Courts Apply Substance Over Form to Help Taxpayers
Two recent cases remind us that there there are limits to liability in "responsible person" cases under Section 6672, and one reminds us on its face that judges do have a heart (a part of the anatomy that is distressingly rarely encountered within the IRS in these cases). As we know, the responsible person penalty is designed to backstop the withholding system by imposing liability on persons required to withhold and pay over to the IRS. It is more like a behavior modification provision, giving persons who have the ability to influence the decision the real world incentive to do so. For those persons who could not materially influence the decision, there should be no basis for asserting the penalty.
Responsibility in this context means two things. The objective power to influence decisions, and the subjective power to do so. I may think I have the power to influence decisions, but that does not make me a responsible person unless I in fact have that power and choose not to exercise it. On the other hand, in some objective sense I may have the power to influence decisions (a notion akin to apparent authority to do so), but if I do not think that I have that power, then I should not be held responsible.
In Unger v. United States, ___ F.Supp. ___ (S.D. N.Y. 3/17/97), unofficially reported at 1997 DTR 63 d26 (4/2/97), Unger was initially a very low-paid corporate officer (later getting paid more) who oversaw the accounting and administrative functions. The power in the company was exercised by its founder and CEO ("Landau"). Virtually all authority relevant to payroll taxes that Unger exercised was pursuant to the direction of Landau, but Unger was given corporate titles indicating apparent authority in this area. The district court initially granted the Government’s motion for summary judgment feeling constrained by an earlier Second Circuit decisions (Hochstein), even though (1) the trial court could not find a "a single instance where it could be said that Unger signed any check or took any action in circumstances where he was not confident that he was acting in accord with Landau's expressed wishes" and (2) felt that imposing the Section 6672 liability was unfair (no rational government should so treat its own citizens).
After this motion for summary judgment was granted, the Second Circuit indicated a sea change in a case called United States v. Rem, 38 F.3d 634 (2nd Cir. 1994). In Rem, the Second Circuit held that objective indications of authority -- titles, even including president -- would not require responsible person status. Rather, the Second Circuit held:
Thus though Section 6672(a) is not meant to ensnare those who have merely technical authority or titular designation, the section encompasses all those connected closely enough with the business to prevent the [tax] default from occurring (inner quotes and citations omitted).
The Unger case then was tried to a jury which found that Unger was a responsible person. The district court granted judgment for Unger despite the jury verdict. (This procedure is technically j.n.o.v., acronym for the Latin judgment non obstante veredicto.) The Judge based his decision based principally upon his conclusion that, despite his titles and apparent authority, Unger felt his powers and authority were limited to acting pursuant to Landau’s wishes. For example, the court credited his testimony that "he had never signed a check or other document without being confident that it was Landau's wish that he do so. " The Court then concluded that "We find that the entirety of Unger's testimony establishes beyond peradventure that Unger firmly believed that his actual authority was limited to following Landau's orders and that such belief was reasonable."
In Vinick v. Commissioner, ___ F.3d ___ (1st Cir. 4/8/97), unofficially reported at 1997 DTR 69 d35 (4/10/97), the First Circuit held that a district court had erroneously granted the Government summary judgment in a responsible person case. Most importantly, the First Circuit indicated that the applicable standard it applied was consistent with the standard in Rem and even cited Rem in stating the standard.
We impose responsibility on all with the responsibility and authority to avoid the default,"* * * but predicate our definition of who is a responsible person on the function of the employee in the business, and not the level of the office held * * *. As the Second Circuit [in Rem] recently stated, Section 6672 (a) is not meant to ensnare those who have merely technical authority or titular designation," but instead encompasses those close enough to the business to prevent the default. At bottom, in order to be responsible, an individual must have had significant control over the financial affairs of the company. * * * * The individual assessed either must have exercised his authority over financial affairs or general management, or must have had a duty to do so.
Although the IRS mouths a standard in this type of case that appears on its face consistent with these holdings (see Policy Statement P-5-60), those of us who practice in this area know that the IRS all too frequently construes the Policy Statement narrowly if it gives lip service to it at all. Unger indicates that mere titles and even the exercise of independent judgment in respects other than the payment of payroll taxes (e.g., the hiring and firing of employees in a department) is not relevant to the issue of whether the person is a responsible person. It is refreshing that the Courts stand as the final protection on this matter. Unger and Vinick are encouraging.
Reasonable Cause: A Defense to Trust Fund Recovery Penalty
In an important recent case of Finley v. United States, ___ F.3d ___ (10th Cir., 8/10/97) (en banc), unofficially reported at 97-2 USTC ¶50,613, the Tenth Circuit held that reasonable cause is a defense to the trust fund recovery penalty, rejecting the Government's attempt to limit jury consideration of that defense.
Floyd Johnson was president and a member of the board of directors of Halsey-Tevis, Inc., a struggling corporation engaged in the interior construction business. In late October 1988, Mr. Johnson learned from board member and secretary-treasurer, Edward Finley, that Halsey-Tevis was delinquent in paying federal social security and income taxes withheld from employee wages during the third and fourth quarters of 1988. Upon learning of the delinquency, Mr. Johnson told Mr. Finley that the taxes had to be paid. Mr. Johnson made no further inquiry and took no further action regarding the unpaid withholding taxes even though he had authority to sign company checks and, at that time, Halsey-Tevis had access to funds that could have been used to make at least partial payment to the IRS.
In November 1988, Mr. Johnson found our that the taxes still had not been paid. On November 14, 1988, Mr. Johnson and Mr. Finley delivered about $105,000 in collections to the company’s bank and asked bank officials to apply the deposit to the withholding tax balance. The bank refused and instead applied the deposit to the company’s loan from the bank.
After a jury trial in the district court, the jury rendered a verdict for Mr. Johnson, finding that he was not willful in failing to pay the withheld taxes to the IRS. However, the district court granted the United States' post-trial motion for a judgment as a matter of law, and reversed the jury verdict, holding that a reasonable jury could not have found that Mr. Johnson met his burden of proof.
In what may be a small step in favor of taxpayers being assessed the trust fund recovery penalty, the Tenth Circuit Court of Appeals has now held that a jury must determine whether there is reasonable cause for failure to pay employment taxes to the IRS. If a taxpayer can show reasonable cause, then there is no willfulness on the part of the taxpayer against whom the trust fund recovery penalty is being assessed.
In hearing the case en banc, the Tenth Circuit reviewed the question of whether under Section 6672 of the Internal Revenue Code, if a responsible person fails to investigate or correct mismanagement after learning of a withholding tax delinquency, must his conduct be found reckless and therefore willful as a matter of law, or, in the alternative, should the jury, in the view of all relevant evidence, be entitled to find the responsible person did not act recklessly?
The Tenth Circuit in reversing the district court held that willful conduct as defined in the context Section 6672 can be negated by a showing that the responsible person had reasonable cause for failing to pay withholding taxes held in trust for the government. This ruling negates the strict liability interpretation of Section 6672 and preserves a role for the jury, as fact finder, to determine whether, in view of all relevant evidence, a responsible person willfully failed to pay employee withholding taxes.
On appeal, the United States argued that a responsible person who has knowledge of unpaid taxes and thereafter personally pays or directs the payment of claims of other creditors, or fails to take appropriate steps to ensure the taxes are paid (e.g., fails to investigate the matter or correct mismanagement), is willful as a matter of law.
The Tenth Circuit responded to the position of the United States as follows:
We are fully aware of the precedent whereby courts have seized on the notion that certain factual paradigms establish willfulness as a matter of law, even though the facts do not involve an intentional failure to pay over withholding taxes to the government. A responsible person's failure to investigate the problem or correct mismanagement after receiving actual notice of a withholding tax delinquency represents the factual paradigm applied in this case. Finley, 82 F.3d at 973; see also, Denbo, 988 F.2d at 1033-34. Reliance upon the representation of someone in control of company finances that withholding taxes will be paid after learning that such taxes are delinquent, and when it is known that the person making the statements is unreliable and has inadequately performed his financial responsibilities in the past, represents another paradigm used to impose liability under §6672 as a matter of law. The payment of other bills with knowledge that the business is in financial trouble, but failing to reasonably inquire whether money would be available to pay withholding taxes when they become due is yet another paradigm courts have applied. See Thomsen v. United States, 887 F.2d 12, 18-19 (1st Cir. 1989) (summarizing the "distinctive fact patterns from which to infer a reckless disregard sufficient to demonstrate willfulness as a matter of law under section 6672" (quoting I.R.S. v. Blais, 612 F. Supp. 700, 710 (D. Mass. 1985))). These paradigms obviously create an expansive web of liability "as a matter of law" and significantly ease the government's burden under Fed. R. Civ. P. 50(b). Thus, it is easy to understand why the government relies so heavily on existing precedent. The en banc question, however, reflects our concern whether this web of case law leaves any role for the jury to determine willfulness. The government's mere reliance on existing precedent does not answer that question.
The Tenth Circuit recognized the reasonable cause exception, and that a jury must decide if reasonable cause exists.
The Tenth Circuit concluded that reasonable cause sufficient to excuse a responsible person's failure to pay withholding taxes should be limited to those circumstances where (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.
While reasonable cause is recognized to a limited extent in the Fifth Circuit, a taxpayer cannot expect the IRS to recognize reasonable cause at the administrative level. Only in court will a taxpayer have a chance to prevail in a reasonable cause defense. The burden of proof is on the taxpayer to prove that reasonable cause existed. While the Tenth Circuit has taken some of the force out of the strict liability of Section 6672, this case may only be a very small step for a taxpayer trying to prevail in a case where trust fund taxes have not been paid.