In a prior blog post, we discussed the case of Dr. Robert McClendon and the IRS’ assessment of the Trust Fund Recovery Penalty against him due to his attempt to do the right thing. In 2016, a U.S. District Court granted the IRS’ motion for summary judgement regarding the trust fund recovery penalty, because Dr. McClendon, after learning that his medical practice owed the IRS payroll taxes, loaned the business $100,000 to make its payroll to employees.
Dr. McClendon was the founder of a family medical practice that had employed numerous doctors, nurses and staff. The practice was managed by a non-physician CFO who, unbeknownst to the practice, embezzled millions of dollars and left the practice with an unpaid federal employment tax liability totaling $10 million. Dr. McClendon learned of the unpaid taxes on May 11, 2009. Four days later, on May 15, 2009, Dr. McClendon made a $100,000 personal loan to the practice for the express and limited purpose of funding May 15th payroll obligations. The practice did in fact use the borrowed funds to make payroll. Years later, as a result of that transaction, the IRS imposed over $4 million of trust fund penalties against Dr. McClendon. The doctor filed suit against the IRS seeking an abatement of the penalties. The doctor argued that because the borrowed funds were encumbered (i.e., could only be used for payroll), he did not act willfully in paying the money to another creditor, i.e., the employees, instead of the IRS – a required element of the trust fund penalty assessment. Alternatively the doctor argued that because he acted morally and generously in making sure the employees received their pay, he acted with reasonable cause which is an affirmative defense.
The district court ruled in favor of the government and upheld the IRS’ trust fund penalty assessments. The district court found that the doctor’s voluntary assumption of the restricted funds was not the type of superior legal interest that trumped the IRS’ status as a creditor. From the court’s perspective, the doctor secured borrowed funds to pay certain creditors, namely the practices’ employees, rather than the IRS, which constituted willful conduct. The district court also found that the reasonable cause defense was not available to the doctor, as there was simply no legal basis for exonerating a taxpayer who consciously decided to use funds to knowingly pay a creditor rather than the IRS.
McClendon subsequently filed a motion for reconsideration with the district court raising a new argument. He argued that even if he were a responsible person and acted willfully, his liability under Section 6672 was limited to the amount of unencumbered funds the practice had available after he learned of the unpaid taxes. He claimed that the evidence submitted at the summary judgement level showed that all of the business’ available unencumbered funds ($400,000 in receivables and $250,000 in insurance proceeds for employee theft) had been turned over to the IRS. The only funds that had not been paid to the IRS was the $100,000 that was loaned to the business to make the May 2009 payroll, and therefore McClendon argued that he should only be liable for $100,000.
In response the IRS argued that McClendon was not entitled to a limit on his liability because he “failed to meet his burden of proving what the universe of available funds were, whether they were unencumbered, and if so whether they were paid to the IRS.” The IRS also argued that even if the liability could be limited, the court would still need to address the Government’s alternative argument on willfulness: that McClendon was grossly negligent in delegating, with no oversight, the responsibility of paying payroll taxes to the CFO for years and that such conduct also constituted willfulness under Section 6672.
The district court denied McClendon’s motion for reconsideration and Dr. McClendon appealed the decision to the Fifth Circuit.
On June 14, 2018, the Fifth Circuit issued an opinion that affirmed in part and vacated in part the ruling on the summary judgement and remanded the case to the district court for further proceedings and consideration. The Fifth Circuit affirmed the district court’s determination that McClendon’s $100,000 loan was unencumbered for purposes of Section 6672 and at a minimum he is liable for $100,000 in trust fund recovery penalty. The Fifth Circuit vacated the remainder of the summary judgement because there is a “genuine issue of material fact as to whether [the business] had $4.3 million in available, unencumbered funds after McClendon learned of the unpaid taxes.” The case is being remanded to the district court for further consideration.
Once again the takeaway from this case is that unpaid payroll taxes are fraught with danger and a taxpayer should be careful in responding to the IRS.
For any questions on this or any other tax-related matter, please feel free to contact me at (214) 749-2456 or firstname.lastname@example.org.