Financial hardship as a reasonable cause for failure to pay.

Possible defense for employers.

From The Tax Adviser:
Financial Hardship as Reasonable Cause
for Failure to Pay

O ne of an employer’s major responsibilities is to withhold federal income and employment taxes from its employees and to pay the amounts collected to the government by passing them on to a valid depository. If an employer fails to perform these duties, it will find itself subject to penalties.

PENALTIES FOR FAILURE TO PAY
The IRC provides various penalties against taxpayers that do not comply with the tax laws on a timely basis. A taxpayer may be able to avoid such penalty assessments if it can show the failure was due to reasonable cause and not willful neglect. A reasonable cause for the failure to pay is if a taxpayer can show satisfactorily that it exercised ordinary business care and prudence in providing for payment of the tax liability but was either unable to pay the tax or would suffer an undue hardship if the tax was paid when due. An undue hardship must be more than a mere inconvenience; it must appear that a taxpayer would have suffered a substantial financial loss (for example, loss due to the sale of property at a sacrifice price) if it had made the payment on the appropriate date.

INCOME VS. EMPLOYMENT TAXES
Courts have made a distinction between the circumstances that may be reasonable cause for nonpayment of income taxes and for nonpayment of employment taxes, which are withheld from others (that is, employees) and are considered held in trust exclusively for the government. To establish reasonable cause for withheld employment taxes, the situation must be particularly compelling; the standard for a taxpayer in such a situation is much stricter.

FACTS-AND-CIRCUMSTANCES APPROACH
Although some courts have ruled that financial difficulties never can be reasonable cause to excuse the penalties for an employer’s nonpayment of withholding taxes, other courts have maintained that the proper approach involves examining the circumstances underlying the taxpayer’s default. The latter courts consider all the facts and circumstances of a taxpayer’s financial situation, including the amount and nature of the taxpayer’s expenses in light of the income it could, at the time of such expenses, reasonably expect to have received before the due date of the taxes. This analysis includes factors such as whether a taxpayer incurred lavish or extravagant expenses or invested funds in speculative or illiquid assets or, instead, made reasonable efforts to conserve sufficient assets in marketable form to satisfy the tax liability.

This determination focuses on a taxpayer’s business decisions. Because of its financial situation, a taxpayer has a business choice as to who gets paidthe government or others; the issue is whether the taxpayer’s actions are reasonable for the situation. And, while severe financial difficulties may be the immediate cause of a failure to pay taxes, the circumstances that precipitated those difficulties (as well as the taxpayer’s allocation of scarce resources during a lean period) often result in the finding that the taxpayer simply failed to exercise ordinary business care and prudence.

CAVEAT
Establishing reasonable cause for a taxpayer’s failure to pay and/or deposit taxes due to financial hardship is not an easy task, especially if withheld employment taxes are involved. Courts have found it extremely difficult to conceive of a specific set of circumstances under which financial difficulties, standing alone, justify a finding of reasonable causewithout some unforeseeable intervening factor (such as the threat of insolvency). At the same time, there are taxpayers for whom this defense should be considered.

For a discussion of recent developments in this and other areas, see the Tax Clinic, edited by Beth Brook, in the January 1999 issue of The Tax Adviser .

Nicholas Fiore, editor
The Tax Adviser