Penalty Imposed on Business Owner Who Used Loan Funds to Pay Expenses Instead of Payroll Taxes

(Parker Tax Publishing March 2018)

A district court upheld a trust fund recovery penalty against the co-owner of a construction business because the court found that the individual was a responsible person who willfully failed to pay over withheld payroll taxes. The court noted a split of authority on whether a voluntarily assumed restriction on a company's ability to direct funds under a loan constituted an encumbrance that would preclude a finding of willful nonpayment, and it followed the majority rule that only encumbrances imposed by statute or regulation negate the willfulness element and excuse a failure to rectify a payroll tax delinquency. Davis v. U.S., 2018 PTC 56 (D. Colo. 2018).

Kelly Davis was a co-owner and the president of WVC, a Colorado construction contractor. Davis managed WVC's field operations, was responsible for the hiring and firing of field staff, and set the hourly rates for its employees. Allyce Card, the other owner, was WVC's bookkeeper and managed its finances and office staff. Davis brought in Card in 2005 to handle banking, loan negotiations and vendor guarantees.

Card exercised total control over the company's finances. However, Davis had signing authority on the company checking account and would sign payroll and vendor checks when Card was unavailable. Davis also had the ability to ask Card to produce a check for Davis to sign. Davis gave Card input on whether one creditor should be prioritized over another, although Davis rarely did so. On one occasion, Card issued a company check to Davis for $113,000 so he could buy a sports car for his personal use.

Before 2009, WVC obtained a line of credit from Mutual of Omaha Bank (MOB) in exchange for a security interest in effectively all of WVC's assets including accounts receivable. Under a commercial security agreement with MOB, WVC agreed that it would not dispose of any physical assets, accounts receivable, or cash on hand without MOB's prior written consent. WVC regularly drew on the MOB line of credit in 2009.

WVC withheld money from employee paychecks to satisfy its payroll tax obligations but did not pay the funds over to the government. Instead, the funds were diverted to pay operating expenses, creditors, and personal obligations of Davis and Card. In 2009, Davis directed at least $1.3 million in corporate funds to Aspen Glen Leasing (AGL) as lease payments on rented equipment. Davis was aware of WVC's failure to remit withheld payroll taxes by early 2009, but never caused WVC to rectify the delinquencies. Davis never asked MOB for permission to use some of WVC's line of credit to pay the delinquent taxes.

The IRS assessed a penalty of approximately $980,000 against Davis under Code Sec. 6672 for nonpayment of the payroll taxes. Davis challenged the assessment in a Colorado district court. The government filed for summary judgment, arguing that Davis was a responsible person who willfully failed to pay over taxes under Code Sec. 6672.

Davis argued that Card was the only person responsible for the nonpayment of the employment taxes because she controlled WVC's finances. He also argued that he did not willfully fail to remit the taxes for two reasons. First, he claimed that under the Colorado construction trust fund statute, WVC was required to hold in trust all progress payments on a given job to guarantee payment to subcontractors, laborers and suppliers. Davis claimed that this obligation sufficiently encumbered company funds so that the failure to use them to pay tax delinquencies did not amount to willful conduct. Second, Davis asserted that WVC's line of credit with MOB prohibited it from disposing of any assets without MOB's prior consent. Davis argued that MOB therefore had absolute control over the use and disposition of all of WVC's assets, effectively preventing Davis from making any payments other than those approved by MOB.

The district court rejected Davis's arguments and found that he was a responsible person who willfully failed to pay over withheld payroll taxes. The court found that although Card exercised considerable control over WVC's finances, she did so effectively by Davis's delegation of authority, and not because Davis lacked the power to control the company's finances. In the district court's view, Davis had the authority to direct that taxes be paid even if his job did not call upon him to exercise that power. The court found that Davis signed checks in Card's absence and could request that she issue checks for him to sign. Most significantly to the district court, Davis requested a check so that he could use company funds to buy a car for his personal use. The district court explained that such a request could only be successfully made by a person with the ability to dictate the control of company finances.

On the issue of willfulness, the court assumed that funds received by WVC as progress payments on existing jobs were encumbered by operation of the state trust fund statute. However, the court found that the MOB credit line did not prevent Davis from remitting the taxes. The court noted a split of authority on the issue of whether a voluntary, contractually imposed restriction on a company's ability to direct funds constitutes an encumbrance that would preclude a finding of willful nonpayment. Under the majority rule, a company's voluntary decision to grant a security interest or other control over company funds to a lender does not create an encumbrance that excuses a failure to rectify tax delinquencies; only legally imposed encumbrances (such as those imposed by a statute or regulation) excuse payment of taxes. By contrast, a minority rule, articulated in In re Premo, 116 B.R. 515 (Bankr. E.D. Mi. 1990), provides that where the taxpayer's discretion is subject to restrictions imposed by a creditor holding a security interest which is superior to the IRS's interest, the funds are encumbered if the restrictions preclude the taxpayer from using them to pay taxes.

The court found that the Tenth Circuit, to which this case would be appealable, followed the majority rule, but reasoned that Davis's failure to pay the taxes was willful under either standard. Applying the majority rule, the district court found that even if MOB effectively controlled MVC's spending, such control was voluntarily ceded by contract from WVC to MOB. Thus, the funds that WVC received from MOB throughout 2009 were not encumbered and Davis was required to apply those funds to WVC's tax delinquencies before using them to pay for operating expenses such as leases, rents, and payroll.

The court then went on to explain that the outcome was the same even under the minority rule. The court reasoned that under Premo, the question is whether the restrictions imposed by a lender preclude the taxpayer from using the funds to pay taxes. This means the court would have to determine whether the responsible person sought permission from the lender to use the funds and was rejected, as opposed to silently assuming the lender would not permit the payment of taxes. It was clear to the court that Davis never asked MOB for permission to use some of WVC's line of credit to pay the delinquent taxes. He was therefore not precluded from using the funds under Premo.

The court concluded that the $1.3 million in unencumbered funds that Davis directed WVC to pay to AGL in 2009 warranted the imposition of the penalty assessed by the IRS, and the court granted summary judgment for the government.

For a discussion of the 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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