Lesson From The Tax Court: The Designated Payment Rule

Payroll taxes present particularly prickly problems.  The problems often arise from a failure to make timely deposits of the correct amounts.  That can happen for lots of reasons, some innocent, some willful.  But once the employer gets too messed up, fixing the problem can be tricky because the IRS will take whatever payments are made and apply those payments in the best interest of the government.  That may not always be in the best interest of the taxpayer.

Today we learn a lesson that will help taxpayers mitigate payroll tax goofs: a voluntary payment allows taxpayers to designate how the IRS should apply the payment.  It's a useful lesson for any kind of tax but especially for payroll taxes.  In Raymond S. Edwards v. Commissioner, T.C. Summ. Op. 2023-29 (Sept. 27, 2023) (Judge Panuthos), the taxpayer got crosswise with the IRS on unpaid payroll taxes and sent in payments that he specifically designated to cover only the taxes owed for five specified quarters, not the accrued interest and penalties, which he wanted to contest.  But the IRS instead applied the payments to interest and penalties.  Judge Panuthos explains why the IRS must honor a taxpayer’s designation of voluntarily remitted taxes.  Not sure this was more than a pyrrhic victory, but it makes for a good lesson.

Details below the fold.

Background: Payroll Tax Obligations
Payroll taxes are of two types: direct taxes and trust fund taxes. To fund the Social Security system, §3111 imposes on employers an excise tax totaling 7.65% on the payment of employee wages.  That’s a direct tax.

In addition to the direct tax, employers must withhold from their employees’ wages sufficient amounts to pay both the employees’ income taxes (§3402) and the employees’ share of Social Security taxes (§3102).  Those are trust fund taxes because §7501(a) says that the collected money is held in trust for the United States until it is paid over.  If the employer does not pay it over, the IRS can go after responsible persons under §6672.  See Lesson From The Tax Court: A Hard Choice Is Still A Choice, TaxProf Blog (November 8, 2021).

Background:  Filing/Payment Obligations v. Deposit Obligations
Generally, employers must file a return each quarter to report their payroll tax obligations.  And that is generally done on Form 941.  See generally Publication 51. If their return shows an unpaid obligation, they must send in a payment or be subject to failure to pay penalties—er...I mean an “additional amount” for failure to pay. See §6651(a).

However, in addition to filing timely returns, employers must also make timely deposits of their payroll taxes more frequently, either once a month or more often, depending on how large they are.  Failure to make timely deposits results in penalties per §6656 regardless of what the quarterly return shows.

Background: Designation of Payments v. Designation of Deposits
As a general rule, taxpayers are allowed to allocate their voluntary tax payments as between the various taxes they owe.  This follows the common rules for debtors and creditors.  For example, if a taxpayer owes taxes for multiple periods, they can send in a payment and designate that payment to be applied to the most recent period.  The issue usually comes up when an employer seeks to designate partial payments to the trust fund portion of their payroll taxes so as to limit personal liability under §6672.  See, e.g., Stevens v. U.S., 49 F.3d 331, 335 (7th Cir. 1995) (reviewing cases).  But it comes up in other contexts as well.  For example, employers can also designate payments to be applied to the income tax liability of specified employees.  See Elms v. IRS, 39 F.3d 1181 (6th Cir. 1994) (unpublished opinion).

The IRS has enshrined this common law rule into Rev. Proc. 2002-26.  Section 3.02 of that document provides that a voluntary payment accompanied by written directions as to its application will be applied pursuant to the taxpayer’s written instructions. In contrast, a payment received without written direction as to the designation will be applied by the Service “in the order of priority that the Service determines will serve its best interest.” Further, “[i]f the amount applied to a period is less than the liability for the period, the amount will be applied to tax, penalty, and interest, in that order, until the amount is absorbed.”

The general rule permitting designation is limited, however, both by law and by how the IRS administers payroll taxes.

First, the legal restriction is that a payment must be voluntary.  If the payment is not voluntary, the IRS can ignore any attempted designation by the taxpayer.  See, e.g., Stevens, supra, 49 F.3d at 334, where Judge Posner gives a great review of this doctrine, writing:

“Voluntary is a word of many meanings. *** [I]n one sense of ‘voluntary’ the victim of an armed robbery who in response to the robber's telling him ‘Your money or your life’ willingly, indeed eagerly, hands over his money is acting voluntarily. But the purpose of the ‘voluntary payment’ rule as we have sketched it shows that this is not the relevant meaning. ‘Voluntary’ here carries a little of the sense of ‘volunteer’ and is to be contrasted with the situation in which actions by creditors leave the debtor with no realistic choice but to make a payment.  Of course, a person who pays a lawful debt is not really a volunteer, not in the sense that an altruist or a good Samaritan is; he is subject to being coerced to pay it. But as realists about the procedures for the collection of debts we know that debtors can often impose heavy costs on their creditors by dragging their heels in payment. A debtor who forgoes efforts to impose those costs is exercising a choice, and it is a choice that the law wants to encourage in order to minimize the costs of the debt-collection process.”

The second restriction is operational.  It comes from the distinction between a payment and a deposit.  As the Supreme Court reminds us in Baral v. United States, 528 U.S. 431, 436 (2000): “Withholding and estimated tax remittances are not taxes in their own right, but methods for collecting the income tax.”  That means that the general common law rule respecting deposits of payroll tax obligations may turn out to be different than the rule for payments.

Up until December of 2010, employers would send in their deposits using Form 8109.  See 75 Fed. Register 75,897 (Dec. 6, 2010).  Form 8109 permitted taxpayers to designate which quarter the deposit was intended to cover and what type of liability.  In addition there was room on the bottom of the Form to make a further designation.  For example, a taxpayer making a deposit for 941 tax liability might designate the deposit as applicable to the trust fund tax portion reported on the 941.

Now, taxpayers must make their deposits using Electronic Funds Transfer, generally through the Electronic Funds Transfer Payment System (EFTPS).  Operationally, that has restricted taxpayer ability to designate deposits.

The rules for how the EFTPS works are found in Treas. Reg.  31.6302-1.  The regulation continues the voluntary payment rule, providing that payments made through EFTPS will be considered as voluntary.  Reg. 31.6302-1(h)(2)(1)(C)(iii) (“A taxpayer that is authorized to make payment of taxes with a return under regulations may voluntarily make a deposit by electronic funds transfer.”)  As I understand it, however, EFTPS limits the ability of taxpayers to designate.  It permits taxpayers to designate the tax period they are paying, it does not permit taxpayers to designate how the payment is to be applied as between trust fund or direct taxes or as to any particular employee's liability.

And it appears that regardless of what the taxpayer does through the EFTPS, the IRS has the right to apply those deposits in the government’s best interest.  That’s the lesson from Babcock v. U.S., 807 F.Supp.2d 904 (C.D. Cal. 2009).  There, the taxpayer tried to argue that the IRS should allocate the EFTPS payments according to how the taxpayer had submitted them but the Court rejected that argument on the grounds that deposits were not payments and the common law rule regarding voluntary payments did not apply.  Wrote the Court:

“the distinction between “payments” and “deposits” is an important one because Revenue Procedure 2002–26 applies only to voluntary payments. See Danoff v. U.S., 324 F.Supp.2d 1086, 1097 (C.D.Cal.2004) (holding that there is a “plain distinction between a ‘deposit’ and a ‘payment’ of taxes.”). Deposits, such as those made by the Companies, are remittances when “no assessment is then outstanding against the taxpayer” and the funds are held “as a deposit made in the nature of a cash bond for the payment of taxes thereafter found to be due.””  Id. at 916.

While all of this may seem like bad news for taxpayers, today’s case shows us that the rule respecting designation of voluntary payments still exists.  Let’s take a look.

Facts
Mr. Edwards operated a business in New York and paid employees.  He started it in September 2014 but ran into some operational troubles.  Those troubles caused him to fail to timely file or pay his payroll taxes for all quarters in 2015 and the first quarter of 2016.  The IRS assessed tax liabilities for those periods, plus additions to tax and interest.  The IRS filed a Notice of Federal Tax Lien and sent Mr. Edwards a Lien CDP notice.  He timely requested a CDP hearing.

At the CDP hearing, Mr. Edwards apparently wanted to just obtain an abatement of the failure to pay liabilities because he thought he had a good reason for the failure: his inability to set up the EFTPS account because the IRS delayed in sending him a PIN.  The Office of Appeals declined to hear his argument, issued a Notice of Determination and Mr. Edwards timely petitioned the Tax Court for Review in January 2020.

During the Tax Court process, Mr. Edwards sent in a $35,524 payment to the IRS.  He told the IRS he just wanted that to be applied to the taxes he owed and not to the failure to pay liabilities.  Judge Panuthos explains that “[c]ontrary to petitioner's directions, the $35,524 was not applied solely against the outstanding total principal of $23,547, but against the total amounts remaining outstanding for the periods ending March 31, June 30, September 30, and December 31, 2015 (which included penalties and interest). *** After the payment was applied, there remained an unpaid tax liability [for the period ending March 31, 2016] including additions to tax and interest.” Op. at 9.

Since Appeals had not heard or ruled on Mr. Edwards’ argument on why he should not be liable for the failure to pay for the five quarters, the Tax Court sent the case back to Appeals in January 2022 to work that issue.  Appeals decided his excuse was not good enough and so the case went back to Tax Court in October 2022.

Lesson: Designation Still Works When A Payment is Voluntary
Judge Panuthos agreed with Appeals that Mr. Edwards did not have a reasonable cause for his failures to timely file or pay his payroll tax obligations.  However, Judge Panuthos also thought that the IRS abused its discretion in misapplying Mr. Edwards’ voluntary payment, writing “[t]he record clearly demonstrates that petitioner intended to designate how the tax payment should be applied.... The IRS did not follow these instructions. Respondent abused his discretion in the improper application of voluntary payments.” Op. at 10.

Accordingly, Judge Panuthos ordered that the NFTL was proper but only for the amounts as modified by his decision.

Alert readers may question whether the designation in this case actually helped or hurt Mr. Edwards.  I don’t know the answer to that.  Under the IRS application, his entire liability for four of the five quarters at issue was satisfied, leaving only a part of the fifth quarter’s taxes unpaid, plus interest and penalties for the fifth quarter.  Under Mr. Edwards’ designation, the taxes for all five quarters were satisfied, but the total amount unpaid remained the same.  The designation just shifted the liabilities owed from taxes to interest and penalties.  I welcome comments on how that works either to Mr. Edwards’ advantage or disadvantage.  Perhaps it would help him in bankruptcy?

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.

[Editor's Note:  If you would like to receive a daily email with links to each Lesson From The Tax Court and other tax posts on TaxProf Blog, email here.]