The Fifth Circuit partly vacated the decision of a district court that had granted summary judgment in favor of the IRS for unpaid withholding taxes of over $4.3 million, remanding the case to the lower court. According to the appellate court, the person held responsible for the taxes had produced sufficient evidence that there was a genuine issue of material fact whether the taxpayer corporation possessed sufficient unencumbered funds to pay the taxes, which could limit his responsibility for them.
Facts: In 1979, Robert McClendon, a physician, founded Family Practice Associates of Houston (FPA). For 21 consecutive quarters from 2003 to 2008, FPA's CFO, who later pleaded guilty to felonious theft, failed to pay taxes withheld from employees' paychecks to the IRS. By 2009, FPA owed the IRS over $11 million. When made aware of the unpaid taxes in May 2009, McClendon and FPA's board of directors immediately stopped payments to its other creditors and vendors. Also, in May 2009, McClendon and his wife loaned FPA $100,000 specifically to pay its employees for that month. FPA subsequently directly remitted to the IRS over $400,000 in receivables and payments on them, plus $250,000 from an insurance claim for employee theft.
In 2012, the IRS assessed McClendon about $4.3 million in penalties under Sec. 6672, on the grounds that he was a responsible person, had willfully failed to pay the taxes when he paid the employees $100,000 from his loan to FPA rather than paying the IRS, and had been grossly negligent by not properly overseeing the CFO. McClendon paid a small portion of the penalty and sued for a refund of that amount and an abatement of the remainder in the District Court of the Southern District of Texas. McClendon conceded that he was a responsible person but argued that the $100,000 was restricted, only to be used to pay the employees.
In November 2016, the district court held the $100,000 was unencumbered and granted summary judgment in favor of the IRS for $4.3 million (McClendon, No. H-15-2664, S.D. Tex. (11/17/16); see "Tax Matters: Medical Practice Owner Is Held Liable for Employment Taxes," JofA, March 2017. McClendon appealed to the Fifth Circuit in March 2017 but died later that year, and his widow, Gail McClendon, was substituted as appellant.
Issues: Employers are required to withhold federal income and FICA (Federal Insurance Contributions Act) taxes. When those taxes are not remitted, any officer or employee of the organization can be assessed a penalty of 100% of the unpaid taxes under Sec. 6672 if the individual was required to collect, account for, or pay the taxes (a "responsible person") but willfully failed to do so. Willfulness can be shown if the responsible person knew the taxes had not been paid and used unencumbered funds to pay non-IRS creditors; however, the responsible person's liability in this situation is limited to the amount of available unencumbered funds deposited into the organization's bank account after the responsible person became aware of the unpaid taxes. Willfulness can also be shown if a responsible person recklessly disregards a known or obvious risk that the taxes will not be paid, such as failing to investigate after receiving notification that the taxes were not being paid.
On appeal, McClendon argued the $100,000 payment to FPA's employees was from encumbered funds and that even if those funds were unencumbered, the maximum penalty should be $100,000, since that was the amount of unencumbered funds paid to non-IRS creditors after McClendon became aware of the unpaid taxes. The IRS countered that McClendon had failed to prove the amount of unencumbered funds that were available after the discovery of the unpaid taxes. The IRS further argued that even if McClendon's argument regarding the limit on his liability was accepted, the IRS's alternate argument that McClendon willfully failed to pay the taxes because he recklessly disregarded a known or obvious risk that the taxes would not be paid must be considered. If this argument were accepted, according to the IRS, McClendon would not be entitled to a limit on his liability for the taxes equal to the amount of available unencumbered funds, so summary judgment would still be appropriate.
Holding: The court partially affirmed and partially reversed the district court's holding and remanded the case to the district court. The court affirmed the district court's holding that the $100,000 paid to employees came from unencumbered funds, as McClendon provided no evidence of error by the district court on that issue. However, the court held that McClendon's testimony concerning FPA's payments to the IRS and copies of checks documenting them were sufficient to raise an issue of material fact of whether FPA had retained $4.3 million in available, unencumbered funds after McClendon learned of the unpaid taxes. Therefore, it vacated the district court's summary judgment imposing the $4.3 million penalty. Regarding the IRS's alternative argument that McClendon had recklessly disregarded a known risk that the taxes would not be paid, the court noted that the district court would have the opportunity to consider the merits of the argument on remand.
- McClendon, No. 17-20174 (5th Cir. 6/14/18)
— By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.