Financial Woes as Reasonable Cause for Payroll Tax Nonpayment

Can financial woes excuse taxpayers from depositing or paying payroll taxes? The Ninth Circuit has now joined two other circuits in saying "yes." In Van Camp & Bennion, 6/6/01, the IRS assessed depositary and late-payment penalties against a law firm for failing to remit employment taxes over a three-year period. The taxpayer paid the penalties, then sued for a refund. It argued, among other things, that the ill health of the partner largely responsible for generating the firm's revenue excused it from paying. The district court disagreed, citing Brewery, Inc., 33 F3d 589 (6th Cir. 1994). In Brewery, the Sixth Circuit held that, as a matter of law, financial distress never constitutes "reasonable cause" for failing to pay withholding taxes. The court reasoned that, under Sec. 7501(a), such taxes are held in trust for the government; thus, an employer may never use them to pay other expenses. Put simply, the government may not be made "an unwilling partner" in a taxpayer's business.

On appeal, the Ninth Circuit reversed and remanded, rejecting Brewery's logic in favor of the Second Circuit's in Fran Corp., 164 F3d 814 (1998), and the Third Circuit's in East Wind Industries, Inc., 196 F3d 499 (1999).

Fran Corp.

In Fran Corp., an electrical contractor failed to pay nearly $150,000 of withheld and other payroll taxes over five quarters. The government conceded that during this period, the taxpayer experienced severe financial difficulties stemming from two projects it was forced to complete despite payment defaults by the contracting parties. The Second Circuit rejected the government's invitation to follow Brewery, observing that nothing in the tax laws rules out reasonable cause for not paying payroll taxes. The court noted that, under Regs. Sec. 301.6651-(c)(1), taxpayers have a reasonable cause for paying taxes late if they exercised ordinary business care and prudence to pay them on time, but were unable to do so because of undue hardship. Under the regulation, all the facts and circumstances of the taxpayer's financial situation must be considered to assess reasonable cause. The court found nothing to support a different rule for payroll taxes. Nonetheless, it found that the taxpayer failed to establish reasonable cause (i.e., that it exercised ordinary business care and prudence). The court noted, among other things, the taxpayer continued to pay rent to its president, but failed to call a large loan it had made to him. In addition, the taxpayer spent a significant amount on entertainment, which did not preserve the business. The taxpayer also did not place its tax obligations ahead of its obligations to creditors, other than the two contractors.

East Wind Industries, Inc.

In East Wind Industries, the taxpayer, a contract manufacturer of military clothes for the Defense Department, failed to remit employment taxes from mid-1982 through 1996. To obtain contracts, the taxpayer had to pay large bribes to certain government employees. The taxpayer eventually sought to put an end to the bribery scheme and alerted law-enforcement authorities. As a result, it lost substantial business and went bankrupt. In addition, as part of an undercover investigation, the taxpayer was not allowed to bid on some government projects. The taxpayer contended that its dire financial situation was an excuse not to pay the taxes.

The Third Circuit held that financial distress might constitute reasonable cause for the nonpayment of payroll taxes. Moreover, the court concluded that the taxpayer had a reasonable cause and did not willfully neglect to pay the taxes. Among other things, the taxpayer operated the business at the minimal level necessary to collect amounts owed it to pay back taxes and other debts. Further, the owners went into substantial personal debt to have additional cash to stay in business. The taxpayer used business revenue to pay either taxes or wages; it did not pay other creditors. In addition, the court felt that, because of the Defense Department's actions, the government had become an active participant in the taxpayer's business. In the court's view, a public policy that would require an employer to close shop in such circumstances was not prudent, because it would create unemployment, idle buildings and plants and reduce the flow of money into the economy. Moreover, the court rejected the government's argument that by initially participating in the bribery scheme, the taxpayer should have foreseen the financial difficulties ahead.

In Van Camp, the court noted that the financial strain on the taxpayer was so great during the period of delinquency that there was some question as to whether it would survive. The court observed, "if the potential ruin of a [business] is not relevant, then the reasonable cause exception is virtually meaningless."

Comment. Small businesses struggling to pay their bills should be pleased with the Ninth Circuit's decision to reject Brewery's bright-line approach to whether a taxpayer has a reasonable cause not to pay payroll taxes. At the same time, even in those courts recognizing financial distress as an element of reasonable cause, taxpayers must make a strong case showing financial distress. Hard times (e.g., a lack of funds or credit) that the taxpayer could not foresee or reasonably guard against (e.g., resulting from contractual defaults or the sudden illness of a key employee) may work in a reasonable-cause defense. Business owners' personal sacrifices in the face of financial reversals may help their arguments. Business expenditures not absolutely critical to survival (and, more particularly, directly related to the generation or collection of money necessary to satisfy the unpaid tax liability) might be viewed as imprudent and doom the defense.

From Ronald A. Stein, LL.M., CPA, Chicago, IL