Applicability of sec. 6662 penalty to employment taxes.

The Court of Federal Claims recently held, in Abbey Carpet Co., Inc. (1997), that a corporation that failed to deduct and withhold employment taxes was liable for the negligence penalty for its employment tax returns; an employer, although a collection agent, is nonetheless a "taxpayer," as to withholding taxes, and Form 941, Employer's Quarterly Federal Tax Return, is a return subject to the Sec. 6662 accuracy-related penalty. This holding highlights a difference between the negligence component (Sec. 6662(b)(1)) and the "substantial understatement of income tax" component (Sec. 6662(b)(2)).

In Abbey Carpet, the employer did not deduct or withhold employment taxes from its employee. Although the employee paid the tax, the IRS assessed a 20% negligence penalty against the corporation. The taxpayer argued that employee taxes withheld by employers were not "taxes required to be shown on a return." According to the taxpayer, Form 941 was a return requiring tax to be shown, but not a return subject to Sec. 6662. The taxpayer further argued that Regs. Secs. 1.6662-3 and 1.6664-2 address the applicability of the Sec. 6662 penalty to income taxes only and, therefore, the penalty did not apply to employment taxes.

The court concluded that a taxpayer is subject to the negligence penalty for a failure to withhold and report employee wage taxes. More specifically, an employer has a duty to deduct, withhold and pay employee wage taxes, regardless of whether the employee pays the tax. The court also rejected the taxpayer's argument that the regulations limited the applicability of the statute only to income tax underpayments. The court determined that the Service was reasonably enforcing the law and therefore did not need to issue a regulation on the applicability of the penalty to employment taxes.

The court's finding is consistent with Sec. 6662's legislative purpose to reform the various penalties applicable to tax returns by streamlining them into one section, eliminating the prior-law stacking of penalties but retaining the negligence penalty for inaccurate tax returns that result in an underpayment of any tax imposed by the Code. Before enactment of Sec. 6662, the negligence penalty under Sec. 6653(a) clearly applied to any tax underpayment, and included a definition (in Sec. 6653(c)(1)) in regard to other taxes, such as employment taxes. In enacting Sec. 6662, Congress restricted the negligence penalty's applicability to the negligent portion of the underpayment, rather than to the entire underpayment if any portion of the underpayment was attributable to negligence. If Congress had desired to limit the negligence component of the Sec. 6662 penalty to only income taxes, it could have enacted such a limit (as it did with the substantial understatement component of the penalty). The court also noted that Regs. Sec. 1.6662-3 "addresses income tax imposed under Subtitle A, but it is not exclusive. It does not state that the statute will not apply to other taxes."

Finally, it should be noted that if a taxpayer fails to deduct and withhold the proper amount from employees' wages, the negligence penalty can be avoided by reporting the correct amount on Form 941 and remitting the amount of the underpayment with the return. However, the taxpayer would still be liable for the failure-to-deposit penalty of Sec. 6656, unless a showing of reasonable cause can be made.

FROM THOMAS M. CRYAN, CPA, J.D., WASHINGTON, D.C.