The Sixth Circuit Court of Appeals in the case of Byrne v. United States, CA6, No. No. 2:06-cv-12179 had to decide if the president and CEO had acted recklessly in not insuring that trust fund taxes had been deposited when they were aware of issues with the quality of work performed by the controller. If they had, they would be liable personally for the undeposited trust fund taxes under IRC §6672.

Any responsible person may be held personally liable by the IRS for unpaid trust fund taxes (that is, federal income taxes and FICA taxes withheld from employee’s paychecks) if the IRS can show that individual either:

Had actual knowledge that the taxes had not been paid and had the ability to pay the taxes (even if that meant not paying other bills) or
Recklessly disregarded known risks regarding a failure to pay such trust fund taxes.

In this case neither the president nor the CEO were aware of the actual nonpayment of trust fund taxes until they were no longer able to control the payment of the taxes. So, the question was whether they had recklessly ignored an obvious danger that taxes would not be paid correctly by their less than reliable (and, eventually, apparently less than honest) controller.

The business’s financing arrangement with GMAC required that it obtain annual audited financial statements prepared by an independent CPA firm. That firm also advised the controller with regard to payroll tax matters, as the opinion notes:

In January 1999, WCD (the CPA firm) provided Fuller (the controller) with the forms he needed to comply with the relevant tax laws and also provided guidance on how to prepare and file trust-fund taxes. Despite this guidance, Fuller deposited trust-fund taxes with the IRS on a biweekly, as opposed to a semiweekly, basis.

The IRS noticed this little problem, which also came to the attention of the president, Mr. Byrne, and the CEO, Mr. Kus. As the opinion continues:

This resulted in a large penalty assessment against Eagle Trim in early 1999. By the end of 1999, Kus and Byrne had decided that Fuller was not adequately performing his duties, and Kus provided Fuller a handwritten list of tasks that he needed to start completing accurately and timely.

GMAC had regular collateral reviews performed as part of their financing agreement with the business, and those uncovered further issues with payroll tax deposits in 2000.

In March 2000, GMAC’s auditor, Lender Services, sent a letter to GMAC, stating that Eagle Trim had provided inadequate supporting documentation for Lender Services’ collateral reviews. Lender Services therefore recommended, among other things, that Eagle Trim implement procedures to “[e]nsure all tax payments are made timely[ ] with supporting detail retained.” GMAC forwarded this letter to Eagle Trim, and Kus reviewed it. Within two weeks, Fuller sent a letter to GMAC, responding to Lender Services’ letter. Fuller acknowledged that he missed two trust-fund tax deposits during Eagle Trim’s switch from Northwestern Bank to National City Bank, but he asserted that Eagle Trim was then current with all tax deposits. Fuller copied Kus and Byrne on this correspondence.

The CPA firm completed its audit of and issued a management letter with certain recommended actions:

Also in March 2000, WCD sent a letter to Kus, copying Byrne and Fuller, advising Eagle Trim of deficits in its accounting practices, which WCD had observed while conducting its 1999 audit. The letter also stated, however, that WCD’s observations did not discover any “material weaknesses,” defined as conditions which Eagle Trim’s internal control structure failed to “reduce to a relatively low level the risk that errors or fraud in amounts that would be material in relation to the financial statements being audited may occur.” WCD recommended in its letter that Eagle Trim hire an assistant controller with an accounting degree.

Pursuant to WCD’s recommendation, in April 2000, Eagle Trim hired Kelly Gillman, an accountant, to assist Fuller with his duties as controller. Perhaps due in part to Fuller’s continued mishandling of Eagle Trim’s finances, in July 2000, Eagle Trim also hired Andrew Jones as Eagle Trim’s chief financial officer. As CFO, Jones reported to both Byrne and Kus on all of the financial aspects of Eagle Trim. Fuller reported to Jones, providing monthly financial statements for Jones to review.

Nevertheless, payroll tax problems continued with another IRS penalty notice for $98,622.32 arriving in October of 2000.

David Drake, a WCD partner, met with Fuller to discuss the penalty. Fuller informed Drake that he had failed to pay the trust-fund taxes on time because of difficulties associated with Eagle Trim’s switch from Northwestern Savings Bank to National City Bank. He said that he had contacted the IRS several times about the issue and that an IRS representative had informed him that Eagle Trim had made all trust-fund tax deposits in full and on time since June 14, 2000. Following his conversation with Fuller, Drake sent a letter to the IRS, repeating Fuller’s explanation for the late trust-fund tax deposit and requesting that the IRS waive the penalties. Drake also attached an Eagle Trim check to the letter to pay the interest on the late trust-fund taxes. On November 10, 2000, Fuller sent a letter to Kus, Byrne, and Jones, describing the IRS penalty, his meeting with Drake, and Drake’s request for an abatement of the penalty.

The next audit was completed by the CPA firm and another management letter was issued.

WCD issued a “clean” audit on December 11, 2000, regarding Eagle Trim’s financial statements through September 30, 2000, opining that the financial statements presented Eagle Trim’s financial position fairly in all material respects. The report found that Eagle Trim was current in the payment of trust-fund taxes. Despite WCD’s clean audit report, in January 2001, WCD sent a letter to Kus, copying Byrne, Jones, and Fuller, identifying flaws in Eagle Trim’s accounting practices observed by WCD in the course of its 2000 audit. The letter included a section devoted to Eagle Trim’s failure to pay trust-fund taxes in a timely manner, recounting the IRS penalties assessed for unpaid trust-fund taxes in 1999 and the first quarter of 2000. The letter added that WCD had been informed by “management” that trust-fund taxes for the second quarter of 2000 had been untimely as well, though the IRS had not yet assessed a penalty. WCD recommended that Eagle Trim “take the measures necessary to ensure that all payroll taxes and withholdings are deposited in a timely manner” and offered to assist Eagle Trim should “any payroll tax questions arise.” WCD stated, however, that its observations did not discover any “material weaknesses” in Eagle Trim’s internal control structure.

Unfortunately, it turned out that the controller, in addition to having issues with depositing trust fund taxes, had been engaging in some “creative” accounting.

Also in January 2001, Lender Services discovered that Eagle Trim’s financial statements were fraudulently overstated and the company, rather than being profitable, was losing money. According to GMAC’s review, Fuller had falsified certain receivables by adding digits to the invoice. For example, an $8,000 invoice was recorded as an $80,000 receivable. Eagle Trim entered into a Forbearance Agreement with GMAC, dated January 31, 2001, and an Access and Accommodation Agreement with GM, dated February 2, 2001. Under the terms of these agreements, GM hired a crisis management company, BBK, Ltd. (“BBK”). At the time the Forbearance and Accommodation Agreements were executed, Kus and Byrne were unaware that Eagle Trim was delinquent on trust-fund taxes for the second, third, and fourth quarters of 2000. After execution of the agreements, both GMAC and BBK reviewed and approved all funding for Eagle Trim and had complete control over the flow of money in and out of Eagle Trim.

The crisis management company discovered there was more unwelcome news for the president and CEO, uncovering the unpaid trust fund taxes

In late February 2001, BBK informed Byrne and Kus that Eagle Trim was delinquent on its trust-fund tax deposits for the last three quarters of 2000. Fuller and Byrne asked BBK for permission to pay these delinquent taxes, but the BBK reviewers refused to approve this expenditure. Fuller was then fired.

Not surprisingly, the auditors took a closer look and uncovered additional problems:

On March 1, 2001, WCD sent a letter to Byrne, copying Kus. The letter explained that due to the discovery of “intentional, improper accounting” resulting in material misstatements, Eagle Trim should no longer rely on WCD’s audit reports for 1999 and 2000. The same day, Drake sent a letter to Byrne explaining that WCD was recalling its audit reports due to the discovery that Fuller had been making “a series of incorrect, inaccurate and/or fictitious entries, primarily relating to tooling receivables, pre-paid tooling and accounts payable.” Drake wrote that “there was a significant effort on the part of Mr. Fuller to disguise these activities, and to prevent their discovery in the course of our audits. . . .”

The IRS argued that the actions of the president and CEO amounted to a reckless disregard of a known risk that trust fund taxes might be paid, but they had taken no action to assure such payments were made. The District Court agreed with the IRS, so the president and CEO appealed the case to the Sixth Circuit Court of Appeals.

The opinion begins by noting what other Circuits had held regardless when reckless conduct rises to a level to trigger the trust fund penalty. The panel eventually decided to follow the guidance of the Second Circuit which it summarized as follows:

The Second Circuit also defines willful conduct as “includ[ing] a reckless disregard for obvious and known risks as well as a failure to investigate . . . after having notice that withholding taxes have not been remitted to the Government.” Winter v. United States, 196 F.3d 339, 345 (2d Cir. 1999) (citation and internal quotation marks omitted). But the Second Circuit recognizes an exception to § 6672(a) liability when a responsible person “believed that the taxes were in fact being paid, so long as that belief was, in the circumstances, a reasonable one.” Id.(citation and internal quotation marks omitted).

The key distinction is the Second Circuit’s recognition of a “reasonable belief” defense. So, the question became whether the president and CEO had a reasonable belief the taxes were being paid.

The panel agreed that the president and CEO were aware that the controller was not performing his work adequately, not completely performing his duties. But the panel found merely knowing that the controller was perhaps not competent did not equate to knowing that the trust fund taxes had not been paid.

The panel disagreed with the District Court that the president and CEO could not rely on the work of its audit firm in this matter. Rather, the panel ultimately found that the information received from the CPA supported a reasonable belief that the taxes had been paid:

…Byrne and Kus’s hiring of WCD — an independent, professional accounting firm — to assist in tax matters and conduct annual, full-scope audits further demonstrates that they took reasonable steps to comply with all of Eagle Trim’s legal tax obligations, including the timely payment of trust-fund taxes. We acknowledge that Eagle Trim, not WCD, was ultimately responsible for its financial statements and payment of taxes. But we find nothing in the record that would cause us to question the reasonableness of Byrne and Kus’s reliance on WCD’s competency. The district court reasoned that Byrne and Kus could not rely on Drake’s October 2000 letter to the IRS, in which he stated, “[Eagle Trim] ha[s] in fact paid all of [its] deposits in full and on time since [June 14, 2000, which] should indicate that [it is a] responsible taxpayer[ ].” According to the district court, because Drake did not say in the letter whether he investigated Fuller’s story, Byrne and Kus could not reasonably have relied on this letter. That is, the district court’s logic is that Byrne and Kus could not reasonably rely on any of WCD’s statements after notice of Fuller’s prior failures to pay the trust-fund taxes on time. Because Byrne and Kus had no prior indication of errors or inaccuracies in WCD’s auditing, we hold that their reliance on WCD’s representations was reasonable.

Third, while WCD noted in its December 2000 audit report that Eagle Trim had been delinquent in paying its trust-fund taxes for the first quarter of 2000 and that deposits for the second quarter of 2000 were late, WCD confirmed that Eagle Trim’s “financial statements . . . [were] fairly presented in conformity with generally accepted accounting principles.” WCD also opined that Eagle Trim had accurately disclosed “[p]ending or anticipated tax assessments or refunds, price or profit renegotiation, other potential or pending claims, lawsuits by or against any branch of government or others[.]” WCD’s audit report also concluded that “there ha[d] been no . . . [f]raud involving management or employees who have significant roles in internal control.”

By the time the CPA firm gave notice that its work could no longer be relied upon, the matter was already out of the hands of the president and CEO, since the entity in control of the business would not allow payment of the taxes.

The Court also noted that experts had not been able to discover what the controller had done without significant work. The Court notes:

Of course, in March 2001, WCD withdrew its December 2000 audit report “[f]ollowing the discovery in January 2001 that Bernie Fuller had been making a series of incorrect, inaccurate and/or fictitious entries.” Thus, even licensed CPAs, who had spent several weeks at Eagle Trim performing a full-scope audit, missed Fuller’s inaccurate accounting entries. Anthony Pierfelice, one of the crisis management consultants, confirmed that by the time GMAC and BBK took control of Eagle Trim’s finances, “it took several months to gain an understanding of the full amount of the tax liability.” In fact, Pierfelice stated that “[i]t was not until after the bankruptcy that [the crisis management firm] w[as] able to meet with the IRS and reconcile the amounts outstanding.”

We cannot say that Byrne and Kus acted unreasonably or held an unreasonable belief that Fuller had begun to pay the trust-fund taxes on time, given that WCD, a CPA firm, did not detect Fuller’s suspect financial accounting after having performed a full-scope audit and that it took several months for a crisis management firm to determine the exact amount of Eagle Trim’s tax liability.