CPAs and the trust fund recovery penalty


CPAs and other accounting professionals should take note of a recent federal district court decision imposing joint and several liability against outside accountants for failure to pay a distressed client’s employment withholding taxes.

In Erwin, No. 1:06CV59 (M.D.N.C. 2/5/13), a federal district court rendered judgment pursuant to Sec. 6672 against two accountants for more than $325,000 each. The case illustrates that application of Sec. 6672, also known as the “trust fund penalty” statute, turns primarily on a finding of control over company finances. The statute can reach beyond company employees and owners to outside accountants and tax preparers, including CPAs. It also is a reminder of a member’s responsibilities under AICPA professional standards, as well as, for federal tax practitioners, Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10).

Secs. 3102(a) and 3402(a) impose on employers the duty to withhold certain employment taxes from the wages of employees and to pay them to the Treasury. These are statutory trust funds (Sec. 7501). The Sec. 6672 penalty imposes civil liability for an amount equal to the unpaid funds on persons who are “required to collect, truthfully account for, and pay over” the taxes but willfully fail to do so. Each circuit court of appeals has developed a fact-intensive version of the test of who is liable for the trust fund penalty, but all require determinations that a “responsible person” willfully failed to pay over the taxes. The IRS may assess against multiple responsible persons, although, by policy, it will collect only once. Upon assessment, the burden of proof shifts to the taxpayer (Kiesel, 545 F.2d 1144 (8th Cir. 1976); and Collins, 848 F.2d 740 (6th Cir. 1988)). To contest the assessment, the taxpayer must pay at least one employee’s liability for each quarter to be disputed (Flora, 362 U.S. 145 (1960); and Steele, 280 F.2d 89 (8th Cir. 1960)). A prevailing defendant is not entitled to attorneys’ fees unless the IRS was not substantially justified in seeking the trust fund penalty (Secret, 373 F. Supp. 2d 619 (N.D.W. Va. 2005)).

The IRS and courts broadly construe “responsible person.” The Internal Revenue Manual (IRM) provides that a responsible person is one who has “significant control” over an employer’s finances or the payment of funds (IRM §; IRS Policy Statement 5-14, Trust Fund Recovery Penalty Assessments (formerly P-5-60)). Exclusive control is not required (Vespe, 868 F.2d 1328 (3d Cir. 1989)). For example, significant control exists where one has “the final word” over which bills or creditors get paid (Commonwealth Nat’l Bank of Dallas, 665 F.2d 743 (5th Cir. 1982)). For more, see “Avoid the Payroll Tax Trap,” JofA, Nov. 2004, page 67.

In Quattrone Accountants, Inc., 895 F.2d 921 (3d Cir. 1990), the Third Circuit affirmed a judgment against a bankrupt accounting firm and one of its principals, Philip Quattrone, for failing to remit withholding taxes for a client, the United Dairy Farmers Cooperative Association (UDF), which was also in bankruptcy. The firm had been hired to perform all of UDF’s financial and accounting activities, including calculating payroll and distributing paychecks, receiving and paying bills, making joint decisions with the president to pay debts outside standard monthly payments, and preparing tax returns. The accounting firm argued that UDF’s president instructed it to pay other creditors over the IRS and that its failure to pay the taxes therefore was not willful. In determining the failure to remit was willful, the appellate court emphasized that the firm had control over UDF’s finances, was in a position to determine which bills were paid, knew that the taxes were not being paid, and had the power to pay the taxes.

In the recent case, Erwin, GC Affordable Dining (GCAD) hired Buddy Light Accounting & Tax Services, which was operated by Buddy Light and his brother, Barry, to manage payroll and accounts payable; calculate employee withholding tax liability; prepare Forms 941, Employer’s Quarterly Federal Tax Return; and make tax deposits. The Lights had access to employee compensation information. They issued payroll checks and remitted withholding taxes to the IRS. They were provided access to the operating account and were authorized to transfer funds to the IRS. They were the first to know the federal withholding taxes owed, as well as whether and when taxes were paid. The Lights were also empowered to pay other creditors and vendors. They reported to management that withholding taxes were owed and that cash flow was insufficient to pay both the withholding taxes and vendor payables. They met with management to devise a payment plan for the tax liability. Nonetheless, when instructed to continue issuing payroll checks and checks to vendors, the Lights did so. There was no evidence that management expressly directed the Lights not to pay the withholding taxes.

The North Carolina federal district court applied the Fourth Circuit’s nonexhaustive list of factors to determine responsible party status: whether the person (1) served as an officer of the company or as a director, (2) controlled payroll, (3) determined which creditors to pay and when to pay them, (4) participated in daily management, (5) possessed the power to write checks, and (6) had the ability to hire and fire employees. The critical inquiry was whether the Lights had the authority or ability to pay the taxes owed, or, put another way, whether they had significant, if not exclusive, authority over the decision. The court found that even though the Lights were not officers or directors, they had substantial control over payroll operations and were therefore responsible persons. It found that the Lights had willfully failed to pay the taxes based on the fact that they had issued checks in preference to other creditors while knowing that the taxes remained unpaid.
Potential liability for the trust fund penalty should trigger caution in the CPA who provides similar services, as well as a heightened awareness of attendant professional responsibilities. If the client insists on paying creditors in preference to the Treasury, AICPA Statement on Standards for Tax Services (SSTS) No. 1, Tax Return Positions, and Sections 10.21 and potentially 10.34 of Circular 230 may, when relevant, require an explanation of the consequences of, and penalties for, noncompliance. Under Rule 102, Integrity and Objectivity, of the AICPA Code of Professional Conduct, a member shall maintain integrity and objectivity and shall not knowingly subordinate professional judgment to others. The member may be required to terminate the engagement (Interpretation 102-4, "Subordination of Judgment by a Member"). Because the inquiry of who is a responsible person is fact-intensive, the members should properly document their relinquishment of control over finances. Failing to remit withholding taxes could be deemed a “discreditable” act under Code of Professional Conduct Rule 501, Acts Discreditable, (see Interpretation 501-7, "Failure to File Tax Return or Pay Tax Liability") and Section 10.51 of Circular 230.

Even if the penalty is erroneously assessed, an accountant can incur substantial attorneys’ fees and possibly have no right to recover them if vindicated. Thus, the tax compliance elements of payroll services should be handled scrupulously.

By Keith Kebodeaux, J.D., LL.M., MSA ( ), a lecturer in accounting at Texas State University in San Marcos, Texas. He was a founding partner of the law firm Kebodeaux, Hargroder & Alexander LLP in Beaumont, Texas, where his practice focused on business transactions, tax planning and controversy, oil and gas law, and business litigation.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at or 919-402-4434.

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