By Mark A. Segal
In Brief
Who Decided Not to Pay the Taxes?
The U.S. taxation system conveys a virtual fiduciary responsibility on employers with respect to employee payroll withholdings. If employers, for whatever reason, fail to pay the amounts in the prescribed time, the IRS seeks serious penalties for those responsible. The burden may especially fall on those with accounting backgrounds, because they are supposed to know better than to use the funds for other purposes.
In IRS investigations and court cases, the following issues are used as a basis for determining responsible person status:
* Authority for signing checks,
* Control over disbursement of funds,
* Authority in financial decisions, and
* Official titles held.
Although lack of authority is no guarantee of protection, several courts have found it a sustainable defense.
The IRS has little tolerance for employers that fail to appropriately remit Federal employment taxes that are or should have been withheld from employees. The issue of whether taxes need to be withheld can be inadvertent or represent good faith differences of opinion. For example, classifying workers as independent contractors rather than employees has long been a subject of honest dispute between the IRS and taxpayers. The IRS prefers that workers be considered employees because of the tax obligations this status creates for employers and the reduced ability of workers classified as employees to deduct work-related expenses. In contrast, those for whom services are provided would generally rather consider workers as independent contractors, which removes the obligation to pay withholding and matching obligations, to provide certain fringe benefits and retirement plan coverage, and to mitigate liability for workers' actions.
On the other hand, the failure to pay taxes withheld may be a conscious decision on the part of the employer because of pressure to satisfy other creditors or demands. It is not uncommon in a troubled business situation to find employers deferring the payment of taxes and using available funds to pay suppliers and others for goods and services needed to keep the business operating.
IRC Guidelines. To deter and sanction misclassification of workers and the failure to meet employer tax obligations, IRC sections 3509, 6651, 6656, 6662, and 6672 have been enacted.
Section 3509 sets forth penalty percentages for failure to properly withhold income and FICA taxes. The percentages are higher when an information return is not filed, unless the filer can show that the failure was due to reasonable causes. Sections 6651, 6656, and 6662, respectively, prescribe penalties for failure to file, failure to deposit, and negligence with respect to an employer's failure to satisfy employment tax obligations.
Perhaps the most consequential employment tax penalty provision is set forth in IRC section 6672. Commonly referred to as the 100% penalty, this penalty applies to persons that--
* are considered responsible for the collection and payment of employment taxes and
* willfully fail to comply with this responsibility.
Toward a Definition of 'Responsible Person'
The IRS and the courts have defined the expression "responsible person" as encompassing individuals that have the duty and authority to comply with the withholding provisions. In deciding whether someone is a responsible person, the totality of facts and circumstances are examined to ascertain whether the individual has significant control over an organization's finances. Courts consider whether the individual
1) can determine the order in which creditors will be satisfied or
2) has some significant control over the disbursement of funds.
In deciding whether significant control exists, courts cite the following factors as relevant:
* Is the individual an officer or a member of the board of directors of the entity?
* Does the individual own stock or have an entrepreneurial position in the company? Is the individual active in the management of the company's daily affairs?
* Does the individual have the authority to hire or fire employees?
* Does the individual make or have authority to make decisions regarding which debts or taxes to pay?
* Does the individual exercise control over daily bank accounts and records?
* Does the individual have check-writing authority?
No single factor is by itself determinable, but the satisfaction of one factor adds credence to classifying the individual as a responsible person. Applying these factors requires certain factual determinations about the authority and practices of the person in question. Authoritative corporate documents, such as articles of incorporation, bylaws, and minutes of meetings, often provide needed insight. In other instances, title, canceled checks, and the other parties dealt with are influential.
The other key element required to be considered a responsible person is "willful" noncompliance with the withholding statutes. To determine whether willfulness is present does not require demonstrating evil motive or intent to defraud. Courts and the IRS typically find willfulness to exist where the person knows of the obligation to pay withholding taxes but pays some other obligation.
Responsible Person Court Cases
Individuals entrusted with the responsibility for assuring compliance with payroll obligations and tax duties--bookkeepers and accountants--are often targets of an IRC section 6672 penalty. Recent examples include the cases of Greenberg v. United States [46 F.3d 239 (3d Cir. 1994)], Hochstein v. United States [900 F.2d 543 (2d Cir. 1990), cert. denied, 504 U.S. 985 (1992)], United States v. Rem [38 F.3d 634 (2d Cir. 1994)], and Unger v. United States [956 F.Supp. 1152 (1997)].
In Greenberg, Mark Greenberg, a CPA and corporate controller, was held liable as a responsible person. Greenberg was a shareholder in the company at issue, as well as its treasurer and controller. As controller he supervised other accountants and bookkeepers, prepared financial statements, prepared and filed corporate tax returns, and participated in hiring and firing employees in his department.
Important to the finding of responsible person status in Greenberg was the fact that he was an authorized signatory on all corporate accounts and, with the president of the company, was responsible for payroll. Greenberg executed most of the company checks issued to payroll and creditor obligations.
When the company failed to make its withholding obligations, the government sought collection of the taxes and penalties against Greenberg as a responsible person. The court looked to the following factors in deciding that Greenberg was a responsible person:
* Contents of corporate bylaws;
* Ability to sign checks on the company's bank account;
* Signature on the employer's Federal quarterly and other tax returns;
* Payment of other creditors in lieu of the United States;
* Identity of officers, directors, and principal shareholders in the firm;
* Identity of individuals in charge of hiring and discharging employees; and
* Identity of individuals in charge of the firm's financial affairs.
Each item was found to point to Greenberg as a responsible person. Greenberg's involvement in the preparation of taxes and the accounting function was deemed significant because it pointed to his awareness of the withholding violations.
In defense, Greenberg alleged that despite his titles and purported role in the organization, he possessed no actual authority. Greenberg claimed that he merely rubber-stamped the decisions made by those with actual authority.
Greenberg attempted to distinguish his position from that of the alleged responsible person in Brounstein [979 F. Supp. 952 (3d Cir. 1992)], contending that unlike himself, the person at issue in Brounstein, a corporate president, held bottom-line authority. The court rejected Greenberg's argument, finding that both he and the party in Brounstein possessed check-writing authority. Citing Brounstein, the court noted, "Instructions from a superior not to pay taxes do not ... take a person otherwise responsible under IRC section 6672(a) out of that category."
The court went on to say, "The fact that Brounstein would have been fired if he contravened instructions from the managing principal and paid the taxes does not make his actions involuntary.... A corporate officer who fails to pay over to the government withheld taxes when there are funds to do so is not entitled to prefer his own interest in continued employment over that of the government, the beneficiary of a trust created by the operation of law when taxes are withheld." Payment of other creditors rather than the U.S. government was considered an impermissible preference of his own interest.
The court also rejected as an invalid defense Greenberg's assertion that he believed payment would be forthcoming. It found the intentional preference of other creditors over the known obligation to the United States to meet the criteria for willfulness. The court noted that this finding would result even where failure to pay other creditors would result in the termination or financial distress of the business.
Greenberg is rooted in the Second Circuit decision in Hochstein, where the court found Hochstein liable for the responsible person penalty. As controller of a manufacturing firm, Hochstein was responsible for oversight of the firm's finances as well as preparing its payroll and filing its payroll taxes. Although not a shareholder, officer, or director, Hochstein possessed authority to sign checks for the company.
As a result of financial difficulties, the company entered into an agreement pursuant to which the company's only operating finances were provided by another company. The company itself, however, remained responsible for satisfying its own taxes.
When the financing company decided to liquidate Hochstein's company, it did not provide enough funds to satisfy the outstanding payroll taxes even though Hochstein had indicated that satisfying the payroll taxes merited the highest priority. The Second Circuit found Hochstein to be a responsible person and to have willfully not paid the taxes. Thus, he was found subject to the IRC section 6672 penalty.
Reversing a lower court ruling in favor of Hochstein, the Second Circuit noted that Hochstein had significant control over the company's finances and that whether he had the final say as to who would be paid was irrelevant.
The court recognized the difficult situation Hochstein faced but found that he was aware of the withholding obligation and did not satisfy it despite having significant control over the company's finances. The court noted that employee wages would have received priority over the withholding obligation in the event of bankruptcy but found this irrelevant to the outcome.
Results similar to Greenberg and Hochstein are found in Winter v. United States [98 U.S. Tax Cas. P50,246 (1998)] and Schramm v. United States [81 AFTR2d 416 (1997)]. In another case, Hutchinson v. United States [962 F. Supp. 965 (U.S.D.N. TX, 1997)], the court granted summary judgment in favor of the IRS's assertion that a corporate president and chairperson was a responsible person. In the court's opinion, Hutchinson had participated in management, was aware of the corporation's financial problems, was in charge of the corporation's financial decisions, was aware that the corporation had outstanding tax liabilities, and had paid other creditors in preference to the U.S government.
A Ray of Hope
Two other cases, Rem and Unger, provide insight into factors that may be helpful in avoiding a responsible person penalty.
In Rem, the Second Circuit reversed a lower court's summary judgment that found Gerard Rem liable as a responsible person. The decision was based on a summary judgment that did not give the evidence due consideration in the light most favorable to Rem in determining whether there was a genuine issue of material fact. According to the court, it could not be assumed that because someone had authorization to make payments of less than $1,000 the person had authority to pay higher amounts or necessarily possessed significant
control over the company's finances. Nor could responsible person status be assumed to exist simply because the person had in the past held 20% of the stock of the company and occupied various positions in the company, such as employee, officer, stockholder, and director.
The court noted in its decision that according to Rem, he held a title only to help the company obtain credit. In addition, he had no direct involvement in payroll, which, according to a witness, "was largely prepared by the bookkeeper and submitted to the controller, after which the payroll tax returns were signed by Mary Rem [Gerard Rem's mother]." Furthermore, it was claimed that Mary Rem controlled the company operations and finances.
In Unger, the District Court for the Southern District of New York set aside a jury verdict and dismissed the government's counterclaim for a $1 million responsible person penalty on a tax delinquent corporation's vice president and chief financial officer. This decision was reversed by the Second Circuit [155 F.3d 93 (1998)] and remanded to the District Court to determine whether Unger was entitled to a new trial. The District Court granted Unger a new trial, indicating that it would be a miscarriage of justice not to do so. The District Court had also set aside a jury decision in favor of Robert Landau (the owner, president, and CEO of the business), which decision was affirmed by the Second Circuit.
Examination of the 1997 decision that set aside the verdict against Unger reflects that he signed checks, hired and fired employees, and executed agreements on behalf of the company but only as directed by Landau, who had controlled every aspect of the
corporation's business affairs since its inception. Unger testified that his authority was limited to that expressly granted by Landau and did not include the payment of taxes. Unger claimed to have urged Landau to pay Federal withholding tax, but Landau refused to do so or to allow Unger to pay the taxes.
Citing Rem, the district court judge indicated that the outcome was controlled by two factors:
* Whether Unger honestly believed that Landau's orders limited his own technical authority and
* If so, whether that belief was reasonable.
Finding the jury apparently unable to understand the reasonableness aspect of these standards, the judge overruled the jury decision. In Unger, the court looked at facts and anecdotal evidence of Landau's belief that Unger would not lie, cheat, or steal. Although at times Unger had to deal with outside parties and creditors and could hire and fire employees in emergency situations, because Unger's testimony that all of his authority was expressly granted by Landau, and because paying taxes was not part of this authority, the court held that Unger in fact lacked actual authority.
Address Concerns and Questions Now
Major financial stakes rest on the determination of whether someone can be held liable under IRC section 6672 as a responsible person. Staff with accounting backgrounds and functions should be aware that section 6672 claims may be brought against them. While certain functions cannot be avoided, as illustrated by Unger, the lack of a role in disbursing funds and deciding which creditors to pay is an important factor that has force of evidence refuting a responsible person claim.
Individuals that find themselves in a situation where employment taxes are not being appropriately remitted should take the matter very seriously. They should attempt to document why they are not a "responsible person" and do not have the authority to direct the payment of the taxes. *
Mark A. Segal, LLM, CPA, is a professor of accounting at the University of South Alabama, Mobile.
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2006 CPA Journal.
Legal
Notices
Visit the new cpajournal.com.