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"Reasonable cause" exception for failure to pay employment taxes requires examination of a taxpayer's total financial situation.

The EW corporation manufactured military clothing for the U.S. Department of Defense (DLA). The manufacturing contracts for this clothing were administered by the DLA; all EW's contracts went through the DLA.

As early as 1976, certain employees at the DLA began soliciting bribes from EW ultimately, they sought compensation equal to half of EW's business. When EW declined to pay the bribes, the DLA did not award EW new contracts, unless it was the only bidder. As a result of refusing to pay bribes, EW was not paid for work completed and goods delivered; payments were intentionally and substantially delayed; inventory was wrongfully rejected; and orders were required to be reworked. The DLA did make some contract payments to EW after it refused to pay bribes, and EW did get some additional contracts.

In 1984, EW contacted the DLA legal staff, but nothing was done. To keep the business going, EW's vice president took out personal loans (including a mortgage on his home) to pay essential employees, creditors threatening to cut off services and payroll taxes. Subsequently, EW asserted claims for damages against the DLA.

In 1984, EW filed for bankruptcy protection. Late in 1984, it was approached by the FBI to gather information on the corrupt DLA employees. EW worked with the FBI for two years. During this time, the FBI instructed EW when to pay and not to pay bribes.

Ultimately, EW and the DLA reached a settlement, as a result of the bankruptcy court's enforcement of EW'S claims against the DLA. EW paid its outstanding employment taxes out of the settlement, as well as penalties and interest.

EW brought suit to recover the penalties paid, arguing that the deficiency was due to reasonable cause and not willful neglect. In 1999, the district court held for the IRS and dismissed EW's challenge. The Court of Appeals (opinion Mansmann, J.) reverses: Reasonable cause existed for EW's failure to pay and deposit its employment taxes timely; thus, EW is entitled to an abatement of the penalties.

Under Secs. 6651(a)(1) and (2) and 6656(a), the Service imposes mandatory penalties for failure to file returns, pay taxes or deposit employment taxes in a government depository, unless a taxpayer can show that such failure was due to "reasonable cause" and not "willful neglect." Thus, to succeed in obtaining an abatement of penalties imposed under Secs. 6651 and 6656, a taxpayer bears the burden of establishing that the failure did not result from "willful neglect" and was due to reasonable cause.

Neither "willful neglect" nor "reasonable cause" is defined in the Code. A definition of "willful neglect" was provided by the Supreme Court in Boyle, 469 US 241 (1985), which found that the phrase "willful neglect" had been construed over the years to mean "a conscious, intentional failure or reckless indifference." Stated another way, the taxpayer must show that the failure to file a return timely was not the result of carelessness, reckless indifference or intentional failure. Regs. Sec. 301.6651-1(c)(1) provides an explanation of the other required element, "reasonable cause":

If the taxpayer exercised ordinary business care and prudence and was nevertheless unable to file the return within the prescribed time, then the delay is due to reasonable cause. A failure to pay will be considered to be due to reasonable cause to the extent that the taxpayer has made a satisfactory showing that he exercised ordinary business care and prudence in providing for payment of his tax liability and was nevertheless either unable to pay the tax or would suffer an undue hardship (as described in [sections] 1.6161-1(b) of this chapter) if he paid on the due date. In determining whether the taxpayer was unable to pay the tax in spite of the exercise of ordinary business care and prudence in providing for payment of his tax liability, consideration will be given to all the facts and circumstances of the taxpayer's financial situation, including the amount and nature of the taxpayer's expenditures in light of the income (or other amounts) he could, at the time of such expenditures, reasonably expect to receive prior to the date prescribed for the payment of the tax.

Thus, for example, a taxpayer who incurs lavish or extravagant living expenses in an amount, such that the remainder of his assets and anticipated income Will be insufficient to pay his tax, has not exercised ordinary business care and prudence in providing for the payment of his tax liability. Further, a taxpayer who invests funds in speculative or illiquid assets has not exercised ordinary business care and prudence in providing for the payment of his tax liability unless, at the time of the investment, the remainder of the taxpayer's assets and estimated income will be sufficient to pay his tax or it can be reasonably foreseen that the speculative or illiquid investment made by the taxpayer can be used (by sale or as security for a loan) to realize sufficient funds to satisfy the tax liability. A taxpayer will be considered to have exercised ordinary business care and prudence if he made reasonable efforts to conserve sufficient assets in marketable form to satisfy his tax liability and nevertheless was unable to pay all or a portion of the tax when it became due. (Emphasis added.)

The term "undue hardship," for purposes of determining whether reasonable cause has been established, has been defined as "more than an inconvenience to the taxpayer. It must appear that substantial financial loss, for example, loss due to the sale of property at a sacrifice price, will result to the taxpayer for making payment on the due date of the amount with respect to which the extension is desired. If a market exists, the sale of property at the current market price is not ordinarily considered as resulting in an undue hardship."

Moreover, in determining whether a taxpayer has exercised "ordinary business care and prudence" in paying its tax liability, courts must consider the nature of the delinquent tax. Regs. Sec. 301.6651-1(c)(2) specifically provides that:

In determining if the taxpayer exercised ordinary business care and prudence in providing for the payment of his tax liability, consideration will be given to the nature of the tax which the taxpayer has failed to pay. Thus, for example, facts and circumstances which, because of the taxpayer's efforts to conserve assets in marketable form, may constitute reasonable cause for nonpayment of income taxes may not constitute reasonable cause for failure to pay over taxes described in section 7501 that are collected or withheld from any other person.

The taxes that EW failed to pay on time were Sec. 7501 taxes. Under Sec. 7501, employers are required to collect or withhold employees' employment taxes as salaries are disbursed. These taxes are commonly referred to as "trust fund taxes" because the amounts withheld from employees' wages or salaries are to be held in a special fund in trust for the U.S.

EW maintains that its failure to pay taxes and make deposits on time was due to the fraudulent criminal activities of top officials at the defense agencies, which so permeated the DLA that, despite EW's ordinary business care and prudence, it could not pay its payroll taxes when due without suffering undue hardship.

On the other hand, the Service contends that EW's failure to pay employment taxes timely was due to willful neglect, because it chose to pay other creditors and employees instead of the IRS. The Service further argues that EW failed to establish reasonable cause. Relying on Brewery, Inc., 33 F3d 589 (6th Cir. 1994), the IRS takes the position that financial distress alone does not establish reasonable cause. Relying on the language in Regs. Sec. 301.6651-1(c)(2), the Service maintains that, when trust fund taxes are at issue, a more stringent standard is applied. The IRS contends that the need for operating capital to prevent insolvency is not reasonable cause for failing to pay over trust fund taxes.

The district court applied the bright-line test set forth in Brewery, which provided that "financial difficulties can never constitute reasonable cause to excuse the penalties for nonpayment of withholding taxes by an employer." The Sixth Circuit based its adoption of the bright-line standard on the trust language of both Sec. 7501 and Regs. Sec. 301.6651-1(c)(2), which provides that circumstances that, because of a taxpayer's efforts to conserve marketable assets, may constitute reasonable cause for failure to pay income taxes, may not constitute reasonable cause for failure to pay trust fund taxes. The Brewery court, agreeing with the district court, held that, because the trust fund taxes were for the government's exclusive use, the taxpayer's use of the trust funds for the payment of other creditors could not, as a matter of law, constitute reasonable cause for abating the penalties assessed under Secs. 6651 and 6656.

The Brewery court's decision is troubling on a number of grounds. First, the application of such a bright-line rule when a tax payment is delayed due to financial difficulties is inconsistent with Congress's creation of a "reasonable cause" exception, as well as the regulations that set forth the factual circumstances that must be alleged to establish reasonable cause. Neither the Code nor the regulations support the bright-line rule.

The Code does not bar consideration of financial difficulties in determining whether reasonable cause has been established, and does not differentiate between trust fund taxes and nontrust fund taxes. This is particularly significant for Sec. 6656 purposes, which specifically address the failure to deposit employment taxes, yet require neither a higher standard in such cases nor that courts turn a blind eye to a taxpayer's financial circumstances. The "reasonable cause"/"willful neglect" standard has been part of the tax penalty provisions since 1916, and Congress has not amended these provisions to create a different standard for the failure to pay trust fund taxes.

Moreover, Regs. Sec. 301.6651-1(c)(1) specifically directs courts to examine "all the facts and circumstances of the taxpayer's financial situation" Similarly, Kegs. Sec. 1.6161-1(b) requires determination of whether a taxpayer would have suffered "undue hardship" (i.e., "substantial financial loss") from paying taxes. Thus, these regulations clearly require a factual assessment of a taxpayer's financial situation to determine whether it has exercised ordinary business care and prudence in responding to competing financial obligations.

In addition, Regs. Sec. 301.6651-1(c)(2) provides that a court must consider, among other factors in its analysis of a taxpayer's care and prudence, the nature of the tax not paid. Its example suggests that facts and circumstances that may constitute reasonable cause for nonpayment of income taxes may not constitute reasonable cause for failure to pay over Sec. 7501 taxes collected or withheld from any other person.

Thus, although courts must take into account the obligations to pay Sec. 7501 trust fund taxes in their determination of reasonable cause, their analysis must not stop there. While it will be the rare case in which the government is an unwilling partner in a floundering business without the employer incurring the duty to pay a penalty for having made such a choice, nonetheless, the court in each case must weigh all of the factors identified in the regulations. To hold otherwise would effectively ignore the statute's "reasonable cause" exception to mandatory penalties in many employment tax cases.

EAST WIND INDUSTRIES, INC., 3RD CIR., 11/16/99, REV'G 33 F SUPP 2D 339 (1999)

REFLECTIONS: Once the Third Circuit determined that the facts and circumstances of a taxpayer's financial situation had to be considered if reasonable cause for not paying employment taxes existed, it still had to determine if EW met this standard.

Because EW's financial viability and cashflow depended entirely on government contracts and cotrupt employees, its ability to pay its debts was controlled by the DLA. In this situation, choosing to pay creditors (whose services were essential to keeping the business going) rather than the employment taxes was not a concious, intentional failure or reckless indifference. Thus, EW's actions did not amount to willful neglect.

Reasonable cause would exist if EW established that it exercised ordinary business care and prudence, and that undue hardship would have resulted if it paid the tax liability when it became due.

Considering all the facts and circumstances bearing on EW's financial situation, the court held that the company did exercise ordinary business care and prudence; in addition, because EW would have had insufficient funds to pay its reduced work force and essential creditors if it had paid the employment taxes when due, EW established that undue hardship would have resulted.
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Author:Fiore, Nicholas J.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Mar 1, 2000
Words:2109
Previous Article:Evaluating a deferred compensation plan.
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