6. WILFULNESS

§ 5:29 In General

The Internal Revenue Service must prove and establish a second element for liability under the Trust Fund Recover Penalty. That element is “willfulness.” A responsible person need not have failed to pay the taxes with a fraudulent or evil purpose. [IRM 5.7.3.3.2] That person must merely be shown to have knowingly and intentionally disregarded the duty to pay trust fund taxes to the IRS. “Willfulness” can be defined as follows:

An act is willful if it is voluntary, conscious, and intentional. [A responsible person acted willfully if he] knowingly used available funds to prefer other creditors over the Internal Revenue Service.

§ 5:30 Liability Requiring Personal Fault

The Trust Fund Recovery Penalty cannot be Asserted without a showing of personal fault. This is a penalty and the penalty is invoked only upon willful failure to pay a tax.

§ 5:31 Personal Fault

Some courts have redefined the definition of “willfulness” by stating:

Personal fault being a necessary element of willfulness, relevant evidence bearing on the element of personal fault may not be ignored.

§ 5:32 Reckless Disregard Of Known Risks

If a person lacks knowledge that withheld taxes were not being paid over, that person can defend against willfulness unless he or she recklessly disregarded obvious or known risks.

§ 5:33 Lack Of Knowledge

Obviously, the best defense of willfulness is to establish that your client neither knew of nor recklessly disregarded the trust fund tax deficiency. If one can show that the purported responsible person was misled by subordinates, liability could be avoided unless he or she recklessly disregarded known risks. An obvious time to raise the willfulness test would be to defend against liabilities which resulted from an IRS audit. If a person had no reason to know that a liability for taxes existed, he or she should not be found to have been willful.

§ 5:34 Subsequent Knowledge

If a responsible person gains knowledge that her company has previously failed to pay trust fund taxes, she might also be held liable by the Internal Revenue Service. In Honey v. United States the corporate president disappeared. Subsequent to the corporate president’s disappearance, other corporate officers took over the management of the business for a short time before it filed for bankruptcy. During that time the officers became aware of the prior tax liabilities due to the Internal Revenue Service. The officers were held liable for the prior accrued liabilities even though the Court found that they were unaware of those liabilities during the time of accrual. The Court reasoned that once the officers gained knowledge, any funds received from any source by the company were imposed with the trust of the United States. Other courts have reached similar conclusions. At least two courts disagree with the reasoning in this case.

The Honey series of cases appears to be in direct conflict with the rules for the Trust Fund Recovery Penalty as announced in Slodov v. U.S. In Slodov, the Supreme Court held that an officer who purchases a company Which has not paid its prior trust fund tax obligations may hot be held liable unless the government can establish that the company had nonencumbered funds available for payment of the taxes. A series of cases acts to penalize subsequent officers who try to correct prior financial problems of thee company. The mere act of taking over a company and trying to rehabilitate it may create liability for prior accrued trust fund taxes. Such a result is inherently unfair to responsible persons who did not participate in the original decisions regarding nonpayment of trust fund takes.

§ 5:35 Liabilities Caused By Embezzlement

The author has successfully defended a corporate president by establishing that the liabilities resulted from an embezzlement by the corporate controller. In that case the controller had used corporate withholding taxes to pay “phantom employees.” The embezzlement was not discovered until an audit was performed by an outside CPA firm. The corporate president had been told by the controller that the taxes had been paid: In fact, the controller had created an elaborate system; in order to prevent the president from discovering the unpaid liabilities. Clearly, the president could not be held to have been willful even though he was responsible person. Where there is active concealment, the deceived officers are not willful.

§ 5:36 Negligence v. Recklessness

Mere negligence is not sufficient proof of willfulness. This is not to say that the asserted liability may lightly be averted. Willfulness can be proved by showing that the responsible person recklessly disregarded his duty to collect, account for and pay over the trust fund taxes or by showing that the person ignored known risks that the taxes might not be remitted. Multiple courts have held that “gross negligence,” like recklessness, constitutes willfulness. The other side of this rule is that absence of negligence can be proven by an affirmative showing that the responsible person did not disregard his duties and that he undertook all reasonable efforts to see that such taxes would in fact be paid. In Circumstances where the employer had the means of payment and could reasonably be expected pay, evidence of written instructions and policies of a company that taxes be paid first would certainly be relevant.

§ 5:37 Reasonable Cause

Many courts have held that reasonable cause is part of the test to determine willfulness. Willfully means without reasonable cause and is used to characterize purpose or motive as distinguished from knowledge. Not all courts will consider reasonable cause as a defense to willfulness.

§ 5:38 Reasonable Cause Exception

The full Tenth Circuit Court of Appeal has held that the factors generally accepted as indicating willfulness can be negated by showing of reasonable cause. In that case, the taxpayer was the president of a corporation and sat on its board of directors when he learned that the corporation’s withholding taxes had not been paid. He directed his fellow board member and secretary treasurer to pay the taxes. He later learned that the taxes had not been paid, and, on that day, the company’s bank account was frozen. Five days later, cash was deposited in the bank and the taxpayer and the secretary treasurer requested that the deposited funds be applied to the withholding tax balance. The bank refused and instead applied the cash to the company’s loan balance. The Tenth Circuit concluded that the question of willful failure was necessarily directed to the person’s state of mind and therefore properly characterized as an issue of scienter. The court concluded that the factors established as identifying willful conduct is a matter of law and should continue to be applied, but that a reasonable cause exception should be recognized as an exception to the application of these factors. The Tenth Circuit noted that its decision is at odds with the First, Seventh, and Ninth Circuits.

§ 5:39 Illness

A president of a company has been found not willful for a period of illness when he was not in a position to act on corporate financial matters or make any decision as to payments to creditors. He was liable for periods other than during illness. In another case however, a sole shareholder was held liable for the penalty during a period of illness. The court held illness was not an excuse since the officer continued to participate in business affairs. The officer did not use available funds to pay taxes after he became aware of the nonpayment.

§ 5:40 Lack Of Funds

A corporation’s poor financial condition and inability to meet debts is not a justifiable excuse for willfulness. A president/CEO has been held liable even though the corporation’s lender controlled corporate finances. The lender provided the corporation with adequate payroll accounts whenever requested. But the penalty was not imposed on corporate officers when the corporation was in liquidation and could not pay taxes.

A good faith expectation to pay is irrelevant even when there is a reasonable expectation of sufficient funds at a later date and is not a defense to failure to pay taxes when due.

§ 5:41 Belief That Trust Fund Taxes Fully Paid

In Oakey v. U.S. corporate officers were not liable for the Trust Fund Recovery Penalty for failure to pay over withheld taxes where tine IRS allocated a corporation’s undesignated tax payment to nontrust fund tax liabilities The corporate officers, on the advice of their attorney, paid all of the trust fund taxes, but they failed to indicate that the revenue should be applied to the trust fund taxes. They were not willful in their failure to pay the taxes since they paid their taxes and they did not know that the IRS allocated all of the money to the non-trust fund taxes. They also were not reckless in the disregard of their duty to pay over the taxes.

§ 5:42 Public Information Requirements

TBR2 requires the IRS to print warnings on deposit coupon books and appropriate tax returns regarding the penalty. The IRS is also directed to create explanatory materials concerning the penalty and to give specific instructions to its employees regarding the application of the penalty to voluntary board trustees and directors. [I.R.C. § 6672(b)]