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"Reasonable cause" defense to imposition of 100% withholding tax penalty against responsible persons.

The Tenth Circuit ruled in Finley, 10th Cir., 8/20/97, when a business has failed to remit Social Security and income taxes (so-called trust fund taxes) withheld from employees' wages, "responsible persons" can avoid the 100% penalty by showing the existence of "reasonable cause. " Finley involved Johnson, corporate president, and Finley, secretary-treasurer, of Halsey-Tevis, Inc. Their corporation was in financial difficulty. In October 1988, Finley advised Johnson that the corporation was delinquent in paying trust fund taxes. Johnson replied that "[t]hey have to be paid" and Finley responded that partial payments were being made. In fact, Finley had used his knowledge of the corporation's accounting records to hide the delinquency.

Johnson took no further action and made no further inquiry with respect to the unpaid taxes, and it was not until two weeks later that Johnson learned that Finley still had not paid the delinquent taxes. That same day, the corporation's bank froze the bank accounts; at that point, no bills could be paid without the bank's approval. One week later, Johnson and Finley delivered funds to the bank, requesting that they be applied to the delinquent taxes. The bank refused and instead applied the funds to the corporation's outstanding bank loans, with bank officials telling them that they would take care of the taxes later.

Sec. 6672 provides that, if a person responsible for collecting and paying over trust fund taxes willfully fails to do so, such person is personally liable for a penalty equal to the unpaid tax. (Most, if not all, states have similar provisions with respect to state trust fund taxes.) The wording of Sec. 6672 seems to allow the IRS to collect the full penalty from each responsible party, although the Service's policy is to collect the penalty only once. The IRS continued to seek the penalty from Johnson after winning a judgment against Finley (due to Finley's apparent inability to pay). There was no indication that the IRS sought to assess the penalty against the bank, although Sec. 6672 does not preclude such action.

At Johnson's trial, the jury found that he, admittedly a responsible person under Sec. 6672, had shown by a preponderance of the evidence that he did not willfully fail to pay the trust fund taxes. The trial judge, however, set aside the jury verdict and ruled that Johnson was liable; he held, as a matter of law, that a reasonable jury could not have found that Johnson met his burden of proof concerning lack of willfulness. The judge did not instruct the jury of the existence of a reasonable cause defense to the imposition of the penalty. A three-judge panel of the Tenth Circuit affirmed, and the case was reheard by the entire Tenth Circuit.

The word "willfully" as used in Sec. 6672 has been the subject of various court interpretations. Since it is often impossible to show that a responsible person knew that trust fund taxes were not being paid, courts have found responsible persons liable under Sec. 6672 if they acted "with a reckless disregard of a known or obvious risk that the trust funds may not be remitted to the government." Courts have defined certain "distinctive fact patterns" (which the Tenth Circuit calls paradigms) and have ruled that their existence constitutes willfulness as a matter of law. One paradigm is the failure of a responsible person to investigate or correct the delinquency on learning of its existence. Another is the payment of other bills with the knowledge that the business is in financial trouble, without reasonably inquiring whether funds are available to timely pay trust fund taxes. The Tenth Circuit felt that, over the years, once the courts identified the existence of one of the Sec. 6672 paradigms, they would find the responsible person liable for the penalty without allowing the jury to consider the particular facts and circumstances of each case. This had the effect of transforming Sec. 6672 into a strict liability statute, which the full court said was not Congress's intent.

The court did not reject the use of the paradigms in determining willfulness, but ruled that Johnson should have been allowed to argue to the jury that there was reasonable cause that excused the failure to pay the trust fund taxes. The responsible person has the burden of proving that the facts and circumstances constituted reasonable cause. This burden of proof is especially onerous, since it is often difficult to prove a negative--i.e., that willfulness did not exist. For purposes of Sec. 6672, reasonable cause is a more difficult standard to meet than the reasonable cause standard applicable to income tax penalties. Reasonable cause can exist only when "(1) the taxpayer has made reasonable efforts to protect the trust funds, but (2) those efforts have been frustrated by circumstances outside the taxpayer's control." The court noted that, although the Fifth Circuit has "conceptually recognized" the reasonable cause exception under Sec. 6672, other circuits have rejected it. Rather than reinstate the jury's verdict, the court ordered a new trial on the issue of reasonable cause. (As of this writing, the Solicitor General's office is considering an appeal of Finley to the U.S. Supreme Court.)

Finley serves as an obvious reminder that all responsible persons who fail to remit trust fund taxes do so at their peril. It also reinforces the principle of earlier cases that the discovery of such nonpayment by other responsible persons imposes a duty on them to take adequate steps to protect the funds that belong to the government the moment they are withheld from employees' paychecks. Sec. 6672 was modified in 1996 to allow for an apportionment of the penalty among the responsible persons according to their proportionate share of the penalty (Sec. 6672(d)).

From Michael Goldberg, CPA, New York, N.Y.
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Author:Goldberg, Michael
Publication:The Tax Adviser
Date:Feb 1, 1998
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