be liable for the amount of tax evaded. The two conditions for liability are (1) that the individual must be a “responsible person,” and (2) their failure to pay the tax must be “willful.”
On appeal, Taxpayer argued that the District Court should not have granted the IRS’s motion for summary judgment because his case presented genuine disputes of material fact regarding both conditions. The Court disagreed.
First, Taxpayer contended that he was not a “responsible person” under the Code. “Responsible person,” while not appearing in the statute itself, is a term of art for the person who has the duty or power to perform or direct the collecting, accounting for, or paying over trust fund taxes. The Court pointed out that “[r]esponsibility is a matter of status, duty or authority, not knowledge.” And “[w]hile a responsible person must have significant control over the corporation’s finances,” the Court continued, “exclusive control is not necessary.” Additionally, there can be more than one responsible person for a particular employer. The Code imposes joint and several liability on each responsible person. A person who has paid the penalty may seek contribution from other liable persons.
To determine whether an individual is a responsible person, the Court stated, the following factors are typically considered:
(1) the corporate bylaws, (2) ability to sign checks on the company’s bank account, (3) signature on the employer’s federal quarterly and other tax returns, (4) payment of other creditors in lieu of the United States, (5) identity of officers, directors, and principal stockholders in the firm, (6) identity of individuals in charge of hiring and discharging employees, and (7) identity of individuals in charge of the firm’s financial affairs.
Based on the foregoing, the Court did not see any error in the District Court’s conclusion that Taxpayer was a responsible person. The undisputed evidence established that he was a fifty-percent owner of LLC and one of only two officers, his approval was required for company decisions and many significant financial transactions, he had check-signing authority, and had exercised his power to pay the company’s bills and sign paychecks.
On appeal, Taxpayer protested that he was not responsible for LLC’s payroll or tax contributions. He claimed these responsibilities were entirely Dead Guy’s. But the District Court properly determined that the division of labor between the two partners was irrelevant, because there can be more than one responsible person, and Taxpayer possessed and exercised the authority that qualified one as statutorily “responsible” to pay over taxes. Moreover, Taxpayer’s contentions that he was somehow not responsible because he managed LLC’s business while Dead Guy directly supervised employees only solidified the District Court’s conclusion. Faced with this evidence, the Court found that Taxpayer was a responsible person.
Taxpayer next argued that his failure to pay over the taxes was not willful.
According to the Court, willfulness is “a voluntary, conscious and intentional decision to prefer other creditors over the Government.” It may also be established, the Court stated, if the responsible person acts with “reckless disregard” of a known or obvious risk that withheld taxes may not be remitted to the government. “Reckless disregard includes failure to investigate or correct mismanagement after being notified that withholding taxes have not been paid.” Willfulness need not be in bad faith, nor does it require actual knowledge of the tax delinquency.
The Court concluded that Taxpayer’s behavior was willful because he permitted LLC to pay other creditors after he knew that the taxes were in arrears. The record demonstrated that he had actual knowledge the taxes were due and, despite this knowledge, LLC paid substantial sums to Taxpayer and Dead Guy throughout the delinquency.
Moreover, to the extent that Taxpayer claimed he was unaware the taxes were not being paid, the Court countered that he was in a position to know for certain that they were not. Under the circumstances, Taxpayer’s inaction amounted to a reckless disregard qualifying as willfulness.
The More Things Change . . .
Indebtedness that isn’t “real,” unreasonable compensation, constructive dividends, below-market transactions with related parties, questionable losses[v], weakly-supported valuations, misclassified service providers – these are but some of the more common instances in which taxpayers flout the tax laws and invite the imposition of penalties.
They are also among the most easily avoidable situations because they fail to comport with economic reality and, as such, are readily identifiable by both the taxpayer and the IRS. Moreover, they typically do not involve especially convoluted fact patterns or complex issues in areas of the law where the outcome may be debatable and where a taxpayer may have a reasonable basis for its position.
For these reasons, among others, a well-advised – i.e., well-informed – taxpayer should never place itself in a position where it will have to concede such an “error” in the course of an audit. Such a taxpayer loses credibility with an examiner, which may taint other, more defensible positions on its tax return. Why jeopardize oneself by repeating the mistakes for which countless decisions have upheld the imposition of penalties? Such an action does not stem from a calculated risk – it’s just reckless.
[i] No, I am not turning this into a social science paper or a discussion on rational choice theory. However, I am channeling that great Sicilian, Vizzini: “You fell victim to one of the classic blunders – the most famous of which is ‘never get involved in a land war in Asia’ – but only slightly less well-known is this: ‘Never go in against a Sicilian when death is on the line’! Ha ha ha ha ha ha ha!” From The Princess Bride.
[ii] As one IRS agent put it to me many years ago, a taxpayer should go out of business before it fails to satisfy its tax obligations.
[iii] All references to “Dead Guy” relate to the period prior to his passing. On information and belief, Dead Guy was alive when LLC was formed, and ceased to be active in LLC’s business only after his death.
[iv] A tax lien arises at the time an assessment of tax is made and continues until the tax is satisfied or becomes unenforceable by reason of lapse of time. Thus, when a trust fund penalty is assessed, a tax lien attaches to all of the responsible person’s property. The lien remains attached and is not invalidated by a transfer of the property upon the death of the responsible person.
[v] For example, where a taxpayer makes deductible cash expenditures year after year in excess of their cash revenue, thereby generating a loss – even without regard to depreciation/amortization or elections to expense certain items – yet remaining in business.