Financial hardship defense to FICA and FUTA penalty.

A manufacturing company, Y, did not timely file its employment tax returns for 1998 and 1999 and failed to timely deposit and pay its corresponding tax liability. Y tardily filed the returns in 2000, and paid the taxes and interest over the next two years.

The IRS assessed penalties against Y for failure to timely file its FICA and FUTA returns under Sec. 6651 (a) (1), for late payment under Sec. 6651(a)(2) and for Failure to deposit taxes under Sec. 6656(a). The penalties totaled over $130,000. Y paid a portion of the penalties, then requested a refund and abatement, asserting that financial difficulties caused by the loss of a major customer justified its noncompliance. After the IRS denied the request, Y filed suit for a refund of the already-paid penalties and for abatement of the remaining penalties. The district court granted summary judgment in the government's favor; Y appealed to the Seventh Circuit.

Analysis

An employer that fails to file FICA or FUTA tax returns, or to deposit or pay the FICA or FUTA tax liability shown on the returns, is subject to a mandatory penalty, unless it shows that the failure was due to reasonable cause and not willful neglect, under Secs. 6651(a)(1) and (2) and 6656(a). The sole issue is whether Y established such reasonable cause.

Although the Code does not define reasonable cause, Regs. Sec. 301.6651-1(c)(1) requires Y to demonstrate that despite exercising "ordinary business care and prudence," it "was nevertheless either unable to pay the tax or would suffer an undue hardship if ... [it] paid on the due date." When assessing Y's ability to pay the taxes, "consideration will be given to all the facts and circumstances of [its] financial situation...." Also, Regs. Sec. 301.6651-1(c)(2) provides that the employer will be held to a heightened standard when trust fund taxes are at issue. In Boyle, 469 US 241 (1985), the Supreme Court described the taxpayer's burden in establishing reasonable cause as a heavy one.

Financial Hardship

Y contends that it had reasonable cause for nonpayment of its employment taxes, due to financial distress caused by the loss of its main customer in late 1995, which accounted for 80% of its business until the end of that year, when it moved its metal finishing in house. Because of that loss, Y's revenue decreased by more than 50%. Y urges the court to join a number of other circuits in recognizing that financial hardship can justify; under some circumstances, failure to pay and deposit employment taxes and to find that a reasonable jury could find those circumstances present in this case; see Van Camp & Bennion, 251 F3d 862 (9th Cir. 2001); East Wind Corp., Inc., 196 F3d 499 (3d Cir. 1999); and Fran Corp., 164 F3d 814 (2d Cir. 1999); but see Brewery, Inc. (6th Cir. 1994). According to Y, it would have been forced out of business or into bankruptcy if it had paid the 1998 and 1999 employment taxes.

The Seventh Circuit agrees with the majority of circuits that have considered this issue and recognize that financial hardship may constitute reasonable cause for abatement of penalties for nonpayment of taxes in some circumstances. Nevertheless, those circumstances are not present in this case. First, Y paid taxes in 1996 when its revenue was at its low point, but then failed to pay employment taxes in 1998 and 1999, by which time it had resumed doing business with the customer and substantially restored its revenue level. Second, in the middle of the asserted financial distress, Y's three corporate officers saw fit to increase their own salaries by 70%, which had the dual effect of dissipating funds that could have been used to pay the taxes and increasing the company's unpaid employment tax liability.

Third, all other creditors were paid during 1998 and 1999; a number of payments were made to the company's president, on a loan made to Y. Finally, when the president was informed about the failure to pay the employment taxes in 2000, he took immediate action to pay the delinquent taxes and interest, which suggests that Y had an available source of credit in times of financial difficulty. In light of these facts, no reasonable jury could find that Y's financial situation excused its failure to pay employment taxes in 1998 and 1999. DIAMOND PLATING CO., 7th Cir., 12/6/04