Doctor Subject to Payroll Tax Penalty for Paying Employees Before IRS

(Parker Tax Publishing December 2016)

A family doctor, whose medical practice owed over $10 million in unpaid payroll and withholding taxes, was a responsible person and was liable for payroll tax penalties when he paid his employees before paying the IRS. The court rejected the doctor's argument that the $100,000 he loaned to his practice to pay his employees was "encumbered" and thus the payment was not a willful transfer of unencumbered funds to a creditor other than the IRS. McClendon v. U.S., 2016 PTC 484 (S.D. Tex. 2016).

Background

Dr. Robert McClendon founded Family Practice Associates of Houston, a medical-service provider, in 1979. In 1995, Family Practice hired Richard Stephen, Jr., as its Chief Financial Officer. By 2009, Family Practice owed over $10 million in unpaid payroll and other withholding taxes. Dr. McClendon learned that these taxes were unpaid on May 11, 2009. Stephen pleaded guilty to three counts of felony theft of money that he embezzled from Family Practice. Family Practice stopped operating and remitted its remaining receivables to the IRS to pay toward the tax liability.

McClendon made a $100,000 personal loan to Family Practice for the restricted purpose of using the funds to pay the May 15, 2009, payroll. Family Practice used that loan to pay its employees. As a result of McClendon paying his employees before paying back payroll taxes to the IRS, the IRS assessed a total of $4.3 million in tax penalties under Code Sec. 6672. McClendon paid a small part, then sued for a refund and abatement of the remaining penalty amount.

Code Sec. 6672 Penalty

To ensure that payroll and withholding taxes are remitted to the Treasury Department, Code Sec. 6672(a) imposes a penalty on any person required to collect, truthfully account for, and pay over any payroll and withholding tax. Under this provision, the term "liability" is composed of two elements:

(1) that the taxpayer was a "responsible person," and

(2) that the taxpayer willfully failed to collect, account for, or pay over such taxes.

Several courts, including the Fifth Circuit (to which the instant case would be appealable), have held that in the case of individuals who are responsible persons both before and after withholding tax liability accrues, there is a duty to use unencumbered funds acquired after the withholding obligation becomes payable to satisfy that obligation and failure to do so when there is knowledge of the liability constitutes willfulness.

Taxpayer's Arguments

McClendon conceded that he was a "responsible person." However, he contended that he did not willfully fail to collect, account for, or pay taxes that Family Practice owed to the IRS. McClendon first argued that because he loaned the money to Family Practice on the understanding that it could use the money only to cover payroll, the funds were "encumbered." According to McClendon, because he loaned the money to Family Practice with the express restriction that it could use the money only to cover payroll, the funds were "encumbered" and willfulness is shown as a matter of law only by evidence that a responsible person directed "unencumbered" funds to a creditor other than the government.

McClendon also argued that he had reasonable cause to provide a way to pay the employees because "he acted morally and generously in using his own money to make sure Family's staff . . . were paid for the work they had performed."

District Court's Opinion

The district court began by citing Logal v. U.S., 195 F.3d 229, 232 (5th Cir. 1999), for the principle that willfulness is normally proved by evidence that a responsible person paid other creditors with knowledge that withholding taxes were due at the time to the United States. Payment of wages to employees, the court noted, counts as a payment to a creditor for purposes of this principle. According to the court, if a responsible person knows that withholding taxes are delinquent, and uses corporate funds to pay other expenses, even to meet the payroll out of personal funds he lends the corporation, he has acted willfully within the meaning of Code Sec. 6672.

Thus, the district court rejected McClendon's arguments and granted summary judgment to the IRS. The Fifth Circuit, the court concluded, has made clear that a taxpayer who consciously decides to use unencumbered funds to pay a creditor other than the government cannot benefit from the reasonable-cause defense. The court found no basis for a different result in McClendon's situation.

For a discussion of the responsible person 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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