13 Court's Revised Opinion Again Finds Company's Co-owner Liable for Trust Fund Penalty

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1 13 Court's Revised Opinion Again Finds Company's Co-owner Liable for Trust Fund Penalty U.S. v. Hartman, (DC MI 8/16/2017) 120 AFTR 2d Vacating its original opinion in light of the recent decision by the Sixth Circuit in Byrne, a district court again concluded that the taxpayer, a 50% co-owner and chief executive officer (CEO) of the company, was liable for the Code Sec trust fund recovery penalty. In the recent decision, the Sixth Circuit adopted a reasonable-cause exception to the reckless-disregard determination, under which a responsible person's failure to cause the withholding taxes to be paid was not willful if he believed that the taxes were in fact being paid, so long as that belief was reasonable under the circumstances. Background. Under Code Sec. 6672(a), if an employer fails to properly pay over its payroll taxes, IRS can seek to collect a trust fund recovery penalty equal to 100% of the unpaid taxes from a person who: (1) is a responsible person i.e., one who is responsible for collecting, accounting for, and paying over payroll taxes; and (2) willfully fails to perform this responsibility. In determining who is a responsible person, the courts generally look at several factors. In the Sixth Circuit, these factors include: (1) the duties of the officer as outlined by the corporate by-laws; (2) the ability of the individual to sign checks of the corporation; (3) the identity of the officers, directors, and shareholders of the corporation; (4) the identity of the individuals who hired and fired employees; and (5) the identity of the individuals who are in control of the financial affairs of the corporation. Liability requires the existence of significant (as opposed to absolute) control of a corporation's finances. Generally, such a person is the one with the ultimate authority over expenditure of funds since such a person can fairly be said to be responsible for the corporation's failure to pay over its taxes or more explicitly, one who has the authority to direct payment of creditors. (Kinnie v. U.S., (CA ) 71 AFTR 2d ) In Kinnie, the taxpayer was the vice-president and 50% shareholder of a company during all the quarters that it failed to pay withholding taxes. He had authority to sign checks on behalf of the company. He had an accountant review the books for possible diversion of corporate funds and subsequently forced the company's president and 50% shareholder, who ran the company on a day-today basis, to leave. Kinnie maintained that he was only a passive investor. But the Sixth Circuit rejected Kinnie's defense that he had delegated the duty to pay the taxes to the company's president, stating that there could be more than one person deemed a responsible person within a corporation, and one who possesses significant control over the company's financial affairs can't escape liability by delegating the task of paying over the taxes to someone else. A failure to pay over taxes is willful for Code Sec purposes if a responsible person makes a deliberate choice to voluntarily, consciously, and intentionally 30

2 pay other creditors rather than make tax payments. Willful conduct may also include a reckless disregard for obvious or known risks. More than mere negligence is required for willfulness; a person is not willful if as a result of negligence he is unaware of the default in the payment of payroll taxes. However, a reckless disregard of the facts and known risks that taxes were not being paid is sufficient to hold a responsible party liable. (Calderone v. U.S., (CA ) 58 AFTR 2d ) In Harold v. U.S., (CA ) 98 AFTR 2d , the Sixth Circuit held that there was no question of material fact whether a taxpayer willfully failed to remit the taxes, largely on the basis that the taxpayer was indisputably aware that the company was having tax problems. The taxpayer, a responsible person by his own admission, did nothing to ensure that IRS was in fact fully paid even though the company had the proceeds to pay the taxes. Instead, he assumed that others would take care of it. In Byrne v. U.S., (CA6 5/15/2017) 119 AFTR 2d ), the Sixth Circuit vacated and remanded a district court decision that had held corporate officers were liable for the Code Sec. 6672(a) trust fund recovery penalty as a result of the controller's fraudulent activities. The taxpayers, the company's president and CEO/chairman, had hired a certified public accounting (CPA) firm, a new chief financial officer (CFO) who oversaw the actual wrongdoer employee, and a thirdparty accountant. Nevertheless, these entities (i) failed to uncover the wellconcealed underpayments after a weeks-long, full-scope audit of the company's finances; and (ii) affirmatively represented to IRS and the taxpayers that the taxes had been paid during the quarters at issue, and that the company was a responsible taxpayer. The Sixth Circuit rejected the district court's conclusion that the taxpayers should have performed their own independent review of the CPA firm's statements, finding that requiring independent verification was unreasonable absent prior indication of errors or inaccuracies in the CPA firm's accounting. However even considering all of the safeguards in place and the reassurances delivered to the taxpayers the Sixth Circuit labeled its decision to vacate the judgment against them as a close call. In Byrne, the Sixth Circuit identified certain factual scenarios in which a finding of willfulness could be based on reckless disregard, including: (1) reliance upon the statements of a person in control of the finances when the circumstances show that the responsible person knew the person to be unreliable; and (2) failure to investigate or to correct mismanagement after having notice of nonpayment of withholding taxes. Facts. Jon Hartman was a 50% co-owner and CEO of Spectrum Tool & Design, Inc. while the company operated from April 2001 to October Dan Ott was a 50% co-owner and chief operating officer (COO) from April 2001 until Hartman laid him off in August Both Hartman and Ott had authority to handle money for Spectrum, open and close bank accounts in its name, and sign checks. 31

3 Generally, Hartman signed employees' paychecks, while Ott prepared the payroll tax deposit checks. Until December 2003, Spectrum used a third-party payroll service provider, ADP, to process its paychecks. But in December 2003, Spectrum was unable to remit the full amount of gross payroll (i.e., including employment taxes) due to ADP, and ADP terminated its contract with Spectrum. Spectrum was, however, able to pay employees their net payroll (i.e., not including employment taxes) during this period. Hartman knew Spectrum could not timely pay its payroll taxes in December 2003, but he and Ott anticipated that they would be able to pay back the shortfall in January or February After being dropped by ADP, Spectrum began using an in-house software system for handling payroll, at Ott's behest. Hartman maintained that Ott was the sole person entrusted to ensure that Spectrum paid its employment taxes. Hartman contended that he did not learn that Ott was routinely failing to pay the payroll taxes until July 2004 at which time he arranged a meeting with IRS to discuss the shortfalls. Going through Ott's desk, Hartman discovered that despite Ott having regularly cut (i.e., created) payroll tax checks, he had not paid the taxes. Up until that point, Hartman claimed that Ott's regularly creating payroll tax checks had led Hartman to believe Ott was paying the taxes. Despite its attempts, Spectrum could not stay current, necessitating another meeting by Hartman with IRS in October At the October meeting, Hartman stated that he discovered that Ott had not been keeping up with Spectrum's current taxes. He also claimed that, during the period at issue, Spectrum's inhouse accounting software reflected that the payroll tax checks were being cut. In January 2005, Spectrum filed for Chapter 11 bankruptcy protection. Hartman acknowledged that he signed tax returns (Form 941) but claimed that he was just signing papers that had to be signed, and that he did not review the returns or understand them. In May 2005, an IRS Revenue Officer interviewed Hartman. He admitted that he first became aware of the delinquent taxes in December 2003 and that while the delinquent taxes were increasing, he authorized the payment of certain of Spectrum's other financial obligations, including payroll, utilities, rent, supplies, operating expenses, loan payments, and equipment leases. Hartman laid off Ott in August 2005 for performance issues. But, even after he fired Ott, he still used Ott to pay Spectrum's employment taxes. Following an investigation, IRS assessed trust fund liabilities against Hartman. Court's conclusions. The district court found that Hartman was a responsible person under Code Sec and that he willfully failed to pay over the employment taxes. While it was undisputed that, in practice, Hartman had no responsibilities related to calculating or paying the payroll taxes, it was also undisputed that he had the 32

4 authority to pay the payroll taxes if he wished to do so. As in Kinnie, Hartman possessed the status, duty, and authority necessary to be a responsible person under Code Sec. 6672, as shown by his title, his stock ownership, his check writing authority, and his ability to force the co-owner out of the business and close down the company. The district court found that every single basis for finding the taxpayer in Kinnie to be a responsible person was present in Hartman's case. Like the taxpayer in Kinnie, the fact that Hartman did not always exercise his powers during the quarters at issue did not absolve him of his responsibility. The district court also noted that, just as the taxpayer in Kinnie was able to commission an inspection of the books to see if his partner was misappropriating funds, Hartman initiated meetings with IRS upon discovering that the accounting balances didn't add up. In fact, the court found, Hartman had more responsibility and involvement than the taxpayer in Kinnie because Hartman assumed the duties of handling payroll and payments to non-irs creditors. Willfulness. Looking to Harold, the district court also found that Hartman recklessly disregarded an obvious risk that the taxes were not being paid. While Hartman became fully aware of Ott's deception in July 2004, he attempted to show that he had no idea that Ott was cooking the books and that Hartman had no reason to exercise oversight of Ott until the fourth quarter of 2004 or later. The court found that the records showed that Hartman discovered Ott's suspicious accounting during the previous quarter, yet, despite this, he continued to trust Ott to pay the taxes until October 2004, after which he learned, again, that the taxes were not being remitted. Yet, Hartman again placed his trust in Ott following the October 2004 conference and declined to exercise any oversight of Spectrum's accounting. The district court's revised opinion presented substantially the same reasoning and conclusions on the issue of willfulness as the previous opinion in this case (U.S. v. Hartman, (DC MI 7/26/2017) 120 AFTR 2d ,), but based on the Byrne decision, rather than that of In re Premo, (Bktcy Ct MI 1990) 71A AFTR 2d The district court concluded that Hartman demonstrated both types of recklessness described above in Byrne. Three separate red flags should have caused Hartman, as a responsible person, to exercise oversight of the taxes. Hartman claimed that, following the October 2004 conference, he attempted to investigate whether Ott was complying with his duties by scrutinizing Spectrum's accounting software, and he found that the checks to pay the payroll taxes were cut. However, the district court noted that the fact that a check was cut didn't mean that the taxes had been paid something Hartman should have realized when he found unremitted checks in Ott's desk in July 2004, despite the fact of those checks having also been cut. The court determined that Hartman's case was nothing like Byrne. Hartman conceded that, as early as July 2004, his suspicions were substantial enough to 33

5 cause him to rifle through Ott's desk where he discovered that, not only were taxes not being remitted, but Ott had manipulated the accounting software to reflect that the checks were, in fact, being remitted. Going forward, Hartman then purported to have relied on the accounting software and Ott's assurances at a July 2004 meeting with the IRS, despite repeated reaffirmations that Ott was not paying the taxes. And none of the mitigating circumstances in Byrne such as the reassurances of a CPA, or indicia that Ott's deception was well concealed (it clearly was not) were present here. Unlike Hartman, the Byrne taxpayers did not simply take the wrongdoer employee at his word regarding tax compliance. By disregarding repeated red flags that Ott was not paying the payroll taxes, Hartman acted recklessly and, so, willfully under Code Sec Hartman's only arguments to the contrary, such as 34