The U.S. District Court for the Southern District of Texas denied a medical practice owner's request for a refund of penalties assessed by the IRS for the failure to pay taxes withheld from paychecks of employees of the practice (trust fund taxes). The court held that the Sec. 6672 penalties should apply because the taxpayer willingly failed to remit the required taxes.
Facts: In 1979, Robert McClendon started the Family Practice Associates of Houston. Because of an embezzlement scheme by its CFO, the company owed the IRS over $10 million of trust fund taxes by May 2009, when the embezzlement was discovered. Family Practice ceased operations and remitted its remaining receivables to the IRS in partial payment toward the tax liability. McClendon paid the practice's employees for their services performed during its final week from the proceeds of a $100,000 personal loan that he made to Family Practice with what he testified was an express restricted purpose of covering that week's payroll.
The IRS assessed McClendon, as the practice's responsible person, more than $4.3 million in penalties under Sec. 6672 for what it contended was his willful failure to pay the remaining owed trust fund taxes. After paying a portion of the penalties, McClendon sued the IRS in district court for a refund of them and an abatement of the remaining penalties. The IRS moved for summary judgment.
Issues: Under Sec. 6672, any responsible person who willfully fails to collect or pay trust fund taxes is subject to a penalty tax equal to the amount of the unpaid taxes. A responsible person is anyone who is required to collect, account for, and pay trust fund taxes or has the power to direct those actions. In the context of a corporation, willfulness exists when a responsible person knew or should have known that trust fund taxes have not been paid and the responsible person uses corporate funds to pay other expenses.
As a matter of law, willfulness is present when a responsible person directs payment of unencumbered funds to other creditors before the government. However, willfulness does not exist if a responsible person can show that there was reasonable cause to pay other creditors before the government. McClendon agreed that he was a responsible person, but he disagreed with the IRS that he willfully failed to pay the trust fund taxes.
Holding: The court granted summary judgment to the IRS. McClendon argued that the restriction on the use of the loaned funds was an encumbrance that protected him from liability for Family Practice's use of the loan proceeds to pay its employees. The court rejected this argument, stating that an encumbrance exists only when the taxpayer is legally obligated to pay other creditors first and that a responsible person cannot avoid liability by entering into a preferential lending agreement, in which the person (in this case, Family Practice) voluntarily assumes a contractual obligation to pay some set of creditors before paying the government.
McClendon also argued that he had reasonable cause to pay the employees because the use of his own money to pay the employees was moral and generous. The court, while "[f]ully accepting as a fact that Dr. McClendon's motives were admirable," rejected this argument, stating that a responsible person who knowingly pays a creditor other than the government with unencumbered funds cannot avoid liability from the penalty due to reasonable cause.
—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.