June 16, 2018

Loaning Money to Business Triggers Trust Fund Penalty

Houston Tax Attorney Blog

Houston Tax Attorney

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You work hard to build a business, you find success over the years, and then you find out that your long term accountant did not remit payroll taxes and you owe a significant balance.  What do you do?  The recent McClendon v. United States, No. 17-20174 (5th Cir. 2018) case provides some answers.

The Facts & Procedural History

The facts and procedural history for the case are as follows.

The taxpayer started a medical practice in 1979 (I use the term “taxpayer” to refer to the individual business owner and plaintiff in the case, not the business that incurred the taxes).  The business grew and it hired an in-house CPA in 1995 to serve as the CFO.  The CFO led the taxpayer to believe that all taxes were paid.

In 2009, the taxpayer learned from the IRS that back taxes were owed for 2003 to 2008.  The taxpayer also discovered that the CPA had been stealing money from the business for several years.

The business owed $11 million in withholding taxes.

On the advice of their tax lawyer, the taxpayer had the business stop paying its creditors.  The taxpayer lent the business funds to pay the outstanding payroll for employees.  The taxpayer formed a new LLC to pay the business’s non-IRS creditors using their own personal funds.  The taxpayer also paid its available funds to the IRS and caused all income and collections for the business to be turned over to the IRS.

In 2013, the IRS assessed trust fund penalties against the taxpayer for the unpaid withholding taxes.  The taxpayer paid a portion of the penalties and sued the IRS for a refund.

The IRS moved for summary judgment, arguing that the personal funds the taxpayer loaned to the business were paid to the business’ employees and that this was sufficient to impose the trust fund penalty.  The IRS also argued that the taxpayer was grossly negligent in delegating, with no oversight, the responsibility of paying payroll taxes to the CPA.

The district court granted the IRS’s motion and the taxpayer appealed.

About the Trust Fund Penalty

The trust fund recovery penalty is equal to the amount of the withheld but unpaid payroll taxes.

The person responsible for the penalty includes an officer or employee of a business who is under a duty to collect, account for, or pay over the withheld tax given their role and responsibility in the business.  This person is referred to as the “responsible person.”

Responsibility is indicated by the holding of corporate office, control over financial affairs, the authority to disburse corporate funds, stock ownership, and the ability to hire and fire employees.

At the administrative level, the IRS often interprets this to include any person who has an ownership interest in the business and any person who has any connection with the business checking accounts.

The courts have generally said it is the person who has decision making authority over the business’ funds.

The Personal Loan to the Business

Most trust fund recovery penalties focus on whether the individual charged with the penalty is a responsible person.  The taxpayer conceded that he was a responsible person in this case.  This case focused on the personal loan to the business.

The taxpayer argued that the funds he loaned to the business personally were restricted to paying certain creditors, thus, they were not funds available to the business to pay the IRS.  As noted by the court, our tax laws do not go this far.  The law says that any funds the business has access to have to be turned over to the IRS or the penalty may be applied.

This is a difficult case.  The taxpayer appears to have taken all of the steps to ensure that the IRS was paid everything the business could pay.  The personal loan to the business to pay wages to the business’ employees also seems to be evidence of a taxpayer trying to do the right thing.  That the taxes were due to CPA fraud and that the taxpayer made the loan on the advice of his tax attorney also shows that he was trying to comply with the law.

Had the taxpayer paid the money from his personal accounts directly or through a different legal entity, it would seem that he would have given the IRS the ability to make this argument.

Despite the inequity, the court concluded that the taxpayer was liable for the amount of the personal loan.  The trust fund penalty is limited to the amount of available funds on hand at the time the individual learned of the unpaid taxes.

Given this rule, the taxpayer argued that the business only had the funds he had loaned to it personally at this time and that this amount was the upper limit of his liability.  The court agreed that there was a genuine question as to whether the business had extra funds on hand at the time.  It remanded the case to the district court to consider this issue.

The IRS’s Heavy-Handed No Evidence Argument

It should be noted that the IRS argued that the taxpayer had failed to present any evidence suggesting that the business had no other funds.  The IRS made this argument in an effort to have the court not remand this issue to the lower court.

The concurring opinion chided the IRS for making this argument:

it takes some chutzpah for the IRS, which submitted 285 pages of exhibits including FPA business records in support of summary judgment, now to assert McClendon did not bear “his” burden to articulate precisely how those records demonstrated whether there were insufficient funds to cover the unpaid withholding taxes and whether all available receipts were in fact paid to the IRS. Is it too much to assume the tax collectors can read bank and financial records adeptly, and that ethically, they wouldn’t make claims without factual foundations of which they ought to be aware? To challenge the legal consequences of McClendon’s $100,000 cash infusion is one thing; to claim, in the face of his sworn affidavit and documents, and their own access to corroborative financial records, that this isn’t enough to raise a fact issue is irresponsible at best.

The case not only answers the question as to how to handle unpaid withholding taxes, it is also telling as to how the IRS responds to unpaid withholding taxes.

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