Employment Taxes
The Fourth Circuit held that a taxpayer who was chairman of the board and vice president of a company with actual authority over the company’s financial affairs could not avoid responsible person status by delegating her authority to control the company to her husband.
Background
In 1969, Ford Johnson formed a nonprofit corporation, Koba Institute Inc., to perform various government contracts in conjunction with Koba Associates Inc., a for-profit corporation that he owned and managed. When Koba Associates failed to pay its payroll taxes in the mid-1990s, the IRS assessed trust fund recovery penalties against Mr. Johnson. The outstanding payroll taxes, accompanied by the lien subsequently imposed on Mr. Johnson for the Sec. 6672 trust fund recovery penalties, ultimately led Mr. Johnson to close Koba Associates. The presence of the lien severely limited Mr. Johnson’s ability to obtain credit for Koba Institute.
To avoid this problem, Mr. Johnson and his wife, Mary Johnson, undertook a plan in 1998, where Koba Institute converted to a for-profit corporation under Maryland law, with Mrs. Johnson as its sole shareholder. Because Mrs. Johnson “was not encumbered by a lien” as Mr. Johnson was, her status as the corporation’s owner enabled Koba Institute to enter into leases and other contracts, as well as obtain lines of credit based on Mrs. Johnson’s endorsement.
As the sole shareholder of Koba Institute, Mrs. Johnson elected herself as chair of the corporation’s board of directors in 2001. According to the Johnsons, because they had agreed that Mrs. Johnson would be the primary caregiver of the couple’s children, Mrs. Johnson “delegated” and “entrusted” her authority in the corporation to Mr. Johnson and thereafter elected Mr. Johnson president of Koba Institute on Feb. 20, 2001. Mrs. Johnson, in turn, served as the corporation’s vice president. As vice president, Mrs. Johnson had the power to sign company checks, including payroll checks.
Having “delegated” her authority to Mr. Johnson, Mrs. Johnson’s actual involvement at Koba Institute was limited from 2001 through 2004. Nonetheless, she had an office at Koba Institute and received a significant annual salary ranging from approximately $100,000 to $193,000, as well as a corporate car and cellphone. In addition, the rent for Mrs. Johnson’s residence, shared with Mr. Johnson, was provided by Koba Institute.
In the period at issue, 2001–2004, Mrs. Johnson had limited involvement with Koba Institute’s affairs, coming into the office only once a month, and Mr. Johnson oversaw the company’s day-to-day operations. Mrs. Johnson signed Koba Institute checks when Mr. Johnson was out of town, but she signed only ones that Mr. Johnson had specifically authorized.
Near the end of 2004, Mrs. Johnson received a notice from the IRS that Koba Institute had not paid its payroll taxes for several quarters from 2001 through 2004. Prior to that time, Mrs. Johnson claimed she was unaware that the taxes were unpaid. Upon receiving the notice, she purportedly told Mr. Johnson the situation was unacceptable and to make sure it did not happen again. Mrs. Johnson also fired the finance director, who had been responsible for making payroll tax payments, and told Mr. Johnson to personally handle all future tax payments as of January 2005 and to provide her with proof of all subsequent withholding tax payments. Additionally, at least with regard to the payroll account, Mrs. Johnson no longer followed the prior procedure for check authorization; that is, she no longer required instruction from Mr. Johnson before writing checks herself from the payroll account for payment of the taxes.
Afterward, Koba Institute began remitting its post-2004 payroll taxes to the IRS in full and generally on time. However, the corporation did not pay the delinquent payroll taxes for 2001 through 2004, although it continued to pay its other business debts, such as employee wages and Mrs. Johnson’s compensation. Because Koba Institute did not pay the outstanding payroll tax liabilities, the IRS assessed trust fund recovery penalties (the 100% penalty) against Mr. and Mrs. Johnson individually. Mrs. Johnson later paid $351 toward her assessed penalty.
Mrs. Johnson then filed a refund suit in district court for the penalty paid, asserting that the IRS’s assessment against her was erroneous. The IRS filed a counterclaim against both of the Johnsons in order to reduce its assessments to judgment. Later, the IRS filed separate motions for summary judgment against Mr. and Mrs. Johnson, contending that each was liable under Sec. 6672 as a responsible person who had willfully failed to pay over the withheld payroll taxes.
A district court held in favor of the IRS. With regard to Mrs. Johnson, the court found she was a responsible person despite her minimal participation in Koba Institute’s affairs during the period at issue and that she had acted willfully in not having the company pay its outstanding payroll tax liabilities when she became aware of them ( Johnson , No. 8:09-cv-00787-DKC (D. Md. 5/31/12)). The Johnsons appealed the case to the Fourth Circuit.
The Fourth Circuit’s Decision
The Fourth Circuit affirmed the district court’s holding that Mrs. Johnson was a responsible person with respect to Koba’s payroll taxes for the periods at issue and that she had willfully failed to have the company pay the payroll taxes it owed. The court found that the fact that she had delegated her authority and control over Koba Institute to her husband did not affect whether she was a responsible person for the company.
The court stated that in determining whether a taxpayer is a responsible person for a corporation’s payroll taxes, it is necessary to perform a pragmatic, substance-over-form inquiry that focuses on the taxpayer’s status, duty, and authority within the corporation. Because the analysis looks at the substance of the taxpayer’s relationship with the corporation rather than its form, a taxpayer’s title alone does not make him or her a responsible person. Factors that the court found should be considered in the determination include whether the person served as an officer of the corporation or a member of its board of directors, controlled the corporation’s payroll, determined which creditors to pay and when to pay them, participated in the corporation’s day-to-day management, had the ability to hire and fire employees, and possessed check-writing authority.
In Mrs. Johnson’s case, the court found that although a person’s title with a company was not an overriding factor in the responsible person determination, as vice president and chair of the institute’s board of directors, Mrs. Johnson had “considerable actual authority” at the company. Further, the corporation’s bylaws, board resolutions, and banking documents demonstrated that Mrs. Johnson was a responsible person because they made it clear that she had effective control of the corporation, including its finances.
Mrs. Johnson primarily argued that she was not a responsible person because she had delegated her authority over Koba Institute’s affairs to her husband. The court rejected this contention, citing Purcell , 1 F.3d 932 (9th Cir. 1993). In Purcell , the Ninth Circuit held that a person who has the authority to exercise significant control over a corporation’s financial affairs may be a responsible person, regardless of whether the person actually exercised the control. In Mrs. Johnson’s case, the court stated, “[a]lthough Mrs. Johnson maintains that any authority she held was merely technical in nature, the undisputed evidence establishes that she possessed both legal and actual authority over Koba Institute.” The court further noted that after she discovered that Koba Institute had not paid its payroll taxes, she actually exercised her control over the company in several ways.
The court also concluded that it was without question that Mrs. Johnson had acted “willfully” with respect to the unpaid payroll taxes. The court explained that the willfulness determination focuses on whether a taxpayer had knowledge of nonpayment of taxes or reckless disregard of whether the payments were being made. Citing its own precedent from Erwin , 591 F.3d 313 (4th Cir. 2010), the court averred that a finding of willfulness was appropriate if a company has unencumbered funds that it could use to pay its outstanding payroll tax liabilities, and the responsible person permits the corporation to use those funds to pay other creditors. Based on the fact that Mrs. Johnson had accepted salary payments from Koba Institute after learning of its payroll tax liabilities, as well as allowing other creditors to be paid, the court found that she had acted willfully.
Reflections
This case demonstrates that while the responsible person rules in many cases result in what may seem like unnecessarily harsh results, they are necessary to prevent abuse of the payroll tax system. Mrs. Johnson claimed to be unaware of the fact that Koba Institute was not paying its employment taxes, but she must have been aware of Mr. Johnson’s prior payroll tax misdeeds with Koba Associates (although she was not a party in that case), and she apparently agreed to become sole shareholder and vice president of Koba Institute to help Mr. Johnson get around his credit problems stemming from those misdeeds. Mrs. Johnson clearly had effective power to ensure that the payroll taxes were paid during the years at issue—as they were after 2004, due to her intervention. Here, the court reaches the right result by applying the responsible person rules.
Johnson, No. 12-1739 (4th Cir. 11/5/13)
