Tax-abatement Issues in Bankruptcy

Journal Issue

Mar 2003

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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.<a href="#2" name="2a">2</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… U.S.C. §§3102(a)</a> and 3402(a) require
an employer to deduct and withhold income and social security taxes from its
employees' wages. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re McTyre Trucking Co., 223 B.R. 588, 592
(Bankr. M.D. Fla. 1998)</a>. The employer
holds the withheld taxes in trust for the exclusive use of the United States. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…;

Additionally, the employer is required to report the withheld taxes on its
payroll tax return (Form 941). <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 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. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…;, citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
U.S.C. §6151</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
C.F.R. 31.6151-1a (2001)</a>.

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. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
U.S.C. §6651(a)(1)</a> 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. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…;

Additionally, §6651(a)(2) uses identical language in imposing a penalty
for failure to pay the amount due on the return. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…;

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." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=4…
States v. Boyle, 469 U.S. 241, 245 (1985)</a>. "Unless both reasonable cause and a lack of willful neglect
are established, imposition of these penalties is mandatory." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
v. United States (In re Carlson), 126 F.3d 915,
921 (7th Cir. 1997), cert. denied, 118
S.Ct. 1388 (1998)</a>.

The Internal Revenue Code does not define "willful
neglect." The Supreme Court has defined willful neglect as "conscious,
intentional failure or reckless indifference." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=4…; 469 U.S. at 245</a>. Willful neglect can be established when a debtor pays other creditors
rather than making tax payments to the United
States. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… Inc. v. United States,

33 F.3d 589 (6th Cir. 1994)</a>. Moreover,
willful neglect does not depend on specific intent to defraud the government. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Trucking, 223 B.R. at 592</a> (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." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…
Inc. v. United States, 33 F.3d 589, 592 (6th
Cir. 1994)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
C.F.R. §301.6651-1(c)</a>. Moreover,
§301.6651-1(c)(2) provides:

<blockquote>
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.
</blockquote>

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." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; The taxpayer
has the burden to prove the requisite reasonable cause. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5…
of Geraci v. Commissioner, 502 F.2d 1148 (6th
Cir. 1974)</a>.

"Undue hardship" has been defined to mean
more than an inconvenience to the taxpayer. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Sykes & Sons Inc., 188 B.R. 507, 512
(Bankr. E.D. Pa. 1995)</a>, citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
C.F.R. §1.6161-1(b)</a>. It must result in
substantial financial loss. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; Nonetheless,
the taxpayer must demonstrate that it exercised ordinary business care or
prudence in connection with the business loss. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; As such,
financial difficulty alone will not satisfy the taxpayer's burden in
proving the right to a tax abatement.<a href="#3" name="3a">3</a>

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. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Upton Printing Co., 186 B.R. 904, 906-7
(Bankr. E.D. La. 1995)</a> (citations
omitted). The Upton Printing court correctly
noted that "almost every non-willful failure to pay taxes is the result
of financial difficulties." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; at 906</a>
(citation omitted). Further, the Sixth Circuit has held that financial
difficulties can never be sufficient to constitute reasonable cause for the
nonpayment of taxes. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…
Inc. v. United States, 33 F.3d 589, 592 (6th
Cir. 1994)</a>. 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. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Printing, 186 B.R. at 907</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…; 33 F.3d at 592</a>.

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

<blockquote>
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.
</blockquote>

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
v. C.I.R., 860 F.2d 1235, 1241 (5th Cir. 1988)</a> (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 <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Metal Fabrication Inc. v. United States (In re Roberts Metal Fabrication Inc.), 147 B.R. 965 (Bankr. D. Kan. 1992)</a>, 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. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; at 968</a>

(citation omitted). The Roberts court found that
the corporate sole shareholder had conducted other business despite his
illness. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…;

The Roberts court further
held that the illness must render the taxpayer, and not an employee, incapable
of filing the return. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…;; see,
also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=6…
v. United States, 612 F.Supp. 605, 608 (D.
Mont. 1985), aff'd., 798 F.2d 1241
(9th Cir. 1986)</a>. 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. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=6…; at 969</a>.<a href="#4" name="4a">4</a>

Similarly, in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Howe Now Inc., 2000 WL 64105 (Bankr. W.D.
Ark. 2000)</a>, 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. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…; at *9</a>.
Further, the amount of funds embezzled, as compared to the amount needed to
make the tax deposits, was considerably less. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 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.

<h3>Conclusion</h3>

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.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> 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. <a href="#1a">Return to article</a>

<a name="2">2</a> Business taxes include payroll or
"FICA" taxes as defined under <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
U.S.C. §§3402-3405, 6051 (RIA ed. 2001)</a>, unemployment
or "FUTA" taxes under <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
U.S.C. §§85(b)</a> 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. <a href="#2a">Return to article</a>

<a name="3">3</a> See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7…
v. United States, 78-2 U.S.T.C. P9610, 1978 WL
4527 (D. D.C. 1978)</a>, 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. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Printing Co., 186 B.R. 906</a> (citations
omitted). <a href="#3a">Return to article</a>

<a name="4">4</a> See, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Sykes & Sons Inc., 188 B.R. at 512-14</a>, 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. <a href="#4a">Return to article</a>

Journal Authors

Craig A. Gargotta

Journal Date

Saturday, March 1, 2003 - 12:00

Bankruptcy Rule

2003