Fifth Circuit Vacates Lower Court Decision on Taxpayer's Liability for Section 6672 Penalty

(Parker Tax Publishing July 2018)

The Fifth Circuit held that, in a case involving a taxpayer whose business failed to pay over to the IRS approximately $11 million in payroll taxes, a district court erred when it (1) granted summary judgment in the IRS's favor on the taxpayer's liability for the unpaid taxes and (2) denied the taxpayer's motion to reconsider on the basis that the amount of the taxpayer's liability was a genuine issue of material fact. The Fifth Circuit found that, under Code Sec. 6672, the taxpayer was liable only for the amount of available, unencumbered funds in the business's accounts after the taxpayer became aware of the unpaid withholding taxes and that the taxpayer presented competent evidence establishing an issue of material fact regarding whether the business's funds were sufficient to cover the tax obligation. McClendon v. U.S., 2018 PTC 173 (5th Cir. 2018).

Background

Dr. Robert McClendon founded Family Practice Associates of Houston (FPA), a professional medical association, in 1979. By 1995, FPA employed five doctors, numerous nurses, and related support staff. That year, FPA hired Richard Stephen, a certified public accountant, to serve as FPA's chief financial officer. From 1995 to 2009, Stephen informed FPA's board of directors that FPA was doing well financially and that all of FPA's tax obligations were being met.

In 2009, the IRS notified FPA that it had no record of any payroll tax deposits from FPA for several of the previous years. FPA discovered that Stephen had failed to remit FPA's withholding taxes from 2003 to 2008, and that he had been stealing money from the company for several years. FPA's unpaid withholding tax balance was over $11 million.

In response, FPA stopped paying its creditors and vendors. To ensure FPA's employees would continue receiving their paychecks in May 2009 without using any of FPA's funds, McClendon loaned FPA $100,000. FPA remitted all of its receivables directly to the IRS, totaling over $400,000. FPA also paid the IRS $250,000 in insurance proceeds it received on its claims for employee theft. In 2013, Stephen pleaded guilty to first-degree felony theft and was sentenced to 10 years in prison.

In 2012, the IRS assessed approximately $4.3 million in penalties against McClendon personally for FPA's unpaid withholding taxes. McClendon paid a nominal amount and then sued for a refund. The IRS filed for summary judgment, contending that McClendon was a responsible person for FPA's payroll taxes and willfully failed to pay the taxes to the IRS. According to the IRS, McClendon acted willfully by using company funds to pay non-IRS creditors. The IRS pointed out that McClendon loaned FPA $100,000, paid a doctor $1,840, and paid an insurance company $2,000. The IRS also argued that McClendon was grossly negligent in delegating, with no oversight, the responsibility of paying payroll taxes to Stephen for years and that such conduct constituted willfulness under Code Sec. 6672.

McClendon conceded that he was a responsible person but contested the willfulness element. He asserted that none of the subject payments were made using FPA funds. He also argued that the $100,000 loan was encumbered and could not have been paid to the IRS because he specified in the loan terms that the money be used only to pay FPA employees.

The district court granted the IRS's motion for summary judgment. It determined that McClendon acted willfully because, after learning of the unpaid taxes, he loaned money to FPA which for payroll rather than to pay the IRS. The district court found that the loan funds were not encumbered, reasoning that a responsible person cannot avoid liability by entering into a lending agreement in which creditors are paid before the government. The district court ruled in favor of the IRS for the total amount of penalties assessed against McClendon, approximately $4.3 million.

McClendon filed a motion for reconsideration. He argued that even if he were a responsible person who acted willfully, his liability was limited to the amount of unencumbered funds FPA had available after he learned of the unpaid taxes. He asserted that all of FPA's available unencumbered funds were paid over to the IRS and that the only evidence of funds not paid over was the $100,000 loan. McClendon asserted that, therefore, he could be liable to the government for, at most, $100,000.

The IRS responded that McClendon was not entitled to this limitation on his liability because he failed to prove the total amount of FPA's available funds, whether they were unencumbered, and if so, whether they were paid to the IRS. The IRS argued that applying the limitation on his liability necessarily required a full accounting of all of FPA's available funds after the date he became aware of the unpaid taxes. The IRS asserted that McClendon had not introduced any of FPA's bank records to show how much was deposited after his discovery of the unpaid taxes. The IRS also argued that McClendon would not be entitled to the liability limit if he was found to be grossly negligent.

In response, McClendon provided a copy of a check showing that FPA's closing balance in July 2009 of approximately $297,000 had all been turned over to the IRS. McClendon further contended that the gross negligence determination was an issue of material fact that could not be decided by summary judgment.

The district court denied McClendon's motion for reconsideration, finding that McClendon failed to raise the limitation of liability argument in response to the IRS's motion for summary judgment and could not raise it for the first time in his motion to reconsider. The district court also found that, even if the argument were properly before it, it failed on the merits because McClendon had the burden of proof as to the availability of the funds and had failed to demonstrate that FPA's funds were insufficient to cover the tax obligation. McClendon appealed to the Fifth Circuit.

Analysis

Employers are required to withhold taxes and social security contributions from their employees' paychecks and hold them in trust for the government. Under Code Sec. 6672, a penalty applies to officers or employees who are responsible for collecting and paying over the taxes but who willfully fail to do so. Such individuals are personally liable for a penalty equal to the amount of the delinquent taxes. Willfulness is established if a responsible person knew the taxes were delinquent but used company funds to pay non-IRS creditors. The responsible person's liability is limited to the amount of available, unencumbered funds deposited in the business's bank accounts after the responsible person became aware that the taxes were due.

On appeal, McClendon reasserted that $100,000 was the upper limit of his liability because that was the amount of available, unencumbered funds paid to non-IRS creditors after he learned of the unpaid taxes. McClendon also argued again that his loan to FPA was encumbered because its use was restricted to payroll.

The Fifth Circuit affirmed the district court's determination that McClendon's $100,000 loan was unencumbered because McClendon failed to identify any error in the district court's analysis on that issue. However, the Fifth Circuit vacated the remainder of the summary judgment because it found that there was a genuine issue of material fact as to whether FPA had $4.3 million in available, unencumbered funds after McClendon learned of the unpaid taxes.

The court recounted McClendon's testimony that as soon as FPA's board learned of the unpaid taxes, FPA stopped paying its creditors and vendors, that he and his wife loaned money to the company, and that FPA remitted its receivables and insurance proceeds to the IRS. The court also noted that McClendon submitted to the district court copies of checks made out to the IRS. One check was dated July 2009 and was for approximately $135,000. Another was dated February 2010 for $297,000, which the court noted was just under FPA's closing bank balance at the end of July 2009. McClendon also submitted a copy of an August 2010 check to the IRS for approximately $275,000.

The Fifth Circuit found that the district court believed McClendon had to provide an accounting of FPA's funds in order to satisfy his burden on summary judgment. The court looked to the decision in U.S. v. Stein, 2018 PTC 130 (11th Cir. 2018), in which the Eleventh Circuit held that a taxpayer's self-serving and uncorroborated statements could create an issue of material fact with respect to the correctness of the IRS's assessments, and that if a corroboration requirement existed, it had to come from a source other than the procedural rule governing summary judgment. The Fifth Circuit found that, while Code Sec. 6672 imposes a harsh remedy against taxpayers such as McClendon, who was in the court's view as much a victim of Stephen's criminality as the government, the statute did not supplant the evidentiary burdens applicable to a summary judgment proceeding.

Observation: In a concurring opinion, one judge opined that it was irresponsible for the IRS to claim McClendon failed to raise an issue of fact when it had access to FPA's financial records. In a dissenting opinion, one judge argued that the court could not vacate the district court's holding based on an argument McClendon never raised in the original summary judgment briefing.

For a discussion of the Code Sec. 6672 trust fund recovery penalty, see Parker Tax ¶210,108.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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