Lesson From The Tax Court: The Misunderstood Trust Fund Recovery Penalty

A recent Tax Court case teaches a lesson about the §6672 Trust Fund Recovery Penalty (TFRP), and about the proper scope of a Collection Due Process hearing.  In Kathy Bletsas v. Commissioner, T.C. Memo. 2018-128 (Aug. 14, 2018), the IRS found Ms. Bletsas to be a responsible person who willfully failed to turn over trust fund taxes.  So the IRS assessed a §6672 penalty against her and filed a Notice of Federal Tax Lien (NFTL) to encumber all her property and rights to property.  Ms. Bletsas asked for and received a Collection Due Process (CDP) hearing about the NFTL. 

Represented by the indefatigable Frank Agostino (and by Malinda Sederquist), she argued that the collection decision to file an NFTL was an abuse of discretion because the IRS was getting steadily paid through an Installment Agreement (IA) with the employer and so did not need to file the NFTL against the Ms. Bletsas.  And, hey, she wasn’t really a responsible person anyway!

Trust fund taxes?  Responsible person?  TFRP?  To learn what that’s all about and what lesson Judge Lauber teaches, read on.  No one would blame you, however, if you instead clicked over to YouTube to watch this old Johnny Carson clip with Robin Williams and Jonathan Winters...

The Law

The tax code imposes on several groups of persons the responsibility to collect, account for and pay over to the government various taxes imposed on other persons.  These are known as "trust fund" taxes because  §7501(a) says that the money so collected is held in trust for the United States until it is paid over. 

Two of the most important trust fund taxes are the income and social security withholding taxes.  Section 3402(a) makes every employer responsible for withholding their employees' income taxes. Section 3102(a) imposes a withholding requirement for the employees’ share of social security taxes.  Employers are supposed to remit these withheld taxes on an ongoing basis and to account for the payments and withholding once each quarter on Form 941.

If the employer fails to properly pay over these withheld amounts to the government, then the Treasury suffers a loss, because §31(a) gives employees a credit for taxes withheld regardless of whether the money actually reaches the government's coffers.  I call this the “duh” credit because even though the government may not have received the money, you can just hear the employee saying, “well, duh, I paid it when it was withheld.” 

Section 6672 is a penalty designed and administered to help ensure payment of trust fund taxes. It provides that the Service may impose a penalty on any "person"—which term can include individual employees as well as the employer—who, "under a duty" to collect a trust fund tax, "willfully fails to collect such tax, or truthfully account for and pay over such tax."   The penalty amount is 100% of the tax owed.  That is why the provision used to be called “the 100% penalty.” 

Though called a "penalty," the Service’s Policy Statement 5-14 (formerly the famous P-5-60) says that it will use the TFRP merely as a tool to collect the missing trust fund taxes just once. Here’s the language of the Policy Statement: “The withheld income and employment taxes or collected excise taxes will be collected only once, whether from the business, or from one or more of its responsible persons.”  So perhaps that is why the penalty is now called the TFRP.  It’s purpose is to recover the trust fund taxes that ought to have been paid; it’s not used to fine or punish the responsible person.  

But just because that’s the policy does not mean that’s the law.  It’s still a penalty.  First, it is both labeled a penalty and is located in the “Assessable Penalties” part of the Tax Code.  Second, the Service can still use the TFRP as a true penalty and has done so in the past.  See e.g. United States v. Mr. Hamburg Bronx Corporation, 228 F. Supp. 115 (S.D.N.Y. 1964).  Still, the Office of Chief Counsel itself is apparently trying to transmogrify policy into law.  In June it released Chief Counsel Notice 2018-006 where it instructs attorneys to argue that in §6672 situations, the Service need not comply with the Tax Court’s newly discovered reading of §6751(b).  Christine Speidel has a very thorough post about this Chief Counsel Notice over at Procedurally Taxing.

Notice the term “responsible person.”  That’s the shorthand term used by courts and the Service to describe those officers and employees who have sufficient control over expenditures that they ought to be held responsible.  Interestingly, the phrase is not used in either the statutes or the regulations and the Supreme Court has explicitly declined to construe the term, even while also using it.  See Slodov v. United States, 436 U.S. 238, 244, n.7.

As a result of this distinction between §3402 liability for withholding taxes and the liability imposed by §6672, the government may look not only to the employer to satisfy the withholding tax obligation (either pursuant to the employer's original § 3402 liability or pursuant to its own §6672 liability) but may also look to those officers and employees who are shown to have had sufficient responsibility so as to bring them within the scope of § 6672's operation. See e.g. Monday v. United States, 421 F.2d 1210 (7th Cir. 1970)("Here too, the separate nature of the tax liabilities imposed upon the Mondays precludes their assertion of any satisfaction of the Company's liability for withholding taxes as a satisfaction of their individual liability under Section 6672.")

The Case

That distinction is basically what causes Ms. Bletsas’ problem.  She was an officer and the sole shareholder of a NY company called Delta, Inc..  For three quarters spanning 2014 and 2014 Delta, Inc. was delinquent to paying over its trust fund tax obligations to the tune of around $400,000.  In 2015, a Revenue Officer opened a TFRP investigation and in November 2015, the RO determined Ms. Bletsas was a responsible person and was liable for the TFRP.  Per the procedures in §6672, the RO sent her a Letter 1153 telling her of that determination and giving her an opportunity to contest that determination with the Office of Appeals.  She did not do so. 

Instead of contesting the proposed TFRP, Ms. Bletsas instead had Delta, Inc. enter into an Installment Agreement (IA) with the IRS in December 2015 to pay off the delinquency.  The payments were $7,500 per month.  

I am guessing that Ms. Bletsas thought she had taken care of the TFRP problem by having the employer get set up to pay off the delinquency (in about five years).  So perhaps she did not feel the need to contest the IRS determination that she was a responsible person.   That was a mistake.

Lesson 1: It’s not Joint Liability

It is a mistake to think that the IRS won’t try to collect from one responsible person just because someone else, even the employer, is actually paying the TFRP or the underlying trust fund taxes.  Each TFRP is a separate liability.  Although the policy treats it like a joint liability, and although the IRS will cross-credit payments by one responsible person against the TFRP assessments made against others, each TFRP liability is separate, and the employer’s original trust fund liability is separate from any TFRP liability.   The Service does not need to wait for the employer to act (or fail to act) before collecting from responsible persons.  For example, when an employer goes into bankruptcy, the Service may proceed to collect from the responsible persons without waiting to see whether the employer will be able to make any payments in the bankruptcy case. In the Matter of Ribs-R-Us, Inc., 828 F.2d 199, 201 (3rd Cir. 1987). The automatic stay does not prevent this precisely because the Service is attempting to collect the responsible person's liability and not the employer's.

That is the first lesson Judge Lauber teaches.  The TFRP is not a joint liability.  He writes “The record established that the IRS has not yet collected enough to satisfy Delta’s outstanding tax liabilities.  Until those liabilities are satisfied in full, the IRS is free to preserve its collection rights against petitioner.”  So the fact that Delta, Inc. was current on its Installment Agreement did not affect the IRS’s ability to proceed to collect the TFRP against Ms. Bletsas.  In theory, the Service could exercise its powers of levy.  But in practice, as Judge Lauber notes, the RO made a deliberate decision to not take levy action in this case.  Instead, by filing the NFTL, the Service was just acting to protect its claim against her as against competing creditors.  Sure, that's a bummer; at the very least her credit rating takes a hit from the NFTL.  So you can be sure that Frank Agonstino will get that NFTL withdrawn as soon as the liability gets paid---in about five years.  But at least she's not out cash or property.

Lesson 2: Timing Matters

I believe a second lesson here is about timing.  It may matter which liability the IRS gets to first. If Delta, Inc. had gotten into an IA before the Revenue Office had finished the TFRP investigation (and sent Ms. Bletsas the Letter 1153), then perhaps she would have been able to get a better result and even may have avoided having the TFRP assessed against her.  That is because the IRM instructions as to business IAs tell ROs to assemble all the information needed to assess a TFRP as part of the IA processing, but also say to hold off on proposing the TFRP assessment if the business gets into an acceptable IA.  See IRM 5.14.7 (BMF Installment Agreements).  As Judge Lauber notes:  “these IRM provisions are directed to the initial acceptance of IAs.  They do not address suspension of collection after assessment with respect to an already established installment agreement.” (internal quotes and citations omitted).

But since Ms. Bletsas did not get Delta, Inc. into an IA until after the RO had proposed a TFRP against her, the rules were different and even located in a different part of the IRM, over in IRM 5.7.6.  Those rules do not cross-reference the IA procedures.  Under the rules on how to proceed when a taxpayer fails to respond to a Letter 1153, the IRM is silent about whether the RO is supposed to account for the fact that others are also on the hook for the tax which is sought to be collected by the proposed TFRP.

Thus, taxpayers who want to avoid Ms. Bletsas’ problem should be sure to get their controlled entity into an IA as soon as possible, certainly before any TFRP investigation gets very far.  Then be sure the controlled entity keeps compliant with the IA.  That’s the other §6672 lesson I see here.

Lesson 3:  Cannot Raise Liability During CDP if given prior opportunity for Appeals Conference

Ms. Bletsas wanted to use the CDP hearing to argue that the IRS was wrong to assess the TFRP against her because she was not really a responsible person.

Sometimes a taxpayer can contest a tax liability in a CDP proceeding.  Section 6330(c)(2)(B) permits the taxpayer to raise arguments about the merits of the liability if the taxpayer “did not receive any statutory notice of deficiency...or did not otherwise have an opportunity to dispute it.”  The lesson here is that the word “otherwise” is not limited to other opportunities that permit the taxpayer to take the dispute to a court.  An administrative hearing is enough of an opportunity to trigger the bar.

Because the TFRP is not subject to the deficiency procedures, no taxpayer ever gets a statutory notice of deficiency about it.  So taxpayers cannot dispute the proposed liability before the Tax Court.  But §6672 does imply that the taxpayer must be given an administrative opportunity to dispute the assessment before it gets made.  First §6672(b)(1) says the IRS must give the taxpayer a preliminary notice of its intent to assess the liability.  That’s the Letter 1153.  Then §6672(b)(2) says that the applicable period of limitations to assess the TFRP will be extended by either 90 days or “if there is a timely protest of the proposed assessment, the date 30 days after the Secretary makes a final administrative determination with respect to such protest.”  The Letter 1153 pretty explicitly tells taxpayers they can protest the proposed assessment with Appeals.  Everybody and his little dog has interpreted that combination as requiring the IRS to afford taxpayers an opportunity to have a hearing before the Office of Appeals.  That’s what the IRS does in Letter 1153.  And that opportunity is good enough to preclude the taxpayer from later contesting the merits in a CDP hearing.  E.g. Thompson v. Commissioner, T.C. Memo 2012-87.   As Judge Lauber puts it: “Because petitioner had, but neglected to avail herself of, a prior opportunity to challenge her TFRP liability before the IRS Appeals Office, she was precluded from dispute that liability at the CDP hearing.”

Coda:  Don’t feel too badly for Ms. Bletsas.  The TRFP is treated like a divisible tax so she does not have to pay the full $400,000 (or whatever) balance due to get into court to contest her liability as a responsible person.   Query whether she has much of a case if she is the sole shareholder and an officer of the delinquent corporation.  Still, she can pay the trust fund taxes for one employee for one quarter and then ask the Service for a refund.  If that gets denied she can file a refund suit in the court of her choice and claim she was not a responsible person who acted willfully.  For details see Chapter 16 of that wonderful tome: “Effectively Representing Your Client Before the IRS” (now in its 7th Ed.).  Published by the ABA Tax Section, that two-volume treatise costs a bunch of pennies but is worth every one.  No, I am not an author, nor do I get anything for saying that, except maybe a hearty handshake from Keith Fogg (its Editor) next time I see him.  It’s just a true statement. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.