Tax Law Insights

This post was co-authored by Adam Landy and Erik Doerring.

On July 5, 2011, the United States Tax Court abated penalties assessed by the IRS against a business taxpayer for failure to pay its employment taxes. The Tax Court agreed with the taxpayer that it had shown reasonable cause. In Custom Stairs & Trim Ltd. v. Commissioner, T.C. Memo 2011-155, the taxpayer, Custom Stairs and Trim Ltd. had a history of filing its IRS Form 941 timely and making timely employment tax deposits. Beginning in 2005 and continuing through 2008, however, Custom Stairs began experiencing financial hardship due to Hurricane Ivan and the 2008 economic collapse. As a result, Custom Stairs laid off employees, eliminated vacations and paid holidays, and cut employee benefits. It even listed its office property with a Florida broker in hopes of using the proceeds from the real estate sale to pay off its debts.

The company fell behind with its employment taxes and deposits. The IRS assessed penalties and interest against Custom Stairs for failure to pay the full amount due. For most of the quarters at issue, Custom Stairs paid employment taxes over the amount due which would have fully satisfied its liability for the current quarter absent penalties and interest; however, the IRS applied its payments to prior quarters, leaving all or portions of each successive quarter's required deposits underpaid or unpaid. This allowed the IRS to assess cascading penalties. Unfortunately, as the company continued to pay, it did not designate a specific quarter for the payment, which allowed the IRS to allocate payments to back quarters in arrears and for which penalties had already been assessed.

The company filed a petition with the United States Tax Court claiming that its inability to timely pay employment taxes was due to reasonable cause because of Hurricane Ivan and the economic recession. The IRS argued that a taxpayer's financial inability to pay is never reasonable cause for abatement of the failure to deposit penalty.

Under Internal Revenue Code Section 6656(a), a taxpayer can avoid failure to pay or deposit tax penalties if it can show that its failure is due to reasonable cause and not willful neglect. In addition, Treasury Regulation Section 301.6651-1(c)(1) provides that 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 its income when determining whether a taxpayer exercised ordinary business care and prudence. The Tax Court in Custom Stairs & Trim Ltd. v. Commissioner cited the following factors in determining whether reasonable cause is present: (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.

The Tax Court ruled that Custom Stairs' failure to timely deposit and pay was due to reasonable cause. The Court believed that Custom Stairs' failure to make its employment tax deposits was due in significant part to Hurricane Ivan, the economic collapse, and cascading penalties. The Tax Court also stated that Custom Stairs had exercised ordinary business care and prudence in cutting benefits and payroll, selectively paying business expenses, and attempting to sell its office real property to pay its tax liability. The IRS argued that if the company could not afford to make timely tax deposits and payments it should not be in business, but the Tax Court rejected this argument finding that this would have a negative impact upon businesses and the economy.

Taxpayer Impact

This decision is a significant win for business taxpayers. The current economic environment has made it difficult for businesses to stay current with their employment tax deposits. When these deposits are not made, however, the IRS will often assess substantial penalties.

Taxpayers are allowed to designate the application of any voluntary payment made to the IRS. Thus, if a taxpayer owes taxes for multiple quarters, and the IRS has also assessed penalties, the taxpayer generally has the ability to make a voluntary payment to the IRS requiring the IRS to apply the payment to tax for the current quarter and to prior quarters or to penalties. If a taxpayer does not make a designation of a payment when made, the IRS is allowed to allocate the payment in its best interest. When a business taxpayer has outstanding employment tax liabilities and makes an undesignated payment, the IRS can apply the payments to a prior period where an amount is due. This creates an underpayment for the current tax period triggering assessment of penalties. Taxpayers can avoid this penalty if they properly allocate payments to the current tax period. Moreover, under decisions such as Custom Stairs, if the taxpayer did not designate the payment and the IRS assessed a penalty, the taxpayer may still avoid the penalty through a showing of reasonable cause.