Newsletter -- January 1998 Issue
IN THIS ISSUE
- Two Circuit Courts Rule Six-year Statute Applies to Criminal Prosecution for Failure To Pay Over Trust Fund Taxes
- Ninth Circuit Changes Position: No Longer Allows Conditions to be Placed on Summons Enforcement
- Failure to Secure a Timely Appraisal Leads to Denial of Charitable Contribution Deduction
Two Circuit Courts Rule Six-year Statute Applies to Criminal Prosecution for Failure To Pay Over Trust Fund Taxes
It is not uncommon for a manager of a troubled business to look to withheld employment taxes as a source of ready cash to pay expenses. Usually, it is hoped that the fortunes of the business will improve and the withheld taxes will eventually be paid to the government. Frequently, this does not happen.
The government strongly discourages using withheld employment taxes to pay business expenses or for other purposes. These withheld taxes are considered a "trust fund." Failure to pay over trust fund taxes subjects a "responsible person" to potentially severe penalties.
The civil penalty imposed on a responsible person under IRC Search7RH6672 is equal to the entire tax not paid over. This is the most common penalty asserted. Increasingly in recent years, however, the government has been invoking a criminal penalty under IRC Search7RH7202, which provides that willful failure to "collect, account for, and pay over" trust fund taxes is a felony punishable by up to five years in prison and a $10,000 fine.
The IRC Search7RH6672 civil penalty can be assessed only during the three-year period after the trust fund return (Form 941) was filed. Lauckner v. United States, 68 F.3d 69 (3d Cir. 1995); Jones v. United States, 60 F.3d 584 (9th Cir. 1995). As a defense to recent prosecutions under IRC Search7RH7202, several responsible persons have argued that a three-year statute also applies to criminal prosecutions.
IRC Search7RH6531(4), which sets criminal statutes of limitations at six years instead of three, applies to any offense involving "willfully failing to pay any tax . . . required by law." The defendants argued that "pay any tax" in IRC Search7RH6531(4) applies to taxes imposed directly on them (e.g., their personal income taxes), while "pay over" any tax in IRC Search7RH7202 applies to taxes imposed on others (e.g., the trust fund taxes) for which they only have a duty to collect. Two U.S. district courts accepted this argument and concluded that since IRC Search7RH6531(4) did not appear literally to apply, prosecutions under IRC Search7RH7202 were subject to a three-year statute. United States v. Block, 497 F.Supp. 629 (N.D. Ga. 1980); United States v. Brennick, 908 F.Supp. 1004 (D. Mass. 1995). The Tenth Circuit Court of Appeals, however, had previously come to the opposite conclusion. United States v. Porth, 426 F.2d 519 (1970).
Recently, the weight of the authorities has shifted to a six-year statute for IRC Search7RH7202 prosecutions. In United States v. Evangelista, 122 F.3d 112 (2d Cir. 8/13/97), the Second Circuit Court of Appeals, with little discussion, held that a six-year statute is applicable to prosecution for failure to pay over withholding tax. It also held that the filing of an accurate Form 941 without payment of the tax shown thereon was not a defense to criminal prosecution. The responsible person has not only a duty to file a Form 941, but a duty to pay over the tax shown thereon.
Even more recently, in United States v. Gollapudi, 130 F.3d 66 (3d Cir. 11/17/97), the Third Circuit (over a vigorous dissent) agreed with the Second Circuit. The Third Circuit found that there was no distinction for purposes of IRC Search7RH6531(4) between failing to "pay" and failing to "pay over" a tax. Moreover, to rule otherwise would result in a three-year statute for this felony, whereas there would be a six-year statute for the misdemeanor (under IRC Search7RH7203) of failing to file a return. The majority noted that this seemed unlikely to coincide with Congress' intent.
Thus, all three Circuit Courts that have considered the question now agree that a six-year criminal statute applies to prosecutions for criminally failing to pay over trust fund taxes.
Why were these cases criminal, rather than civil? In Evangelista, the real estate business involved suffered the usual financial reverses, but then the responsible persons started hiding assets and spending some of the trust fund taxes and other monies which could have been used to pay the trust fund taxes on personal expenses. This clearly enraged the government more than in the typical case. In Gollapudi, the responsible persons did not hide or divert the trust fund taxes to personal use. The funds were used to pay corporate operating expenses. However, no Forms 941 were filed for three years. The government felt this was done to avoid detection. The cases suggest that criminal prosecution is most likely when withheld trust fund taxes are hidden or used for personal purposes.
Ninth Circuit Changes Position: No Longer Allows Conditions to be Placed on Summons Enforcement
In our newsletter of February 1997, we discussed a 1995 case in which the Ninth Circuit Court of Appeals had refused to hear an appeal of a district court order which directed a taxpayer to respond to an IRS summons for documents. As a condition for ordering the taxpayer to turn over the documents, the district court had required the IRS to notify the taxpayer five days in advance of showing any documents to any person at the IRS working outside the civil examination division. The district court was concerned that the IRS would show the documents to its criminal investigation division.
As authority for the proposition that the summons enforcement order could contain conditions, the district court relied on the opinion of the Ninth Circuit Court of Appeals in United States v. Zolin, 809 F.2d 1411 (9th Cir. 1987). However, a year after the Zolin case, the Fifth Circuit had held that an order enforcing a summons could not contain any conditions. United States v. Barrett, 837 F.2d 1341 (5th Cir. 1988). The Supreme Court tried but failed (in a 4-4 tie) to resolve this intercircuit conflict in an appeal of Zolin. 491 U.S. 554 (1989).
In the 1995 case, the Ninth Circuit had held that the issue was not ripe for appeal because the IRS said it had no current intention of showing the summoned documents to any division other than the civil examination division. United States v. Jose, 71 F.3d 1484 (9th Cir. 1995). The government appealed the ripeness issue to the Supreme Court. Without indicating how it would rule on the issue of whether conditions could be imposed in summons enforcement orders, the Supreme Court held that the Jose case was ripe for appeal. Therefore, the Supreme Court remanded the case to the Ninth Circuit to make a ruling on this question. 117 S. Ct. 463 (12/2/96).
In a surprise, the Ninth Circuit on remand has reversed its position, as stated in Zolin, that conditions can be attached to summons enforcement orders. United States v. Jose, __ F.3d __, 98-1 USTC 50,119 (9th Cir. 12/19/97). In the recent Jose opinion, the Ninth Circuit, sitting en banc, has held that Congress intended the IRS to have expansive summons powers to investigate tax liability and that this intention, absent any contrary statutory provision, prohibits district courts from attaching conditions to enforcing otherwise valid summonses. Thus, by now siding with the Fifth Circuit's Barrett opinion, the Ninth Circuit has removed any intercircuit conflict, and the matter will not go to the Supreme Court anytime soon.
Failure to Secure a Timely Appraisal Leads to Denial of Charitable Contribution Deduction
The Tax Court's recent opinion in Hewitt v. Commissioner, 109 T.C. No. 12 (Oct. 29, 1997), reminds us of the importance of following the procedural requirements of the Treasury regulations as carefully as possible. All the facts and documents in the case were stipulated. In 1990 and 1991, the taxpayers made gifts of non-publicly-traded common stock to charity, which they claimed as deductions on Schedule A of their income tax returns. They also attached to their returns Forms 8283 (Non-Cash Contributions). The fair market values of the charitable gifts claimed by the taxpayers were based on the average per share price at which the stock had traded in bona fide arm's-length transactions at approximately the same time as the gifts. Thus, it was stipulated that the gifts to charity were fairly valued. However, the taxpayers did not obtain a qualified appraisal for each gift prior to the filing of each return. The Service allowed the taxpayers' deductions only for the amount of their cost basis for the stock, which was less than 10% of the fair market value.
Section 170 of the Code allows a deduction for a charitable contribution for the fair market value of the donated property at the time of the contribution. The statute also provides that such a deduction is allowable only if "verified under regulations prescribed by the Secretary". The Treasury issued regulations which contain fairly elaborate and detailed provisions concerning the appraisal requirement. They include the requirement that where the property donated consists of non-publicly-traded securities with a fair market value in excess of $10,000, a "qualified appraisal" must be obtained prior to the filing of the first return in which the deduction is claimed. The regulations also require that an appraisal summary be submitted with the return. The appraisal summary requirement is satisfied by completing Section B of Form 8283 and filing the form with the return.
It is clear that the taxpayers had not obtained a qualified appraisal. The Tax Court also found that the Forms 8283 filed did not contain qualified appraisal summaries because they were not signed by a qualified appraiser and did not identify the name of the corporation whose stock was contributed or state the number of shares donated.
The taxpayers argued that literal compliance with the statutory requirement was not necessary, arguing that the reporting requirements of these Regulations were "directory" and not "mandatory" and, therefore, that these reporting requirements could be met by substantial rather than strict compliance. In general, the Tax Court has held that strict compliance with a regulation is required if its requirements relate to the substance or essence of the statute. On the other hand, if the requirements relate to the orderly conduct of business, the regulations are procedural or directory and may be satisfied by substantial compliance.
In a previous case, the Tax Court had held that failure to obtain a separate appraisal report was not fatal to deduction of the gift to charity. Bond v. Commissioner, 100 T.C. 32 (1993). In that case, the Court concluded that the Form 8283 attached to the return, which was signed by a qualified appraiser, satisfied both the requirement of an appraisal summary and of an appraisal report, even though a statement of the qualifications of the appraiser (which is required to be part of a qualified appraisal) was not attached to the appraisal summary. These minor technical flaws were held not to go to the substance or essence of the statutory requirement.
In Hewitt, however, the Tax Court held that having a qualified appraiser conclude that the donated stock had a fair market value equal to the price determined by arm's-length transactions between other shareholders was essential to the substance of statute. The Tax Court's determination of the essence of the statute was not based on anything set forth in Section 170 of the Internal Revenue Code. The Court looked to a non-codified provision of the Tax Reform Act of 1984 (TRA '84), Section 155. This section had its origins in proposed amendments to Section 170 of the Internal Revenue Code which never made it into the Internal Revenue Code. Section 155 of TRA '84 directed the Secretary of the Treasury to prescribe regulations which would require a taxpayer to secure a qualified appraisal for donated property which exceeds certain values, to attach an appraisal summary to the return in which the deduction is first claimed, and to include such additional information on the return as the Secretary prescribes in such regulations.
The Tax Court reasoned that the principal objective of Section 155 was to provide a mechanism whereby the IRS would obtain sufficient return information in support of the claimed valuation of the charitable gift to enable it to deal more effectively with potential overvaluations. The Tax Court apparently rejected the argument that the Forms 8283 filed by the taxpayers with their returns provided sufficient information to fulfill this essential statutory objective. It is unclear why omitting the name and signature of the appraiser, the name of the privately-held company whose shares were donated, and the number of shares was detrimental to enabling the IRS to deal with potential overvaluation. How would this information help the IRS determine whether to audit the return for possible overvaluations? Most likely, the omission of the information actually caused the IRS to audit the taxpayers' returns. It appears the essence of the statute is to require an unrelated third-party expert to be part of the valuation process in order to enhance the integrity of the process. No such third-party was involved in Hewitt.
The sticking point here is another question that the Tax Court did not address directly: Whether the requirement of the Regulations that an appraisal report be obtained prior to the filing of the first return which claimed a charitable gift goes to the substance or the essence of the statute? Although not addressed directly, by implication, the Tax Court answers this question in the affirmative.
Several observations are in order: First, the IRS allowed the taxpayers deductions for their basis in the gifted stock. However, there appears to be no statutory authority for allowing any amount as a deduction in light of the failure to secure the required appraisal.
Second, a 20% penalty was proposed by the IRS, but was dropped before trial. Although the grounds for the penalty are not set forth in the opinion, presumably it was an overvaluation penalty. Even though the taxpayers had fairly valued the gifts to charity, because most of the deductions were disallowed, albeit for a procedural omission, the Service might well have succeeded in imposing this penalty. It would seem that the Service was being generous by allowing deductions for the cost-basis and not imposing a penalty.
Third, although the substantial compliance argument may succeed in some cases (see, e.g., Bond), strict compliance with the terms of the regulations is recommended. Thus, a taxpayer should not file a tax return claiming a deduction for a charitable contribution which requires a qualified appraisal unless that appraisal is in hand before the return is filed and a properly completed appraisal summary, signed by the qualified appraiser, is attached to the return. If you don't have the required appraisal, request an extension of time to file your return. Alternatively, file the return without claiming a deduction for the charitable gift and then file an amended return with Form 8283 attached after you have obtained the qualified appraisal.