On July 5, 2011, in the case of Custom Stairs & Trim, LTD., v. Commissioner (TC Memo 2011-155), the US Tax Court addressed the issue of what circumstances constitute “reasonable cause” for the purpose of abating a penalty for an employer’s failure to deposit employment taxes in a timely manner. Does a downturn in the economy constitute reasonable cause? Some may find the result surprising.
Federal law requires employers to withhold taxes from its employees’ paychecks. Each time the employee pays wages, it must withhold – or take out of its employees’ paychecks – certain amounts for federal income tax, social security tax, and Medicare tax (these taxes are termed “employment taxes”). Further, an employer must file a quarterly Form 941 reporting the wages it paid to its employees for the previous quarter. The IRS Form 941 includes totals for: (a) the number of employees and total pay for the period being reported; (b) amounts withheld from the pay of employees for the period; (c) taxable Social Security and Medicare wages for the period; and (d) calculation of total Social Security and Medicare wages. The form requires a calculation of the total taxes and the total deposits (from the employer to the government) made during the period. Beginning January 1, 2011, an employer deposits all depository taxes (such as the employment tax) electronically by electronic funds transfers.
IRC Section 6656 imposes penalties on late deposits of the employment tax (of 2 to 15% on the amount of tax, depending on the lateness of the deposit). Under IRC Section 6656(a) and Rev Proc. 2001-58, however, the IRS may abate the penalty if it determines there exists “reasonable cause” to do so.
Does a Downturn in the Economy Constitute “Reasonable Cause”?
In Custom Stairs & Trim, LTD., v. Commissioner, the employer failed to make certain employment tax deposits. As a consequence, the IRS imposed a penalty under IRC Section 6656- Failure to Make Deposit of Taxes. The issue before the US Tax Court was whether the company’s failure to make the deposit of taxes was attributable to reasonable cause, so that the penalties should be abated. As a reason for failing to make the deposit for the 2nd quarter of 2008, the company cited the effects of the economic recession. It noted it had been forced during this time to lay off employees, eliminate vacations and reduce employee benefits. The company stated it simply did not have enough money to deposit the taxes for that quarter and meet its other crucial operating expenses. The company did deposit taxes during that time it owed for a previous quarter for which it was in arrears. The IRS responded, in turn, that it never constitutes reasonable cause (for the purposes of abating penalties) to pay other creditors before the IRS.
In its decision, the Tax Court noted that in the 2nd, 3rd, 7th and 9th circuits (the 9th circuit is California’s circuit) the courts have opined that financial hardship, under certain circumstances, can constitute reasonable cause. The Tax Court stated 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.” 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. Primary factors in determining whether a taxpayer exercised ordinary business care 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.”
Because the company did actually make deposits during the 2008 quarter (albeit, for amounts due from prior periods, and not the actual amounts due for the 2nd quarter of 2008) the Tax Court reasoned the company was not paying other obligations instead of its obligation to the IRS. That fact coupled with the economic downturn (including proof that the company cut benefits and payroll and was attempting to sell some of its real property) satisfied the Tax Court, which ruled that the company exercised ordinary business care, and that the IRS must abate the company’s penalties for failure to deposit the employment taxes for the second quarter of 2008.
Include your author as one of the surprised.