McDonald’s Franchisee Loses Its Payroll Taxes to an Embezzler and Then Loses It Penalty Argument with the IRS

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The case of Kimdun, Inc. v. United States provides yet another example of the havoc wrecked by payroll provider companies. Over the last 15 years, a fair number of payroll providers have run off with the money leaving their clients in hot water with the IRS. The IRS standard approach to these cases involved telling the cheated taxpayers that they owed their taxes, penalties, and interest. The cheated taxpayer received little compassion from the IRS as they tried to sort through the financial wreckage caused by the payroll provider.   The traditional IRS view on this issue sees the payroll provider as an agent of the taxpayer and any problems created by the payroll provider as problems the taxpayer must fix.   That approach has a sound legal basis but does not always make good policy because some of the payroll provider cases invoke a lot of sympathy.

I thought the IRS position concerning payroll providers had softened. Several pronunciations seemed to suggest a kinder, gentler approach by the IRS on these cases. I quote from the relatively new IRM on ETA offers at the end of the post and cite there to other relevant IRM provisions that a taxpayer facing this problem should explore.

Kimdun definitely did not meet the kinder side of the IRS. This case does not involve Kimdun’s liability for the stolen taxes themselves but rather picks up at the penalty phase. This case involves delinquency penalties for failure to pay and failure to deposit. Kimdun loses the argument in a preemptory fashion. The five McDonalds franchise locations will need to flip a lot of burgers to pay off the penalty for hiring a company that cheated on it and caused it not to pay its taxes on time.

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Kimdun paid the taxes and penalties assessed by the IRS in addition to making payments of the taxes to its payroll provider who ran off with the payments. This case involves a refund suit for return of the money paid for the penalties. Kimdun and the affiliated corporations that made up the franchise group owned by Kim Dobbins have operated in the Los Angeles area for about 30 years. The opinion states that for that entire time or almost that entire time, the companies hired Copac Payroll Service and its clearinghouse bank, Cachet Banz, Inc. to process its payroll, make the necessary deposits, fill out the payroll returns, etc. The payroll company and the bank would electronically sweep the money to pay the payroll and the taxing authorities from the bank accounts of the franchisees. The companies could see (I assume they were looking) that the money was coming out of their bank accounts. They knew their employees received payment because the employees would have quickly sounded an alarm if they had not received payment, and the company assumed that the payroll provider sent the appropriate amounts to the state and federal taxing authorities. Unfortunately the companies apparently did not check up on the timely filing and payment of the taxes.

Some question exists whether the companies had notice of failures before the firing of the payroll company, but eventually the failure became clear. and they fired the payroll provider, The companies also learned that the payroll provider was the subject of a federal grand jury investigation, and the companies received bills from the IRS and California for the unpaid taxes.

Kimdun and the affiliated companies apparently paid over the taxes without a fuss. Having worked on payroll provider cases when I worked in Chief Counsel’s office, I can say that not every taxpayer who gets cheated like this can stroke a check and do that. Many taxpayers who find themselves in this situation face quite a struggle to come up with the taxes for a second time. The ability of Kimdun to pay the IRS the taxes and the penalties attests to the strength of the business and demonstrates that the business stepped up when it learned of the problem and did not shirk from the problem. Hopefully, it also received a theft loss deduction to soften the blow somewhat.

Nonetheless, the IRS stuck to its guns on the penalty. Kimdun argued that the failure to pay the taxes on time and to make the required deposits resulted from reasonable cause and not willful neglect. The court cited United States v. Boyle, 469 U.S. 241 (1985). When a court in this situation cites to Boyle, it is generally a bad sign for the taxpayer and that held true in this case. In Boyle, the Supreme Court set a high bar for taxpayer seeking penalty relief based on the failure of someone on whom the taxpayer relied. The district court here characterized the Supreme Court’s view of the misplaced reliance as providing little relief from penalty where the task involved something the taxpayer could check without expertise such as the timely filing of a return or the timely payment of a debt contrasted with reliance where the expertise of the person on whom the taxpayer relied would reasonably occur such as the taking of a legal position on a return.

The district court here cited to an earlier 9th Circuit case, Conklin Bros. v. United States, 986 F.2d 315 (9th Cir. 1993), involving embezzlement by an in-house bookkeeper rather than a payroll provider. In Conklin, the 9th Circuit, the circuit to which the appeal in this case would lie and the circuit providing controlling precedent to this district court, held that Congress had “charged Conklin with an unambiguous duty to file, pay, and deposit employment taxes and Conklin cannot avoid responsibility by simply relying on its agent to comply with the statutes.”   The district court here applied the same logic in holding Kimdun and its affiliates liable for the delinquency penalties.

This is a tough outcome. If you represent a company whose payroll provider steals its money, look hard at the IRS pronunciations on the relief it may provide to taxpayers in this circumstance. Even if the IRS can win in court decisions that sustain the application of the delinquency, it may not always press for such penalties. It appears there was a little evidence that Kimdun might have had some information to support firing the payroll provider earlier. The case also did not contain information about the IRS failing to follow its own procedures and sometimes you will find that in these cases. Before giving up, seek penalty relief (and in the right circumstances, relief from some of the taxes themselves) but be aware of the precedent and the uphill battle your client will face, because the payroll provider was their agent and ultimately the IRS can place the burden of the loss on the taxpayer.

While Effective Tax Administration offers can prove very hard to obtain, I.R.M. 5.8.11.2.2.1.4 (08-05-2015) entitled “Public Policy or Equity Compelling Factors” has some language that appears to give hope to taxpayers cheated by a payroll provider. The section states:

Compromise may promote ETA and allow for relief if the taxpayer demonstrates that the criminal or fraudulent act of a third party is directly responsible for the tax liability.

In any case involving a fraudulent act of a third party, the taxpayer should be able to provide supporting documentation that the act occurred and was the direct cause of the delinquency. The taxpayer should also be able to show that the nature of the crime was such that despite prudent and responsible business actions the taxpayer was misled to believe the tax obligations were properly addressed. There should be evidence that the funds required for the payment of the taxes were segregated or otherwise identified and were available to pay the taxes in a timely manner. Compromise would promote ETA in such situations only where the failure to comply is directly attributable to intervention by a third party and where the taxpayer has made reasonable efforts to comply and taken reasonable precautions to prevent the criminal or fraudulent acts at issue. If appropriate, the taxpayer’s efforts to mitigate the damages by pursuing collection from the third party should also be considered. Compromise for this reason would only promote ETA where there is a very close nexus between the actions at issue and the failure to comply.

In situations where the actions of a payroll service provider (PSP) contributed to the delinquency, once the offer specialist (OS) has determined sufficient supporting information or documents are available to verify the PSP was the cause of the delinquency and the taxpayer acted in a reasonable manner, the OS may proceed with minimal additional documentation, refer to IRM 5.8.11.5.

Factors which demonstrate the taxpayer was acting reasonably may include, but are not limited to:

– the manner and frequency of monitoring federal tax deposits via EFTPS or other means,

– verifying references prior to entering into the arrangement with the PSP, determining if the PSP was bonded or licensed as required by state laws and regulations and if any corporate filings and licenses required by the state were up to date;

– the fact immediate steps to remedy the problem after learning of the PSP’s misconduct were taken and – whether mitigating factors were involved that may have hampered the ability to identify and correct the problem, e.g. serious illness, natural disaster, etc., as well as a determination as to whether consideration of the taxpayer’s offer under ETA Hardship is a more appropriate resolution

Other IRM provisions worth looking at include IRM 5.1.24.4  (08-15-2012) Types of Third-Party Payer Arrangements; IRM 5.1.24.4.2  (08-15-2012) Payroll Service Provider; IRM 5.1.24.5  (08-15-2012) Collection Actions in Cases Involving Third-Party Payers; IRM 5.1.24.5.1  (11-06-2015)Assignment of Third-Party Payer Client Cases; IRM 5.1.24.5.3  (08-15-2012) Use of Electronic Federal Tax Payment System (EFTPS) for Payment Verification; and 5.1.24.5.8  (08-15-2012)Trust Fund Recovery Penalty (TFRP) Investigations.

Victims of payroll tax providers should take a hard look at the ETA offer provisions because they do provide a way out of the problem caused by paying over the taxes twice. Of course, the IRS does not want to serve as a taxpayer’s insurer; however, this relatively new section of the IRM suggests that in the right circumstances, the IRS will take the hit for the taxpayer because that provides the most effective manner to administer the tax laws.

Comments

  1. Jim Malone says:

    Good post. This is a very serious problem, along with its analog, the trusted long-term employee who should not have been trusted. On the payroll side the certified peo program will provide relief in the future. Over time, you would expect the certified peos to drive the others out of the market.

  2. Chris Kenefick says:

    “Victims of payroll tax providers should take a hard look at the ETA offer provisions because they do provide a way out of the problem caused by paying over the taxes twice.” This is an excellent point and is the best, if not the only, way out in these situations. Essentially, the ETA provisions, since they invoke the element of fairness, which is non-existent elsewhere in the Code, have the ability to throw Boyle on it’s head.

  3. Rick Stack says:

    Excellent post, Prof. Fogg. I unfortunately was counsel for the taxpayers in the related cases that you’ve discussed. The problem in applying Boyle to the context of an employer who relies on a payroll service company to handle its payroll tax processing and payment is that it imposes de facto strict liability on the employer if the payroll servicer (or the correspondent bank) later absconds with the trust funds.

    In this particular case, because the taxpayer had full paid the penalties before we represented him and his companies in the refund actions, we weren’t able to claim relief based on ETA, which appears to apply only before payment of the payroll tax penalties. In other words, the taxpayer ordinarily would assert ETA in response to IRS collection action to either support an Offer in Compromise for payment of less than all of the assessed penalties or for a waiver of penalties.

    Finally, the difficulty in making an ETA argument in these cases is that it wasn’t listed as a basis for requesting waiver of the payroll tax penalties in the Claims for Refund and Request for Abatement (Form 843) prepared by the taxpayer’s previous tax professional. “Reasonable cause” was the only basis for refund stated in the Claims and not ETA.

  4. Howard Bookbinder says:

    I handled two cases on payroll tax providers and only paid the taxes and interest. I stressed to my clients that their address should appear on the payroll forms not the peo and they should make sure they are bonded. I worked with TAS and the matter was take care of. The penalties were not paid.

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