Debtors have several tools at their disposal in litigating tax claims. They may object to the claim; move to determine the validity, extent and priority of a tax lien; alter the treatment and payment of a tax claim through a chapter 11 or 13 plan; or seek a §505 determination of the claim. Additionally, a debtor may also seek abatement of penalties and interest in limited circumstances. This column discusses case law treatment of abatement issues and the circumstances a debtor must show to obtain an abatement of penalties or interest.

Generally, the most common scenario in which an abatement issue may be implicated arises when a corporation fails to file payroll tax returns or make payroll tax deposits or "business" taxes.² 26 U.S.C. §§3102(a) and 3402(a) require an employer to deduct and withhold income and social security taxes from its employees' wages. In re McTyre Trucking Co., 223 B.R. 588, 592 (Bankr. M.D. Fla. 1998). The employer holds the withheld taxes in trust for the exclusive use of the United States. Id. Additionally, the employer is required to report the withheld taxes on its payroll tax return (Form 941). Id. Payroll tax returns are filed on a quarterly basis. The employer is obligated to account for and pay all withheld taxes by the due date of the tax return. Id., citing 26 U.S.C. §6151; 26 C.F.R. 31.6151-1a (2001).

In an effort to coerce tax compliance, Congress has imposed a variety of tax penalties and the accrual of interest. In particular, Congress has imposed penalties on employers who fail to deposit and remit payroll taxes. 26 U.S.C. §6651(a)(1) imposes a penalty for failure to file a required return unless it is shown that such failure is due to reasonable cause and not due to willful neglect. Id. Additionally, §6651(a)(2) uses identical language in imposing a penalty for failure to pay the amount due on the return. Id.

The taxpayer bears the heavy burden of proving both (1) that the failure to file the return or pay the tax was not the result of "willful neglect" and (2) that the failure to do so was attributable to "reasonable cause." United States v. Boyle, 469 U.S. 241, 245 (1985). "Unless both reasonable cause and a lack of willful neglect are established, imposition of these penalties is mandatory." xCarlson v. United States (In re Carlson), 126 F.3d 915, 921 (7th Cir. 1997), cert. denied, 118 S.Ct. 1388 (1998).

The Internal Revenue Code does not define "willful neglect." The Supreme Court has defined willful neglect as "conscious, intentional failure or reckless indifference." Boyle, 469 U.S. at 245. Willful neglect can be established when a debtor pays other creditors rather than making tax payments to the United States. Brewery Inc. v. United States, 33 F.3d 589 (6th Cir. 1994). Moreover, willful neglect does not depend on specific intent to defraud the government. McTyre Trucking, 223 B.R. at 592 (citation omitted). "A taxpayer can establish reasonable cause by making a satisfactory showing that it exercised ordinary business care and prudence in providing for payment of the taxes, but nevertheless was either unable to pay or would have suffered an undue hardship if it had paid on the due date." Brewery Inc. v. United States, 33 F.3d 589, 592 (6th Cir. 1994); 26 C.F.R. §301.6651-1(c). Moreover, §301.6651-1(c)(2) provides:

In determining if the taxpayer exercised ordinary business care and prudence in providing for the payment of his tax liability, consideration will be given to the nature of the tax which the taxpayer has failed to pay.

As such, in situations where funds were not paid to or deposited with the Internal Revenue Service (IRS) (such as trust fund taxes), "the facts and circumstances required to establish reasonable cause must be particularly compelling." Id. The taxpayer has the burden to prove the requisite reasonable cause. Estate of Geraci v. Commissioner, 502 F.2d 1148 (6th Cir. 1974).

"Undue hardship" has been defined to mean more than an inconvenience to the taxpayer. In re Sykes & Sons Inc., 188 B.R. 507, 512 (Bankr. E.D. Pa. 1995), citing 26 C.F.R. §1.6161-1(b). It must result in substantial financial loss. Id. Nonetheless, the taxpayer must demonstrate that it exercised ordinary business care or prudence in connection with the business loss. Id. As such, financial difficulty alone will not satisfy the taxpayer's burden in proving the right to a tax abatement.³

As an initial matter, an overwhelming amount of courts that have considered the issue of "undue hardship" as a defense to the payment of taxes have found that economic difficulties are not a basis for not paying taxes or reasonable cause for not doing so. In re Upton Printing Co., 186 B.R. 904, 906-7 (Bankr. E.D. La. 1995) (citations omitted). The Upton Printing court correctly noted that "almost every non-willful failure to pay taxes is the result of financial difficulties." Id. at 906 (citation omitted). Further, the Sixth Circuit has held that financial difficulties can never be sufficient to constitute reasonable cause for the nonpayment of taxes. Brewery Inc. v. United States, 33 F.3d 589, 592 (6th Cir. 1994). Moreover, most courts have recognized that reasonable cause should be limited to instances where the taxpayer made reasonable efforts to protect trust funds, but those efforts were frustrated by circumstances outside the taxpayer's control. Upton Printing, 186 B.R. at 907; Brewery, 33 F.3d at 592.

Additionally, the IRS has identified specific causes that it considers "reasonable cause" for failure to file a timely return. These causes include:

unavoidable postal delays, the taxpayer's timely filing of a return with the wrong IRS office, the death or serious illness of the taxpayer or a member of his immediate family, the unavoidable absence of the taxpayer...the taxpayer's reliance on the erroneous advice of an IRS officer or employee...and the taxpayer's failure to file is based upon his reasonable reliance upon the advice of a tax advisor that the return need not be filed.

Roberts v. C.I.R., 860 F.2d 1235, 1241 (5th Cir. 1988) (citation omitted).

Examples of what the courts have considered in determining reasonable cause for the abatement of penalties and interest include illness of a taxpayer and embezzlement and misconduct by an employee of the debtor. In Roberts Metal Fabrication Inc. v. United States (In re Roberts Metal Fabrication Inc.), 147 B.R. 965 (Bankr. D. Kan. 1992), the chapter 7 debtor's sole shareholder had suffered a stroke and was involved in a divorce proceeding. The debtor argued that these calamities were reasonable cause for the failure to file tax returns and make tax deposits. The court found that for the illness to constitute reasonable cause, the illness must be present at the time the return is customarily prepared and render the taxpayer "physically or mentally incapable of preparing the return or conducting business activity, and the taxpayer must not even conduct other business. Id. at 968 (citation omitted). The Roberts court found that the corporate sole shareholder had conducted other business despite his illness. Id.

The Roberts court further held that the illness must render the taxpayer, and not an employee, incapable of filing the return. Id.; see, also, Wolfe v. United States, 612 F.Supp. 605, 608 (D. Mont. 1985), aff'd., 798 F.2d 1241 (9th Cir. 1986). The debtor argued that he had transferred the function of filing tax returns and paying taxes to an employee and that his absence from the office due to his illness was reasonable cause. The court found that the duty to file returns and pay taxes is a non-delegable duty. The court concluded that the debtor's failure to implement internal controls over employees to file returns and pay taxes demonstrates a lack of ordinary business care and prudence. Id. at 969.⁴

Similarly, in In re Howe Now Inc., 2000 WL 64105 (Bankr. W.D. Ark. 2000), the debtor sought an abatement of penalties and interest because a former employee had embezzled funds that could have been used to make payroll deposits. The court discounted the debtor's assertion that the embezzlement was the root of debtor's non-compliance by finding that the preparation of the returns did not in any way relate to the employee's misconduct because the returns were prepared by an outside accounting firm. Id. at *9. Further, the amount of funds embezzled, as compared to the amount needed to make the tax deposits, was considerably less. Id. Finally, the court found that the employee's misconduct was not beyond the control of the debtor. The debtor's chief officers had control over the employee who had embezzled the funds. Therefore, the debtor had failed to utilize controls that would have prevented the misconduct.

Conclusion

Financial difficulty alone will not justify an abatement of penalties and interest. The taxpayer will have to demonstrate that s/he used prudent business judgment in the operation of its business and that the cause of the failure to file/pay taxes was beyond the taxpayer's control. Moreover, misconduct by a third party or employee of the taxpayer will not justify abatement of any associated penalties and interest without the taxpayer carrying its burden that it had controls in place to prevent said misconduct.

---

Footnotes

¹ The views expressed in this article are Mr. Gargotta's and do not necessarily reflect the views of the Department of Justice or Internal Revenue Service. Return to article

² Business taxes include payroll or "FICA" taxes as defined under 26 U.S.C. §§3402-3405, 6051 (RIA ed. 2001), unemployment or "FUTA" taxes under 26 U.S.C. §§85(b) and 6050B (RIA ed. 2001). There are other business taxes (corporate, partnership and highway-use taxes) that are usually not involved in tax-abatement considerations. Return to article

³ See Glenwal-Schmidt v. United States, 78-2 U.S.T.C. P9610, 1978 WL 4527 (D. D.C. 1978), and In re Pool & Varga Inc., 60 B.R. (Bankr. E.D. Mich. 1986). These decisions hold that the failure to pay taxes where the taxpayer experiences serious financial problems is reasonable as long as the taxpayer did not act recklessly or jeopardize its ability to pay taxes. These decisions have been criticized as not well reasoned. Upton Printing Co., 186 B.R. 906 (citations omitted). Return to article

⁴ See, also, In re Sykes & Sons Inc., 188 B.R. at 512-14, wherein the court found that the business patriarch's and his family's inability to carry on the business was not reasonable cause given that there were no measures in place for family members to succeed and learn the operation of the business. Return to article