One benefit of conducting business through a corporation, limited liability company or other limited liability entity is the “shield” from personal liability that these entities generally afford stockholders, directors and officers. There are, however, exceptions to this general rule. One such exception is in the case of so-called “trust fund taxes,” or those taxes that are collected by a business entity on behalf of the government, such as payroll and sales and use taxes. The willful failure to pay these taxes by one with control over the financial affairs of a business entity may result in personal liability.
During challenging economic times, such as the deep recession hanging over the United States for the last few years, business leaders must navigate complex issues and balance multiple constituencies and priorities. Unfortunately, in the face of these difficult challenges, some corporate fiduciaries cross the line from shrewd business tactics to illegal or improper conduct. The decision to withhold the payment of “trust fund taxes” is one that may result in temporarily keeping the company afloat, but also expose fiduciaries to significant liability.
Section 6672(a) of the Internal Revenue Code (the “Code”) imposes penalties on those who are required to collect and pay taxes and “willfully” fail to do so. This is commonly referred to as the “trust fund recovery penalty,” so named because the one who is responsible for collecting and paying such taxes is deemed to hold those funds in trust for the government. In determining whether the penalty applies to an individual, the Internal Revenue Service (“IRS”) must first determine who is a “responsible person,” and then whether that individual was “willful” in failing to pay the taxes to the IRS. While courts consider several factors in determining whether one is a “responsible person,” the essence of these different tests is: did the person have knowledge of the underpayment and did he have the ability to control the decision of whether the taxes were paid. Certain corporate titles put individuals squarely in the government’s crosshairs, such as “president,” “CEO,” “CFO” or any other title that connotes control over, or responsibility for, the financial affairs of the company. While generally one who is only a stockholder or only a director would not meet the legal definition of a “responsible person,” we have seen cases where a zealous revenue agent will cast a wide net and seek to impose liability on a director or majority owner.
For example, suppose investors provide capital to a business and those investors are elected to serve on its board of directors. The company is growing rapidly, and the board delegates day-to-day management to a CEO, who further delegates specific duties to other members of a management team. During the course of its growth, the corporation experiences a cash crunch and the CEO directs the controller to hold back funds that should be paid to the IRS and instead use those funds to satisfy other obligations. The CEO initially intends to “borrow” the funds and pay them back quickly, but when the company’s cash flow crisis deepens the CEO decides to hold back funds again in order to keep the company going. Although the board members have access to the company’s banking records and financials, the board has not instituted appropriate internal controls or audit procedures to ensure that the company is satisfying its tax obligations. When the IRS discovers the company’s failure to remit payroll taxes, it seeks to impose liability not only on the CEO but also on certain members of the board who the agent believes either knew that the company was not paying taxes or recklessly disregarded the facts. In such a scenario, an otherwise unwitting board member might find herself with tax penalties in the hundreds of thousands or even millions of dollars. Worse, in cases of fraud or other misconduct, certain tax violations also carry the risk of misdemeanor or felony convictions.
Several recent cases demonstrate that while certain titles carry a presumption of liability, it is possible to show that the individual lacked sufficient control or willful conduct to be deemed a “responsible person.” These cases also serve as a cautionary tale that should motivate corporate fiduciaries to proactively establish policies and procedures to limit risk or, at a minimum, take immediate action at the first sign of trouble.
Certain Recent Cases
In Skoczylas v. United States, the United States District Court for the Eastern District of New York denied the plaintiff’s and government’s cross-motions for summary judgment. Long Island Health Associates Corp. (“LIHAC”) was an entity that was formed to acquire a hospital out of bankruptcy. During the relevant periods, Dvora Skoczylas was a member of the board of directors, the president and the sole stockholder of LIHAC. Although Skoczylas held these titles, she was not actively involved in LIHAC’s day-to-day affairs. Throughout the early 2000s, LIHAC was in dire financial condition and had difficulty meeting its obligations, including its tax obligations. Eventually it filed a voluntary Chapter 11 bankruptcy petition, and continued to operate as the debtor in possession. LIHAC’s former CFO testified that he alone made the decision to satisfy other obligations but not the applicable payroll taxes. The former CFO further testified that while he later informed the then-CEO that LIHAC was not paying its payroll taxes, he did not share the IRS correspondence or other information with the CEO or Skoczylas. When Skoczylas learned of the tax liability, she asked the CEO whether LIHAC could use its remaining funds to satisfy the obligation, but he informed her that it could not due to the pending bankruptcy petition. Eventually, the IRS determined that Skoczylas was a “responsible person” who willfully failed to pay certain payroll taxes, and therefore the IRS imposed the trust fund recovery penalty against her. Skoczylas sought to abate the penalty.
The District Court denied the parties’ cross-motions for summary judgment, holding that a material fact existed as to whether Skoczylas was a “responsible person” under §6672. Specifically, the court noted that while Skoczylas was president and a member of the board of directors, and owned 100 percent of the stock of LIHAC, there remained an issue of fact regarding other factors bearing on her “control,” such as the extent of her management authority and dominion over LIHAC’s financial affairs. Moreover, an issue of fact existed as to whether Skoczylas acted “willfully,” noting that the “principal component of willfulness is knowledge,” and that the parties disputed the extent of her knowledge and involvement throughout the relevant period, particularly given that the former CFO testified that he had not informed her of the issue.
In another recent case, Stevens v. Commissioner of Revenue, the Supreme Court of Minnesota held that there was a material dispute of fact regarding whether the president of a convenience store chain had requisite control over the company’s finances to be held personally liable for more than $4 million in petroleum and sales taxes, and therefore reversed the state tax court grant of summary judgment in favor of the state Commissioner of Revenue. In that case, Scott Stevens (“Stevens”) was the president of Twin Cities Avanti Stores, LLC (“Avanti”), which owned and operated various convenience stores in Minnesota. Stevens owned 1 percent of the “parent” entity of Avanti, while a man named Bruce Nelson (“Nelson”) owned 85 percent of the stock of the parent. Nelson, along with a “consultant” named Robert Lovejoy (“Lovejoy”) exercised significant day-to-day management responsibilities. Nelson and Lovejoy made most, if not all, of the significant financial decisions involving Avanti while Stevens was primarily responsible for operational matters, including managing personnel and vendor relationships. Stevens presented testimony and evidence, including affidavits from key employees, that Nelson exercised tight control over the company’s finances, including the payment of tax liabilities. Moreover, while Stevens negotiated with the Department of Revenue concerning a payment plan for Avanti’s tax liabilities, it was Nelson and Lovejoy who were pulling the strings.
The Minnesota Supreme Court held that the tax court erred granting summary judgment in favor of the Commissioner and determining that Stevens exercised sufficient control, supervision and responsibility for collecting and paying Avanti’s taxes. The Court believed that the record presented a dispute of material fact as to whether Stevens, despite his title and responsibilities as president and his stock ownership, lacked sufficient control to be held personally liable for the $4 million tax liability.
These cases are but a sample of recent cases involving officers of companies who are exposed to significant financial penalties and, in some cases, criminal liability for failure to properly manage and satisfy tax obligations. While the facts of each case differ, the general theme is usually the same: a company hits a financially difficult period; one or more officers or directors look for ways to maximize cash to keep the company afloat; a decision is made to hold back tax payments and when the company’s financial condition does not improve, the tax liability grows and the IRS gets involved and assesses liability. In such cases, liability may extend not only to the officer or director primarily responsible for withholding payment of the taxes, but also to those deemed to be a “responsible person” who exercises sufficient control over financial affairs and acts “ willfully,” with knowledge of the non-payment. What is unique about the cases discussed above is that, notwithstanding the presumption that one who carries the title “president” or a similar title that connotes financial control is a “responsible person,” in some cases an individual might be able to demonstrate that the title is misleading and he did not possess control or did not act “willfully,” and therefore should not be liable for the trust fund penalty.
These cases also illustrate the importance of taking proactive measures to limit personal risk. For example, a company should establish policies and procedures, such as an audit committee, with responsibility for oversight of the company’s financial operations and tax payments. In addition, the board might ensure that no one officer has complete control over the day-to-day financial responsibilities of the company. The bottom line is, it is simply not enough for directors or officers to delegate authority to another officer or employee and expect that such delegation will insulate the person from liability. Indeed, if one discovers that an officer or director is failing to pay applicable taxes, he or she should take immediate action to ensure prompt payment of those taxes (if within that person’s control) or possibly resign his position with the company. In any case, it is extremely important to consult with legal counsel before speaking with the IRS to ensure that the individual does not expose himself to greater liability than might otherwise be present under the circumstances.