Monday, January 27, 2020
Lesson From The Tax Court: §6672 Trust Fund Recovery Penalty Is Really A Penalty ... Sort Of
Sometimes we get so used to norms of practice that we forget the legal text governing that practice. Last week the Tax Court taught that text is still important. In David J. Chadwick v. Commissioner, 154 T.C. No 5. (Jan. 21, 2020) (Judge Lauber), the Court held that the IRS must comply with §6751(b)’s supervisory approval requirements before assessing the §6672 Trust Fund Recovery Penalty. That is because the text of §6751(b) says those requirements apply to any “penalty” and the text of §6672 permits the IRS to assess a “penalty.”
Some may laugh! Some may snort “It’s so simple!” But, truly I tell you, nothing is simple when you combine the Tax Code and lawyers. While the lesson may seem simple, it’s more nuanced than you may realize. And even though this is a reviewed opinion, it may be of surprisingly limited reach. Details below the fold.
In Chadwick, the Tax Court continued its clean-up of the various legal issues created by its reinterpretation of §6751(b) in Graev v. Commissioner, 149 T.C. 485 (2017). Readers will recall that §6751(b) requires supervisory approval of tax penalties at some point before those penalties are assessed. About three weeks ago the Court decided that the required supervisory approval needed to be done before the IRS formally notified the taxpayer “that the Examination Division had completed its work and...had made a definite decision to assert penalties.” Belair Woods, LLC v. Commissioner, 154 T.C. No. 1 at p. 16. I blogged the case here. Chadwick attempts to brings closure to another question created by Graev: whether assessments made under the authority of §6672 were “penalties” subject to §6751(b)’s supervisory approval requirement. For reasons I explain below, that attempt may be futile.
“Trust Fund Taxes” are those taxes that are paid by the taxpayer to an intermediary who, after collecting the tax, is then supposed to forward it to the government. 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 collected by employers from their employees. 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, my employer withheld it. It’s not my fault my employer failed to actually pay it!”
Section 6672 is a penalty designed and administered to help ensure payment of trust fund taxes. It provides that if any “person required to collect, truthfully account for, and pay over any tax imposed by this title...willfully fails to collect such tax, or truthfully account for and pay over such tax" then that person is “liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.” The term “person” in the statute can include a corporate employer as well as individuals within the company who have sufficient control such that they should be held responsible for ensuring proper payment. The short-hand term for such individuals is “responsible persons.”
Though called a "penalty," the Service has a long established policy of using §6672 only as an additional tool to collect unpaid trust fund taxes. In Policy Statement 5-14 (formerly P-5-60) the IRS says: “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.” This policy reads the statute’s purpose as recovering trust fund taxes that ought to have been paid, and not as imposing additional penalties on the responsible persons. Thus, the IRS will cross-apply any payment of a trust fund tax against the accounts of all who have been assessed for purpose of collecting that trust fund tax. See IRM 5.7.7 for the various payment application rules.
Over the decades, courts have acknowledged that this IRS policy is a valid legal interpretation of §6672. This has sometimes worked to the government’s benefit and sometimes to its detriment. Let’s look at one example of each.
On the one hand, the government has benefited in bankruptcy law. Responsible persons would ask courts to enjoin collection of the TFRP until after the bankruptcy trustee made payments on the unpaid trust fund taxes through a liquidation or a plan of reorganization. Responsible persons argued that because the penalty could only apply to unpaid trust fund taxes, the IRS had to wait out the employer’s bankruptcy to see how much remained unpaid after distribution of the bankruptcy assets. With multiple variations, the theme remained this: §6672 was a penalty, so the IRS should not be able to penalize a responsible person when there is, ultimately, no violation because the taxes get paid.
Courts overwhelmingly rejected these kinds of arguments. These courts held that §6672 was not really a penalty and that the IRS policy to treat the TFRP as an alternative source of collection accurately reflected the Congressional purpose behind the text of §6672. For a really good example, go read In Re: Ribs-R-Us, 828 F.2d 199 (3rd Cir. 1987). Here’s how the Ribs-R-Us court summed up its review of the case law: “These cases serve to reaffirm the continued vitality of section 6672 and the policy to protect government revenue that underlay its enactment, even in the context of a Chapter 11 reorganization.” Id. at 204. Thus, the IRS could collect the unpaid taxes from any available source at any time because the IRS was simply collecting the unpaid taxes once, with any payment from one source reducing the exposure of the other sources. Id. If you want even more detail on this exciting Bankruptcy-Code-Meets-Tax-Code fun, see Bryan Camp, Avoiding the Ex Post Facto Slippery Slope of Deer Park, 3 Am. Bankr. Inst. Law Rev. 329 (1995).
On the other hand, the government was hoist by its own petard in Lauckner v. United States, No. 93-1594, 1994 WL 837464 (D.N.J. May 4, 1994) (sorry, but I could not find a free link to the opinion). There, the IRS assessed the TFRP against a taxpayer for over $1 million in unpaid trust fund taxes and did so three years and one day after the date the corporate Forms 941 which reported the unpaid taxes had been filed.
The taxpayer argued that “it has long been settled that the § 6672 penalty is a collection device for the recovery of an employer’s delinquent trust fund employment taxes.” Since it was NOT a penalty, but just an alternative source of payment for the trust fund taxes, the 3-year limitation period in §6501(a) applied.
The government argued that gosh, yeah, it had indeedy long interpreted the statute as just a collection device to collect trust fund taxes, but gee willikers, it was not, actually, an assessment of the unpaid taxes reported on Form 941. It was, by gosh, a separate liability, a penalty! It required “willful” behavior and no one reports on Form 941 the “willful” failure to pay over the trust fund taxes! The fact that §6672 could only be assessed when a responsible person “willfully” failed to withhold, account for, or turn over trust fund taxes meant that the employer’s returns would never report the “penalty.” Hence, those returns could not trigger the limitations period of §6501(a) because the period is only triggered when “the return” reporting the taxes was filed.
The district court (later affirmed by the Third Circuit in an unreported opinion you can find here) agreed with the taxpayer. The gravamen of the district court’s reasoning was that the Service’s long-standing policy had, over the course of time, become embedded as the legal interpretation of the statute. Here’s the court’s summation of its reasoning:
“It seems clear from this review of the case law that courts have long taken the view that a §6672 liability is “separate and distinct” only in the sense that it provides a collection device whereby the IRS may recover an employer's delinquent trust fund taxes from a “responsible person” at its discretion. Based on this reading, courts have imposed a low standard of “willful” behavior necessary to trigger the §6672 obligation. Although this reading may not be compelled by the wording of the tax code, it seems clear that courts have based the lower standard of conduct necessary to trigger §6672 liability on their understanding, unchallenged until now, that §6672 functions only as a collection device, not as a truly “separate and distinct” penalty." (emphasis added)
Therefore, the court concluded, filing 941 returns that reported trust fund taxes triggered not only the 3-year limitation for assessing the taxes required to be reported on that return, but also triggered a 3-year limitation period for the IRS to assess a §6672 liability against any responsible person.
As these two examples show, even though the text of §6672 says it is a “penalty,” both the IRS and the courts have long interpreted the statute as being something else: a separate and distinct tax liability imposed on responsible persons to help collect unpaid trust fund taxes.
It is not surprising, then, that the IRS Office of Chief Counsel has taken the position that the IRS need not comply with §6751(b) when assessing the TFRP. In June 2018 it released Chief Counsel Notice 2018-006 where it instructs attorneys to argue that in §6672 situations, the Service need not comply with supervisory approval requirement. So far, one district court has agreed with the IRS. United States v. Rozbruch, 28 F. Supp. 3d 256 (S.D.N.Y. 2014).
It is also not surprising that the Tax Court---a court which normally has little experience with §6672---would take the very straightforward reading of the statute and reject the government’s position. Let’s look at the case because it is interesting how the taxpayer here was able to bring up the issue in the first place.
Mr. Chadwick was the sole member of two companies, each of which failed to pay employment taxes with respect to its employees’ wages. The matter went to collection and each company’s failure was handled by a different revenue officer (ROs). Each RO decided that Mr. Chadwick was liable for the TFRP. Each RO completed the proper internal paperwork (Form 4183) and each RO’s supervisor signed off on the paperwork. Before 1998, the IRS could have then simply assessed the penalty. However, in 1998 Congress added §6672(b) which says that before it can assess, the IRS must offer the taxpayer an opportunity to protest the proposed assessment in Appeals. Here, the Letter 1153 was sent out the same day that each RO’s supervisor signed off on the Form 4183. Mr. Chadwick did not go to Appeals and so the IRS assessed the penalties.
Typically, taxpayers in Mr. Chadwick’s situation will pay one quarter’s employment tax for one employee and then, after the IRS denies a claim for refund, will file a refund suit. Typically, the government will counter-claim for the balance. Therefore, disputes about §6672 typically get heard by federal district courts and not the Tax Court. That is why the only precedent directly on point was Rozbruch, a district court case.
Mr. Chadwick did not follow the typical procedure. Instead of going the refund route, Mr. Chadwick chose the CDP route. He hired a representative, went to Appeals, and tried to pursue collection alternatives. Ultimately he failed, and the Settlement Officer (SO) issued a Notice of Determination to proceed with collection. Actually, it is not clear that Mr. Chadwick really made a choice as much as just reacted to circumstance. Judge Lauber notes that after filing his Tax Court petition in response to the CDP Notice, Mr. Chadwick went into radio silence and gave the Court nothing more to work with.
Regardless of Mr. Chadwick’s failure to pursue the case, the Tax Court was obliged to review the SO’s decision. That is because the SO was supposed to confirm “that the requirements of any applicable law or administrative procedure have been met.” §6330(c)(1) So that’s how we get to the issue. If §6751(b) was “applicable law” then the SO had to have verified that the IRS had obeyed its command.
Judge Lauber took a very strong textualist approach to resolving the question. First, he notes that the text of §6751(b) says “no penalty under this title shall be assessed” unless the IRS satisfies the supervisory approval requirement. Section 6672, in turn, uses the word “penalty” right there in the text of the statute. While §6751(c) carves out some exceptions to the supervisory requirement, none encompass §6672.
Second, beyond text, Judge Lauber finds that the statutory context of §6672 supports reading it as a penalty. Heck, it’s in Chapter 68, Subchapter B which is titled “Assessable Penalties.” He writes: “It would be anomalous, in the absence of any textual justification, to exempt section 6672 penalties from the scope of these rules.”
Third, Judge Lauber points out that even though the IRS treats the TFRP as a collection tool, the willfulness requirement makes it a penalty. “Like penalties for failure to file returns and failre to disclose information, TFRPs are imposed as a sanction for failing to do something. From the standpoint of the person sanctioned, they are ‘penalties’ both as denominated by the Cod and in the ordinary sense of the word.”
First, as to the basic question presented by the case, Judge Lauber’s interpretation is supported by more than textualist analysis. To begin with the Service has actually used the TFRP as a true penalty in the past. See e.g. United States v. Mr. Hamburg Bronx Corporation, 228 F. Supp. 115 (S.D.N.Y. 1964). Yes, that case is really, really, old. And the Service has a pretty strong set of procedures to cross-credit the various responsible persons when any one of them makes a payment. But that just brings up another set of precedents supporting Judge Lauber’s reading: the Service to this day reserves the right to refuse to make the cross-credit. 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."). And the Service certainly makes each responsible person remain liable for accrued but unpaid interest. See IRM 184.108.40.206. Thus, the Service’s very emphasis on the separate nature of the TFRP liability from the underlying liability for withholding and paying over (the §3401 liability) preserves its ability to impose the liability over and above the underlying trust fund liability it seeks to collect.
Second, this decision may not be anywhere near the last word on the issue presented in it, despite being a reviewed opinion with no dissents. One reason is that Judge Lauber’s interpretation might be dicta. That is, after deciding that §6751(b) applies to §6672 assessments, Judge Lauber goes on to find that the IRS obtained the required supervisory approval under the Belair Woods rule. In future cases, the IRS could argue that the demonstrated compliance moots the initial question. A holding is that which is necessary to the disposition of the case. Dicta is that which is not necessary to the disposition of a case. Here, because of Belair Woods, the IRS could argue that it was not necessary to the disposition of this case for the Court to find that §6672 is subject to §6751(b). So while Judge Lauber’s reasoning is instructive, it is not binding. Think about it: you cannot issue a ruling adverse to a party and then deny that party the opportunity to appeal. If the Court had also found the IRS out of compliance with §6751, then the ruling would be a holding. But the IRS won the case, so it cannot appeal Judge Lauber’s embedded adverse interpretation. Put another way, because Judge Lauber found that the IRS complied with §6751, he really did not need to decide whether the compliance was required or not. I doubt this argument has much traction within the Tax Court itself. But it may have traction outside the Tax Court and that leads to a second reason for skepticism about Chadwick's impact.
Another reason why Chadwick may be more flash than bang is that most decisions regarding the TFRP are made in federal district courts, not the Tax Court. Tax Court holdings are not binding on federal district courts and judges there may be more receptive to the Service’s non-trivial arguments for why §6672 is not subject to the §6751(b) supervisory approval requirement. In short, Chadwick may not have legs to carry taxpayers in federal district courts. Of course, to the extent that is true, savvy practitioners might now advise their clients to forgo the refund route and instead bite their nails in hopes of catching the CDP butterfly during its short 30-day lifespan!
My third observation is that Chadwick may be more molehill than mountain. I do not see it affecting the settled interpretation of §6672 as not being a true penalty outside the narrow question presented in Chadwick: whether the term "penalty" in §6751(b) applies to TFRP determinations. I do not think it will hurt the IRS in bankruptcy situations (the Ribs-R-Us line of cases) nor do I see it providing any basis for the IRS to resuscitate its losing position that the TFRP has no limitation period, the issue it lost in Lauckner. In fact, now that the Tax Court has drawn the line in Belair Woods, it certainly would not surprise me to see the IRS accept the ruling in Chadwick. As far as I can tell, obeying the ruling requires no changes in TFRP assessment procedures (I always worry that I’m overlooking something and I rely on the kindness of readers to point out when that happens).
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law
The revenue officer uses the IRS computer program for processing a TFRP case. Before sending the responsible person notice of the proposed assessment a report recommending the assessments has to be approved and e-signed by the revenue officer's manager. The chance of getting off a TFRP assessment for lack of managerial approval is something south of zero. The court approved e-sign instead of pen and ink.
Posted by: Michael S Cash | Jan 27, 2020 2:53:49 PM
One other aspect of TFRP cases is they often involve a failed company on which investment the individual has losses. By contributing the trust fund amount to the company and having the company pay the IRS, the penalty issue is bypassed and the taxpayer has a capital contribution that may be eligible for loss treatment.
Posted by: KENNETH SOUSA | Jan 27, 2020 12:00:30 PM
Correction: Even though the Chadwick opinion will be published as a Tax Court opinion and not a Memorandum opinion, it was not a reviewed opinion. I thank Jack Townsend and others for pointing out the error. I always thought that TC opinions were, by definition, reviewed by the entire Court, but that turns out not to be true. I am always glad to learn new stuff and will definitely be more careful in the future.
Posted by: bryan camp | Jan 28, 2020 8:23:15 AM