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Boyle and Baldwin Spell Penalty Trouble

Posted on June 5, 2023

Picture a taxpayer with over 100 years of pristine tax compliance history getting some unwelcome news: despite a dedicated and competent executive board headed by a hands on de facto CEO, an employee with a history of ensuring employment tax compliance, and an external auditor regularly checking on finances and bookkeeping, the taxpayer neglected to make employment tax deposits or file Forms 941 for the last two quarters of 2018 and the first quarter of 2019. This led the IRS to assess to over $500,000 in delinquency penalties.

The taxpayer paid the penalties, filed a refund claim and eventually a refund suit, on the grounds that it had reasonable cause for its failure to file and pay. This is the basic set up of Operating Engineers Local Union Number 3 v United States, a case that breaks no new ground but illustrates how taxpayers must be ever vigilant when relying on employees to satisfy federal payroll tax compliance. Operating Engineers provides a useful vehicle to review two key procedural cases we have discussed many times before, Boyle v United States and Baldwin v United States.

Operating Engineers No. 3 (OE3) is the largest construction local union in the US. It had a longtime employee who was responsible for ensuring employment tax compliance in her position as Accounting Manager. When that employee was promoted in 2015 to Finance Director and Controller, the union hired a new Accounting Manager, who assumed the tax responsibilities. The employees, both the Accounting Manager and Finance Director, reported to the Executive Board, in particular the Board’s Business Manager who was effectively the CEO. In addition, the union had a longtime external auditor who provided a check on internal operations.

Fast forward to June of 2018: the Accounting Manager who had been working at the union for about three years resigned. Rather than hire a new manager, the old manager performed additional duties. Just prior to the Accounting Manager’s departure, the Finance Director asked the soon to be departing employee to train one of her staff to assume the tax filing and compliance. That did not happen, though the Finance Director did not appreciate that the departing employee did not train her subordinate to pick up the tax slack.

To make matters worse, starting in 2018 the Finance Director was experiencing personal problems due to her family losing their residence in that year’s deadly northern California wildfires. And there was conflicting evidence in the record as to whether the Finance Director recommended replacing the departing Accounting Manager: a member of the Executive Board claimed that the Director assured the Board that she could do both roles, but the Finance Director claimed that she recommended that the union hire a replacement.

Fast forward six months to December of 2018. The Director realized that the tax compliance had slipped through the cracks. She made all outstanding tax payments by the end of the month but she did not tell anyone on the Executive Board until the external auditors discovered the oversight in early 2019. In April 2019 two IRS Revenue Officers make an unannounced visit to the offices as the IRS had no record that the union had filed a Form 941 for the last two quarters of 2018. The Finance Director told the IRS employees that she had mailed those returns but could not produce additional evidence of mailing and reprinted the Forms and signed them and gave them directly to the Revenue Officers. (Of course, relying on handing a return to an IRS employee as proof of filing has its own issues. See Keith’s post on Seaview Trading here.)

After paying the penalties for failing to file and pay its employment taxes, OE3 sought a refund, arguing that its oversights were not due to willful neglect and that it had reasonable cause for its mistakes. The union emphasized that its process reflected ordinary business care, ensured tax compliance for over 100 years and that it had no knowledge of its employee’s mistakes:

[We] could not control [our employee’s] intentional act of omitting the payroll tax deposits from the financial reports. [The employee] had full control over the financial reporting to the CEO and the Board. The CEO and the Board did not have control over the financial reporting matters as the Government suggests. They were often out of the office and districts for meetings. Thus, OE3 was rendered objectively incapable of meeting its [payroll tax] obligations because the agent in control of financial reporting caused OE3’s disability.

Framing the problems on misconduct of the Finance Director reflects the slight crack in the formidable 1985 Supreme Court Boyle holding that it is inexcusable to delegate compliance responsibilities to an agent. The Court in Boyle distinguished reliance on an agent to perform a known duty from the question of the taxpayer’s disability, with the latter potentially amounting to a penalty defense.

A Third Circuit case, In the Matter of American Biomaterials Corp., 954 F.2d 919 (3d Cir. 1992), analogizes misconduct of corporate officers as effectively incapacitating a corporate taxpayer that may amount to reasonable cause to excuse delinquency penalties.

OE3 analogized its situation to a disabled taxpayer, given that it argued that it had no knowledge of her problems and had a sound practice of internal and external oversight. The district court distinguished Biomaterials, leaning on Ninth Circuit case Conklin Bros. of Santa Rosa v. United States, 986 F.2d 315, 317 (9th Cir. 1993). Conklin involved a controller who hid from her supervisors her failure to file returns and pay taxes, and who actively intercepted correspondence from the IRS and other evidence that would have let corporate officers know of the tax problems:

Applying Conklin to this case, it is clear as a matter of law that OE3 has not established reasonable cause to avoid the late penalty fees. The undisputed facts show that OE3 relied solely on [its employee], acting within the scope of her authority, to ensure that it met its payroll tax obligations during the periods in question. But OE3 “cannot avoid responsibility by simply relying on its agent to comply with the [tax] statutes.” Id. at 317. The undisputed facts also show that, as in Conklin, the circumstances resulting in OE3’s payroll tax delinquencies were not beyond OE3’s control.

What distinguished Biomaterials from Conklin and the union’s facts was that the misconduct in Biomaterials was at a higher level. Here, the Finance Director “was at all times subject to the direct supervision of OE3’s Business Manager… who could have seen to it that OE3 timely fulfilled its tax obligations.”

After failing to persuade the court that it had reasonable cause for its delinquencies, OE3 also argued that it in fact timely filed its third quarter 2018 payroll tax return. It argued that it was inappropriate for the government to prevail on summary judgment with respect to the filing penalty, pointing only to deposition testimony of the Finance Director, who claimed that she had mailed the return in the fall of 2018.

In granting the summary judgment motion, the opinion notes 2011 Treasury regulations that provide that taxpayers can only rely on Section 7502 to prove delivery.  Those regulations effectively bar the introduction of extrinsic evidence if there is no direct evidence of actual delivery to the IRS or no proof of proper use of registered or certified mail or an authorized private delivery service.

The Ninth Circuit upheld those regulations in Baldwin v United States (for a discussion of Baldwin see Carlton Smith’s Ninth Circuit Holds Reg. Validly Overrules Case Law; Disallows Parol Evidence of Timely Mailing). As such, given that OE3 could offer no admissible evidence to prove filing, the government was able to prevail on its motion for summary judgment.

Conclusion

What about the IRS’s first time abatement (FTA) policy? OE3 also argued that it should have received a one-time pass, but the court did not reach the issue, noting that its origins in the IRM render it not binding. Absent a handful of CDP cases that have pressed the issue of whether IRS failure to apply FTA is an abuse of discretion, courts have not applied it in refund cases like this.

Boyle’s bright line at times can lead to harsh outcomes, even if one might agree with the result. And from the union’s perspective two or three quarters of noncompliance in 100 years reflect a taxpayer that has taken their responsibilities seriously. As Keith has noted one can imagine a tax system like the Virginia DMV which allows a driver to build up positive points for driving a year with no violations up to five points. The points can be used to mitigate when a violation occurs. While past compliance is not irrelevant when considering if a taxpayer can establish reasonable cause, other than the IRS’s discretionary FTA there is no mechanism for incentivizing past filing and paying compliance.

This case serves as a warning that boards and officers must keep close watch over tax matters; even longtime employees who have acted appropriately for years may experience personal and professional issues that can lead to sizable and unexpected sanctions.

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