Custom Stairs & Trim Ltd., Inc., TC Memo 2011-155
The Tax Court has abated a company's failure-to-deposit penalty under Code Sec. 6656 after determining that there was “reasonable cause” for the failure. It reached this conclusion despite the fact that the company was a multiple offender. The Court was swayed by significant business downturns the company suffered and its failure to allocate payments in a way that would prevent the cascading of penalties.
Observation: For the same reason, it also abated a small addition to tax for failure to pay under Code Sec. 6651(a)(2). Our discussion, however, primarily focuses on the failure to deposit penalty.
Facts. Custom Stairs & Trim Ltd. (“Custom Stairs”) has been in business since December’85 fabricating stairways for residential properties along the Florida Gulf Coast. Its troubles began in September 2004 when Hurricane Ivan severely damaged its place of business and significantly affected many of its customers.
In 2005 through 2008, as Custom Stairs felt the effects of the hurricane, collapse of the housing bubble, and economic recession, it began laying off employees, eliminating vacations and paid holidays, and cutting employee benefits. It even went so far as to list its office property with a real estate broker in hopes of paying off its debts.
The company had a history of timely filing its Forms 941 and making deposits of the tax assessed. However, following the hurricane, it also had a history of failing to pay the full amount and having to pay penalties and interest. The company fell behind with its employment taxes in early 2005 and was thereafter consistently in arrears. For most of the calendar quarters at issue, Custom Stairs actually paid over to IRS amounts that would have fully satisfied its liability for the current quarter, but IRS applied its payments to prior arrearages, leaving all or portions of each successive quarter's required deposits underpaid. This situation caused IRS to assess cascading penalties.
Observation: In Rev Proc 2001-58, 2001-2 CB 579, IRS provided guidance on how it credits federal tax deposits to determine whether a failure-to-deposit penalty applies in situations where deposits have not been made in sufficient amounts to satisfy the cumulative deposit obligations as of at least one deposit due date. The guidance provides examples of how taxpayers can make deposit allocations to avoid cascading penalties.
On July 30, 2008, an IRS revenue officer met with Rebecca Cordes, Vice President of Custom Stairs, about its employment tax arrears. The revenue officer explained that certain documents were needed so that IRS could compile a collection plan. However, the documents were not submitted and the review was put off after it seemed that Customs Stairs would be able to pay off past due liabilities.
As it turned out, the taxes were not paid, and on Nov 20, 2008, Custom Stairs received from IRS a Final Notice, “Notice of Intent to Levy and Notice of Your Right to a Hearing” (CDP levy notice), showing a $9,919 liability for the quarter ended June 30, 2008. On Dec. 2, 2008, it was mailed a “Notice of Federal Tax Lien Filing and Your Right to a Hearing.” On Dec. 11, 2008, Custom Stairs timely filed a Form 12153, Request for a Collection Due Process or Equivalent Hearing. Under the heading “Offer in Compromise,” Custom Stairs requested a “reduced penalty, under the present economic conditions.” Under the heading “Lien Withdrawal,” Custom Stairs stated that the lien was filed prematurely because it had been keeping current while slowly paying the past due liabilities. Custom Stairs also claimed that, as of Dec. 4, 2008, all of the past due amounts (except penalties) had been paid.
In early 2009, an IRS settlement officer from Appeals contacted Cordes about the federal tax lien. She claimed that the lien was unnecessary because the underlying taxes had been paid and the only balance for that period was a penalty. She said that she did not believe that she had to submit the documentation because she had been making payments on the delinquent tax liability. The settlement officer apprised Cordes that she did not have “reasonable cause” for the abatement of the penalty as Custom Stairs had not submitted any of the documentation requested, and the company had not suggested any collection alternatives. When he asked Cordes how she wished to resolve the liability, she informed him that she did not know because she did not have the money to pay it.
On Mar. 26, 2009, IRS mailed Custom Stairs a Notice of Determination Concerning Collection Action(s) Under Section 6320 and/or 6330 (determination letter). The letter explained that “the Notice of Intent to Levy should not be withdrawn” and “the Notice of Federal Tax Lien will not be withdrawn.” It stated that the lien was reasonable under the circumstances and that all of the legal and procedural requirements had been met.
Custom Stairs timely filed a Tax Court petition for review of the Appeals Office's actions and the determination letter. Custom Stairs claimed that because it could not pay the tax liability, there was reasonable cause for the failure to pay and therefore the penalties should be abated. Custom Stairs concluded that since the penalty was improper, there was no underlying tax liability to warrant a lien against its property and thus the lien was unnecessary and unreasonable.
Background. Employers and others who have withheld taxes are generally required to deposit them within certain prescribed periods of time (depending on the type and amount of tax). A penalty, equal to the applicable percentage, is imposed for failure to make required tax deposits. The penalty is not imposed if it is shown that the failure is due to reasonable cause and not due to willful neglect. (Code Sec. 6656)
Parties' arguments. Custom Stairs claimed that its inability to timely pay the taxes on account of the lingering effects of Hurricane Ivan and the economic recession constituted reasonable cause even though some vendors were paid. IRS countered that the mere inability to pay, coupled with the payment of other creditors rather than the Treasury, is never reasonable cause for abatement of the failure to deposit penalty. IRS also stressed that this was not a first-time offense. Indeed, regs under Code Sec. 6656 do not address reasonable cause except as to first-time offenders. (Reg. §301.6656-1)
Tax Court's analysis. The Tax Court observed that a majority of the Courts of Appeals that have decided the issue at hand have determined that financial hardship can, under certain circumstances, justify failure to pay and deposit employment taxes.
Observation: The Sixth Circuit has held that financial difficulties never can constitute reasonable cause to excuse the penalties for failure to deposit and pay withholding taxes by an employer. However, the Second, Third, Seventh and Ninth Circuits and the Court of Federal Claims rejected application of the Sixth Circuit's “bright line” rule that financial difficulties can never constitute reasonable cause.
The Tax Court further observed that the Code Sec. 6656 regs don't address reasonable cause for a multiple offender. Because of this, it looked to the regs under Code Sec. 6651 (imposing an addition to tax for failure to timely pay tax) for guidance. Under Reg. §301.6651-1(c)(1), reasonable cause will be found if the taxpayer “exercised ordinary business care and prudence in providing for payment of his tax liability and was nevertheless either unable to pay the tax or would suffer an undue hardship.” The reg goes on to state that in determining whether the taxpayer exercised ordinary business care and prudence, “consideration will be given to all the facts and circumstances of the taxpayer's financial situation, including the amount and nature of the taxpayer's expenditures in light of the income.”
The Court also pointed out that the primary factors cited by the Courts of Appeals in assessing a reasonable cause defense for the inability to make employment tax deposits are: (1) the taxpayer's favoring other creditors over the government; (2) a history of failing to make deposits; (3) the taxpayer's financial decisions; and (4) the taxpayer's willingness to decrease expenses and personnel.
Applying the cited reg and Courts of Appeals factors, the Tax Court concluded that Custom Stairs' failure to timely deposit and pay was due to reasonable cause. It concluded that Custom Stairs' failure to make the deposits, in the context of cascading penalties being assessed from one quarter to another, was due in significant part to Hurricane Ivan, the 2008 economic collapse, and the practical fact of the cascading penalties themselves. The Court also noted that Custom Stairs had exercised ordinary business care and prudence in cutting benefits and payroll, selectively paying business expenses, and attempting to sell its real property to pay its tax liability. While IRS argued that if the company cannot afford to make timely tax payments it should not be in business, the Court found that the economy would be negatively impacted by such an approach, and pointed to Custom Stairs' earnest attempt to stay current with its taxes despite difficult financial conditions.
References: For the penalty for failure to deposit taxes, see FTC 2d/FIN ¶V-1651; United States Tax Reporter ¶66,564; TaxDesk ¶862,001; TG ¶71623.