Sixth Circuit Finds CEO Took Reasonable Steps to Ensure Payment of Payroll Taxes

(Parker Tax Publishing June 2017)

The Sixth Circuit, in a case of first impression, rejected a district court's judgment and held that two corporate officers were not liable for unpaid payroll taxes under Code Sec. 6672 because they did not willfully fail to pay the taxes. The court applied a reasonable cause exception in finding that the officers believed the taxes were in fact being paid, and their belief was reasonable under the circumstances. Byrne v. U.S., 2017 PTC 239 (6th Cir. 2017).

Background

In 1988, Roger Byrne and Eric Kus were among a group of investors who formed Eagle Trim, Inc., an automotive trim business. Kus was named the chairman and CEO and Byrne the president. Another investor, Bernard Fuller, became the controller. The business was financed by General Motors Acceptance Corporation Business Credit LLC (GMAC) with a revolving line of credit. The financing agreement gave GMAC the right to have an accounting firm periodically examine Eagle Trim's business records. GMAC used Lender Services to conduct these examinations. The agreement also required Eagle Trim to provide GMAC with annual financial statements audited by an independent accounting firm. Eagle Trim hired Weber, Curtin & Drake (WCD) to conduct these year-end audits. WCD's engagement letter stated that although its services would provide reasonable assurance of detecting errors or fraud that would have a material effect on the financial statements, an audit was not a guarantee of the accuracy of the financial statements and that there was a risk that material errors or fraud might go undetected.

As controller, Fuller was responsible for ensuring that Eagle Trim's tax liabilities, including payroll taxes, remained current. WCD provided Fuller with guidance on how to make the payroll tax payments. Despite this guidance, Fuller made biweekly instead of semiweekly payments, resulting in a large penalty assessed against Eagle Trim in early 1999. By the end of 1999, Byrne and Kus had determined that Fuller was not adequately performing his duties and provided him with a handwritten list of tasks that he needed to start completing accurately and timely.

In March 2000, Lender Services notified GMAC that Eagle Trim had provided inadequate supporting documentation for Lender Services' collateral reviews. Lender Services recommended that Eagle Trim implement procedures to ensure timely tax payments and appropriate recordkeeping. GMAC forwarded the letter to Eagle Trim and Kus reviewed it. Fuller responded to the letter stating that two payroll tax payments were missed in the course of moving Eagle Trim's accounts to a new bank. Fuller's letter, on which Byrne and Kus were copied, said that Eagle Trim was current with all of its payroll taxes at that time.

In April 2000, on WCD's recommendation, Eagle Trim hired an accountant to assist Fuller with his duties. In July 2000, Eagle Trim hired Andrew Jones as CFO, reporting to Byrne and Kus. Fuller reported to Jones and provided monthly financial statements to him.

In October 2000, the IRS notified Eagle Trim of a penalty for approximately $98,000 for unpaid payroll taxes for the first quarter of 2000. In a meeting between Fuller and David Drake, a WCD partner, Fuller said the payment was late because of the company's switch to a new bank. Fuller also said an IRS representative informed him that all of Eagle Trim's payroll taxes had been paid in full and on time since June 2000. Drake sent the IRS a letter repeating Fuller's explanation and requesting a waiver of the penalty. In November 2000, Fuller sent a letter to Kus and Byrne describing the IRS penalty, his meeting with Drake, and Drake's waiver request.

WCD issued an audit in December 2000 stating that Eagle Trim was current on its payroll taxes. In January 2001, WCD sent a letter to Kus, copying Byrne, Jones and Fuller, identifying flaws in Eagle Trim's accounting practices that WCD found during its 2000 audit. The letter discussed Eagle Trim's failure to timely pay its payroll taxes and recounted the penalties assessed in 1999 and the first quarter of 2000. The letter stated that WCD had been informed that the payroll taxes for the second quarter of 2000 had also not been paid, although no penalty had yet been assessed. WCD recommended measures to ensure the timely payment of payroll taxes and offered its assistance. WCD stated, however, that it did not see any material weaknesses in Eagle Trim's internal control structure.

Lender Services discovered in January 2001 that Eagle Trim's financial statements were fraudulently overstated. According to the review, Fuller had falsified certain receivables by adding digits to the invoices. At this time, Kus and Byrne were unaware that Eagle Trim was delinquent on its payroll taxes for the second, third and fourth quarters of 2000. GMAC hired a crisis management firm, BBK, Ltd, and both GMAC and BBK took complete control over Eagle Trim's finances.

BBK informed Byrne and Kus in February 2001 that Eagle Trim had not made its payroll tax payments for the last three quarters of 2000. Fuller was then fired. In March 2001, WCD notified Byrne and Kus that, because of the discovery of improper accounting resulting in material misstatements, Eagle Trim should no longer rely on WCD's audit reports for 1999 and 2000. Drake also notified Byrne that WCD was recalling its audit reports due to the discovery that Fuller had been making false entries. Drake said that there was a significant effort on Fuller's part to disguise these activities and to prevent their discovery in the course of WCD's audits.

In April 2001, Eagle Trim filed for Chapter 11 bankruptcy and ultimately liquidated. The IRS received payment for the unpaid payroll taxes for the second quarter of 2000 in the liquidation. In July 2005, the IRS assessed a trust fund recovery penalty under Code Sec. 6672 against Byrne and Kus of approximately $855,000 for Eagle Trim's outstanding payroll tax liability for the year 2000. Byrne paid $1,000 to the IRS and then filed for a refund and an abatement of the penalty and of the entire assessment. The IRS denied Byrne's claim and Byrne filed suit in a district court. The IRS's counterclaim seeking a judgment for assessed balance included a claim against Kus.

Under Code Sec. 6672(a), a person who is responsible for collecting and paying payroll taxes who willfully fails to do so is personally liable for the unpaid taxes. A responsible person willfully fails to pay the taxes if the person either has actual knowledge that the taxes were not paid or recklessly disregards known risks that the taxes were not paid.

District Court's Judgment

The district court entered summary judgment in favor of the IRS. Byrne and Kus appealed, arguing that they were not responsible for paying Eagle Trim's payroll taxes and if they were, they did not willfully fail to pay the taxes. On appeal, the Sixth Circuit held that Byrne and Kus were responsible persons under Code Sec. 6672 but reversed the district court's grant of summary judgment, finding that there was a genuine dispute whether Byrne and Kus should have known that the payroll taxes were not being paid. On remand, the district court found that Byrne and Kus willfully failed to file Eagle Trim's payroll taxes for the third and fourth quarters of 2000. The district court entered judgments of approximately $533,000 each against Byrne and Kus, which they appealed.

Sixth Circuit's Decision

The Sixth Circuit held that Byrne and Kus did not willfully fail to pay Eagle Trim's payroll taxes and thus vacated the district court's judgment. The court noted that what constitutes reckless disregard with respect to the nonpayment of payroll taxes was an issue of first impression for the Sixth Circuit. The court cited its holding in Calderone v. U.S., 799 F.2d 254 (6th Cir. 1986) that a responsible person is reckless and therefore willful under Code Sec. 6672(a) when he or she disregards obvious or known risks that payroll taxes are not being paid and fails to investigate. However, to balance the IRS's right to recover taxes it is owed with limiting liability for that recovery to those who are personally at fault, the Sixth Circuit adopted a reasonable cause exception which the Second Circuit articulated in Winter v. U.S., 196 F.3d 339 (2d Cir. 1999). A responsible person is not liable if he or she can demonstrate a reasonable belief under the circumstances that the payroll taxes were being paid on time. The Sixth Circuit characterized this rule as a narrow exception which limits liability to those who fail to take reasonable steps to ensure payment after receiving notice that the taxes have not been paid.

The Sixth Circuit agreed with the district court that Byrne and Kus did not have actual knowledge that the payroll taxes were not being paid until after GMAC and BBK assumed control of Eagle Trim's finances. However, the Sixth Circuit did not agree that Byrne and Kus recklessly disregarded the risk that the taxes were not being paid in the third and fourth quarters of 2000. The court said that it would not impose liability on Byrne and Kus simply because they did not independently verify WCD's reports or Fuller's account of the status of Eagle Trim's tax position. Rather, under the circumstances, the Sixth Circuit held that Byrne and Kus took reasonable steps to ensure the timely payment of the payroll taxes and reasonably believed they were being paid.

The court thought that the hiring of an accountant to assist Fuller and the hiring of a CFO to oversee him were important considerations in determining whether Byrne and Kus reasonably believed Eagle Trim was making timely payroll tax payments. The court also pointed to the hiring of WCD, which demonstrated to the court that Byrne and Kus took reasonable steps to comply with Eagle Trim's tax obligations. The court found that Byrne and Kus reasonably relied on WCD's representations because there were no prior indications of errors or inaccuracies in WCD's auditing. The Sixth Circuit also cited WCD's December 2000 audit report, which concluded that there had been no fraud involving management and that Eagle Trim had accurately disclosed its pending or anticipated tax assessments. Although that audit was withdrawn in March 2001 following the discovery of Fuller's wrongdoing, it was significant to the court that WCD's auditors, who had spent several weeks at Eagle Trim, missed Fuller's inaccurate accounting entries. The court reasoned that if WCD did not detect Fuller's misconduct, and that it took several months for BBK to determine the exact amount of Eagle Trim's tax liability, then Byrne and Kus did not act unreasonably in believing that Fuller was paying the payroll taxes on time. The court said that it was not clear what additional measures Byrne and Kus could have taken short of personally contacting the IRS to verify Eagle Trim's tax liabilities or firing Fuller after the first or second notice of his irresponsible actions.

For a discussion of the Code Sec. 6672 penalty for failure to collect, account for, and pay over payroll taxes, 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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