The 100% penalty.

"Responsible Persons" Can Be Held Liable for Their Companies' Failure to Collect and Pay Over Tax

Congress enacted the 100% penalty statute, Sec. 6672, to encourage the immediate payment of amounts withheld from employees by giving the IRS the authority to hold responsible third parties personally liable if their companies do not pay these taxes. The IRS need not file a suit first against the company; it may take direct action against the responsible persons. Therefore, the person responsible for the collection and payment of withholding taxes cannot avoid the 100% penalty by asserting that the IRS made no attempt to collect the taxes from the corporation that employed him.(1) The liability of the person responsible for payment of the taxes is distinct from the corporation's liability and may be asserted by the IRS without first attempting to collect from the corporation.

Once the penalty has been assessed under Sec. 6672, the burden of proof falls on the taxpayer to prove that he was not a responsible person or his failure to pay the taxes was not willful.

Trust Fund Taxes

"Trust fund taxes" include the employee's portion of Federal income tax withheld from the employee and FICA collected from the employee. These taxes do not include the employer's matching portion of the taxes.

If a corporation or partnership fails to pay the withheld taxes to the Government, the 100% penalty may be assessed against the agent of the employer who is the responsible person and who willfully failed to collect and pay over these taxes to the Government. The amount of the penalty is equal to the trust fund portion of the taxes. Note that sole proprietorships are responsible for the total amount of taxes (the employer's portion as well as the employee's portion) plus any applicable interest and penalties.

The 100% penalty is not assessed in the same way as income or estate and gift tax: The IRS never issues a Statutory Notice of Deficiency; the Tax Court has no jurisdiction over employment and withheld income tax cases; and the Appellate Division is the only level of administrative review. Once the penalty is imposed, the IRS has the same rights to collect the penalty as it would be collect any other taxes from the taxpayer. The IRS also has the power to file liens and seize assets from the taxpayer. Any person who pays such a penalty may sue the company under Sec. 6672 to recover the amounts paid.

Responsible Persons

Sec. 6671(b) defines a responsible person as "an officer or employee of a corporation, or a member or employee of a partnership, who as such officer, employee, or member is under a duty to perform the act in respect of which the violation occurs." Various court cases have determined that Sec. 6671(b) includes any person who has all or part of the power of making decisions as to which liability will be paid and which debt will not be paid. The courts have established that a responsible person is one who has the final or significant word as to which bills or creditors should be paid and when.(2) The "final word" does not mean "exclusive" control but "significant" control.(3)

To be deemed a responsible person, that person is not required to prepare the tax returns, pay wages or withhold taxes and keep the books and records. Rather, over the years the courts have considered the following factors in determining who is a "responsible person."

* The ability to sign checks.(4)

* Preparation of employment tax returns.(5)

* Service as an officer, director or shareholder of the corporation.(6)

* The authority to hire and discharge employees.

* An entrepreneurial stake in the corporation.

* Corporate officers and employees

The major factor in determining the responsible person is to find out who has control over company finances for seeing that the taxes withheld are remitted to the IRS. Such a duty is found in "high corporate officials charged with general control over corporate business affairs who participate in decisions concerning payment of creditors and disbursal of funds."(7)

Seitz(8) is an important case in this area because it specifically identifies the "responsible person" and defines his responsibility. George Seitz had his inventory of automobiles financed by a bank; because his dealership was in financial difficulties, the bank kept a representative at the dealership Seitz made out checks to the IRS but the bank representative did not forward the checks to the Service. The court ruled that Seitz had the responsibility of writing the checks and for following through to ensure that the IRS received the payments.

The IRS may assess the penalty against more than one responsible person. Generally, the IRS will not collect more than 100% of the tax liability, but occasionally it will make an error and collect more than the assessed amount from the responsible persons. In any event, if the Service has collected more than 100% of the tax liability, a partial refund may be requested. If the IRS is able to establish that there is more than one responsible person and the affected parties are related, it is recommended that all the affected parties be represented by one CPA or attorney, who will ensure that no overpayment occurs.

* Creditors

The courts have ruled that a "responsible person" need not have prepared the tax return, paid the wages or withheld taxes.(9) This opens the door for the assessment of the 100% penalty against persons other than corporate officers and employees, such as creditors, insurance companies and accountants. For instance, in one case, a bank had its officer determine which creditor to pay for one of its financially troubled customers. The bank officer knew that the employment taxes were in arrears but he choose to pay other creditors instead. The court ruled that the bank was a "responsible person" and was liable for the unpaid employment taxes.(10)

Net payroll financing: Before 1966, only employers were directly liable for payroll taxes required to be withheld and deducted from employee wages even though many persons other than employers (e.g., lenders) directly or indirectly paid wages to the employees. In some situations, these third parties (i.e., other than employers) paid only net wages to employees and did not pay payroll taxes to the Government, even though the employees received credit on the Treasury Department records as if the taxes had been paid. To prevent any revenue loss, Congress enacted Sec. 3505(a) and (b), which impose direct liability on lenders and others who pay, or provide funds to pay, wages for employers. Sec. 3505(a) specifies that the person who pays wages directly to the employees will be personally liable for paying the taxes withheld to the IRS. Sec. 3505(b) further specifies that the person who supplies the funds is liable for payment to the IRS for the taxes (together with interest) if that person is aware that the responsible person who should be paying the taxes is not doing so. Sec. 3505(b) therefore equates awareness of nonpayment with willful nonpayment. For example, the Fifth Circuit has ruled that when a contractor advances a subcontractor its net payroll only, and makes no provision for withholding and FICA taxes, it has knowledge that the subcontractor could not and would not pay such taxes.(11) Thus, it makes itself liable for payment of the taxes.

* Accountants

Accountants who perform substantial recordkeeping services for their clients may be deemed responsible persons. In Quattrone Accountants, Inc.,(12) the United Dairy Farmers Cooperative Association (UDF) was formed as a dairy cooperative, owned and operated by member-volunteers. Quattrone Accountants, Inc. had contracted to handle all accounting and financial activities for the association, and in so doing had made itself the responsible person. Even though the accounting firm declared bankruptcy, the court found that it had acted in "reckless disregard" of its responsibility and thus assessed the firm for full payment of the 100% penalty.

Willfulness

The second element in assessing the 100% penalty is willfulness.

* Knowledge of the liability

One of the essential elements of willfulness is knowledge that withheld taxes are not being paid. In one case, the taxpayer took control of a financially troubled corporation in an attempt to save the corporation from failure. He was the only authorized signatory on the corporate bank accounts and was designated as the responsible person to collect and pay the withheld taxes. The court observed that a bank had seized the corporate accounts under a loan agreement but that the taxes were due before the seizure. It also indicated that sufficient funds were available at that time to permit the payment of other creditors. The court ruled that the taxpayer's failure to pay overdue taxes was willful.(13)

The lack of knowledge that withheld taxes were not being paid can be the best defense against willfulness. If the taxpayer can prove that he was not aware of any payroll tax liability or that his employees or associates kept him in the dark regarding the liability, the taxpayer may not be liable for the taxes. In Feist,(14) for example, the taxpayer learned about the delinquent payroll taxes shortly before he sold the company and arranged to have the new owners pay the taxes. The court ruled that the taxpayer was the responsible person for the collection and payment of withholding and FICA taxes, but he was not liable for them since he did not willfully fail to pay over the taxes to the Government.

* Reasonable cause

Some courts have held that willfulness can be mitigated by a reasonable cause. Lack of knowledge that payroll taxes are due or about to come due or a lack of funds to pay the taxes when the liability is discovered may be reasonable cause,(15) but this exception is very limited in scope. In Monday, the court stated:

The standard of willfulness should not be construed to include lack of "reasonable cause" or "justifiable excuse." These concepts tend to evoke notions of evil motive or bad purpose which properly play not part in the civil definition of willfulness. . . . In addition, "reasonable cause" and "justifiable excuse" invite consideration of such misleading and improper factors as the financial condition of the business or the demands of creditors.(16) (Cases omitted.]

The difference between civil and criminal statutes should be noted: The criminal statute generally requires bad purpose or absence of any justifiable cause, but these elements need not be present in civil actions.(17)

In Newsome,(18) the Fifth Circuit ruled that the advice and information the president of a construction company received from its accountants and attorneys was not reasonable cause for his failure to pay over withheld payroll taxes.

In a Court of Claims case, the taxpayer was a "responsible person" but not during the years at issue. Therefore, he had reasonable cause for not paying the taxes and hence was not "willful" in not remitting taxes to the Government.(19) In this case, payments were made under an agreement with the IRS. The Navy knew about the agreement when it took over management and control of the company. After making two payments, though, the Navy caused the company to breach the agreement by not allowing any further payments on delinquent taxes.

The court ruled that taxes equal to the value of the company's property could have been collected by the IRS had it foreclosed its tax liens on default of the payments of the tax arrears, as provided in the agreement. The Service's desire to wait for the taxes absolved the taxpayer's willfulness in failing to pay the withholding taxes while he possessed the authority to do so.

Payment of the Liability

The penalty is equal to the trust fund, which consists only of the withheld taxes, i.e., withheld income taxes and the employee's share of the Social Security taxes. Such a trust fund does not include the employer's share of Social Security taxes. The author has found that the IRS often makes mistakes in calculating the 100% penalty. One way to verify is to request the transcripts from the Service and to calculate the trust portion of the liability. Additionally, practitioners should check the accuracy of the Form 941 (filed with the IRS), which is the basis for calculating the trust fund portion of the taxes.

* Voluntary vs. involuntary payments

If a taxpayer makes a voluntary payment to the IRS, he has the right to direct the application of such payments toward whatever type of liability he chooses.(20) When a taxpayer makes a voluntary payment and does not direct the application of the funds, the Service may make the allocation as it chooses.(21) The Internal Revenue Manual states that involuntary payments may be applied to attain the maximum benefit for the United States.(22) Therefore, if an employer owes taxes in addition to the trust fund liability, the IRS would probably allocate payments to those other taxes first, since it could then use the 100% penalty to collect the trust fund amount. One procedure to reduce the potential trust fund liability is to place a restrictive endorsement on the back of each check, which may be worded as "Payment for the amount of $ -- to be applied to Trust Fund Only for the time period --."

In many cases, the courts have ruled that if payment is made after the tax return has been filed or (in the absence of a return) the tax liability is otherwise established, it is deemed involuntary.(23) Therefore, payments made before the liability for the taxes becomes fixed are voluntary and the allocation may be designated by the taxpayers. A payment is also involuntary when the taxpayer has no immediate control over the source, such as payment made as a result of distraint action by the revenue officer or judicial action. The distinction between a voluntary and involuntary payment is based on the presence of court or administrative action resulting in an actual seizure of property or money, as in a levy.(24)

Bankruptcy

The 100% penalty is not really a penalty but a collection device used by the IRS to recover trust fund taxes from the responsible person. An adjudication of bankruptcy does not discharge the debtor's liability to pay taxes withheld from employees. Withholding taxes collected before filing for bankruptcy are funds held in trust; the 100% penalty then becomes nothing more than the amount of matching funds held in trust before being turned over to the Service.(25) Therefore, the penalty is assessed to assure that all funds owed to the IRS are collected.

How to Avoid or Minimize the 100% Penalty

The IRS begins its investigation of prospective responsible persons by examining corporate minutes, the corporate organizational structure and financial records. Generally, the IRS will ask for bank statements, canceled checks, loan agreements, the corporate minutes and any other documents that will help to determine potential responsible persons; inquire as to who had the authority to sign checks, borrow funds and repay loans to creditors; and also conduct interviews and use Form 4180, Report of Interview Held With Persons Relative to Recommendation of 100-Percent Penalty Assessment, to gather information from the interviewee.

After collecting all the data, the revenue officer will propose the 100% penalty against the responsible persons. The penalty being assessed is presented to the group manager for concurrence. After obtaining his approval, the proposed 100% penalty(ies) are mailed to the responsible person(s). The taxpayer has 10 days to contact the revenue officer to present his case, or, within 30 days of receipt of the letter, he may request an appellate conference. Once the taxpayer receives the proposed 100% liability, he should protest in writing to the IRS. Generally, the revenue officers have very limited authority to negotiate, but if the taxpayer or his counsel can convince the officer that he is in no position to pay the 100% liability, the Service may start searching for another responsible person.

If the taxpayer is unable to convince the IRS that he was not a responsible person, the taxpayer or his counsel should ask the revenue officers and group manager the reasons for assessing the 100% penalty. Another person to ask is the disclosure officer at the district level. Their responses will help a CPA or attorney prepare a defense to present during a meeting with the Regional Director of Appeals.

It is recommended that once the accountant is hired by the taxpayer, he should immediately request the following documents under the Freedom of Information Act: Form 4183, Recommendation re 100-Percent Penalty Assessment, Revenue Officer's History Sheets, Revenue Officer's Rebuttal (or Report), all Forms 4180, Revenue Officer's notes, bank signature cards with the taxpayer's signature, any check(s) signed by the taxpayer and any other supporting evidence in assessment of the Sec. 6672 (100%) penalties.

If the taxpayer is not successful in abating the 100% penalty at the revenue officer or group manager level, the taxpayer or his counsel should inform the group manager in writing that the taxpayer plans to appeal to the office of the Regional Director of Appeals.

It is recommended that such a request be hand delivered to the group manager and a signature obtained as proof of receipt. The taxpayer has 30 days to request an appeal from the date of the proposed assessment letter.

There are various advantages to filing an appeal. First, the taxpayer can "buy more time" because the appeal will delay the assessment of tax. Second, an Appeals Office Conference gives the IRS and the taxpayer a chance to settle the case without the cost of litigation. A revenue officer does not consider the hazards of litigation, while an appeals officer must weigh these hazards in settling a case. If the taxpayer can convince the appeals officer that he has a very good chance of winning the case, the officer may settle for less than 100% of the proposed liability. The taxpayer's counsel must prepare thoroughly before going to the Appeals Office because the taxpayer is entitled to only one conference with the Appeals Division.(26) Furthermore, if there are a number of responsible persons and one has filed a suit for refund, the others will be denied an Appeals conference.

If the taxpayer is unable to resolve the case in the IRS Appeals Office, he may file a claim for a refund in a U.S. District Court to secure judicial review of the 100% penalty. The 100% penalty is classified as an excise tax and is divisible. The divisible tax consists of a separate tax liability for each separate transaction or event. Therefore, the taxpayer may pay the tax attributable to one individual for one quarter in order to start refund litigation. But the IRS is permitted to counterclaim for the entire amount of the assessed penalty. (1) Richard R. Sage, S.D. Ill., 1981 (49 AFTR2d 82-712, 81-2 USTC [Paragraph] 9764). See also Joseph L. Bernadi, N.D. Ill., 1973 (33 AFTR2d 74-523, 74-1 USTC [Paragraph] 9170). (2) Pacific National Insurance Co., 422 F2d 26 (9th Cir. 1970)(25 AFTR2d 70-714, 70-1 USTC [Paragraph] 9238), cert. denied, reh'g denied. The Ninth Circuit had already established this description in Arthur King Wilson, 250 F2d 312 (9th Cir. 1957)(52 AFTR 1048, 57-2 USTC [Paragraph] 10,040). See Pacific National, at 70-1 USTC 82,938. (3) Robert G. Dudley, 428 F2d 1196 (9th Cir. 1970)(26 AFTR2d 70-5108, 70-2 USTC [Paragraph] 9520), quoting from Kyle I. Turner, 423 F2d 448 (9th Cir. 1970)(25 AFTR2d 70-851, 70-1 USTC [Paragraph] 9282), at 70-1 USTC 83,079. (4) James R. Cash, 346 F2d 670 (5th Cir. 1965)(15 AFTR2d 1057, 65-1 USTC [Paragraph] 9428). (5) Emil Horwitz, 236 F Supp 812 (S.D.N.Y. 1964)(14 AFTR2d 5077, 64-2 USTC [Paragraph] 9577), aff'd 339 F2d 877 (2nd Cir. 1965) (15 AFTR2d 053, 65-1 USTC [Paragraph] 9149). (6) Arthur J. Singer, 354 F2d 992 (2nd Cir. 1966)(17 AFTR2d 154, 66-1 USTC [Paragraph] 9171). But see Michael A. Cassis, Jr., S.D. Ohio, 1986 (59 AFTR2d 87-378, 86-2 USTC [Paragraph] 9800). (7) Robert W. Monday, 421 F2d 1210, 1214-1215 (7th Cir. 1970)(25 AFTR2d 70-548, 70-1 USTC [Paragraph] 9205), at 70-1 USTC 82,830. (8) George R. Seitz, E.D. Ky., 1990 (91-2 USTC [Paragraph] 50,499). (9) Robert White, 372 F2d 513 (Ct. Cl. 1967)(19 AFTR2d 683, 67-1 USTC [Paragraph] 9250). See also R. John Genins, 489 F2d 95, 96 (5th Cir. 1974)(33 AFTR2d 74-708, 74-1 USTC [Paragraph] 9239), aff'g per curiam N.D. Ga., 1973 (31 AFTR2d 73-1190, 73-1 USTC [Paragraph] 9420). (10) First American Bank and Trust Co., W.D. Okla., 1979 (43 AFTR2d 79-739, 79-1 USTC [Paragraph] 9205). (11) Algernon Blair, Inc., 441 F2d 1379 (5th Cir. 1971)(27 AFTR2d 71-1302, 71-1 USTC [Paragraph] 9383). See also Jersey Shore State Bank, 781 F2d 974 (3d Cir. 1986)(57 AFTR2d 86-530, 86-1 USTC [Paragraph] 9151). (12) In re Quattrone Accountants, Inc., W.D. Penn., 1989 (63 AFTR2d 83-1364, 89-2 USTC [Paragraph] 9538), aff'g Bankr. Ct., W.D. Penn., 1988 (62 AFTR2d 88-5280, 88-2 USTC [Paragraph] 9442). (13) Gary F. Wyner, E.D. Mich., 1982 (50 AFTR2d 82-5031, 82-1 USTC [Paragraph] 9341). But see also Robert S. Chappell, DC Ind., 1975 (35 AFTR2d 75-931, 75-1 USTC [Paragraph] 9296). (14) Howard N. Feist, Jr., 607 F2d 954 (Ct. Cl. 1979)(44 AFTR2d 79-5843, 79-2 USTC [Paragraph] 9635). (15) See Rutledge Slattery, 224 F Supp 214 (E.D. Penn. 1963)(12 AFTR2d 5973, 64-1 USTC [Paragraph] 9150). (16) Monday, note 7, at 70-1 USTC 82,831. (17) Harry Murdock, 290 US 389 (1933)(13 AFTR 821, 3 USTC [Paragraph] 1194) (18) J.A. Newsome, Jr., 431 F2d 742 (5th Cir. 1970)(26 AFTR2d 70-5078, 70-2 USTC [Paragraph] 9504). (19) Lewis C. McCarty, Jr., 437 F2d 961 (Ct. Cl. 1971)(27 AFTR2d 71-682, 71-1 USTC [Paragraph] 9232). (20) Norene R. O'Dell, 326 F2d 451 (10th Cir. 1964)(13 AFTR2d 567). (21) See J.F. Liddon, 448 F2d 509 (5th Cir. 1971)(28 AFTR2d 71-5454, 71-2 USTC [Paragraph] 9591), cert. denied. (22) IRM 56(18)6.2. (23) See, e.g., In re Hannan Trucking, Inc., Bankr. Ct., N.D. Tex., 1981 (49 AFTR2d 82-459, 81-2 USTC [Paragraph] 9793). See also Ralph S. Hirsch, II, S.D. Ohio, 1975 (35 AFTR2d 75-1358, 75-1 USTC [Paragraph] 9348). (24) Frederic M. Muntwyler, 703 F2d 1030 (7th Cir. 1983)(51 AFTR2d 83-997, 83-1 USTC [Paragraph] 9275). (25) Onofre J. Sotelo, 436 US 268 (1978)(42 AFTR2d 78-5001, 78-1 USTC [Paragraph] 9446). (26) Rev. Proc. 84-78, 1984-2 CB 754.

Darshan L. Wadhwa, Ph.D., CPA Associate Professor University of Houston-Downtown Houston, Tex.