Doctor Subject to Payroll Tax Penalty for Paying Employees Before IRS

A family doctor, whose medical practice owed over $10 million in unpaid payroll and withholding taxes, was a responsible person and was liable for payroll tax penalties when he paid his employees before paying the IRS. The court rejected the doctor’s argument that the $100,000 he loaned to his practice to pay his employees was “encumbered” and thus the payment was not a willful transfer of unencumbered funds to a creditor other than the IRS.


Dr. “A” founded Family Practice Associates of Mason, a medical-service provider, in 1979. In 1995, Family Practice hired Richard “Person”, as its Chief Financial Officer. By 2009, Family Practice owed over $10 million in unpaid payroll and other withholding taxes. Dr. “A” learned that these taxes were unpaid on May 11, 2009. “Person” pleaded guilty to three counts of felony theft of money that he embezzled from Family Practice. Family Practice stopped operating and remitted its remaining receivables to the IRS to pay toward the tax liability.

Dr. “A” made a $100,000 personal loan to Family Practice for the restricted purpose of using the funds to pay the May 15, 2009, payroll. Family Practice used that loan to pay its employees. As a result of Dr. “A” paying his employees before paying back payroll taxes to the IRS, the IRS assessed a total of $4.3 million in tax penalties under Code Sec. 6672. Dr. “A” paid a small part, then sued for a refund and abatement of the remaining penalty amount.

Code Sec. 6672 Penalty

To ensure that payroll and withholding taxes are remitted to the Treasury Department, Code Sec. 6672(a) imposes a penalty on any person required to collect, truthfully account for, and pay over any payroll and withholding tax. Under this provision, the term “liability” is composed of two elements:

(1) that the taxpayer was a “responsible person,” and
(2) that the taxpayer willfully failed to collect, account for, or pay over such taxes.

Several courts, including the Fifth Circuit (to which the instant case would be appealable), have held that in the case of individuals who are responsible persons both before and after withholding tax liability accrues, there is a duty to use unencumbered funds acquired after the withholding obligation becomes payable to satisfy that obligation and failure to do so when there is knowledge of the liability constitutes willfulness.

Taxpayer’s Arguments

Dr. “A” conceded that he was a “responsible person.” However, he contended that he did not willfully fail to collect, account for, or pay taxes that Family Practice owed to the IRS. Dr. “A” first argued that because he loaned the money to Family Practice on the understanding that it could use the money only to cover payroll, the funds were “encumbered.” According to Dr. “A”, because he loaned the money to Family Practice with the express restriction that it could use the money only to cover payroll, the funds were “encumbered” and willfulness is shown as a matter of law only by evidence that a responsible person directed “unencumbered” funds to a creditor other than the government.

Dr. “A” also argued that he had reasonable cause to provide a way to pay the employees because “he acted morally and generously in using his own money to make sure Family’s staff . . . were paid for the work they had performed.”

District Court’s Opinion

The district court began by citing Logal v. U.S., 195 F.3d 229, 232 (5th Cir. 1999), for the principle that willfulness is normally proved by evidence that a responsible person paid other creditors with knowledge that withholding taxes were due at the time to the United States. Payment of wages to employees, the court noted, counts as a payment to a creditor for purposes of this principle. According to the court, if a responsible person knows that withholding taxes are delinquent, and uses corporate funds to pay other expenses, even to meet the payroll out of personal funds he lends the corporation, he has acted willfully within the meaning of Code Sec. 6672.  Thus, the district court rejected Dr. “A’s” arguments and granted summary judgment to the IRS. The Fifth Circuit, the court concluded, has made clear that a taxpayer who consciously decides to use unencumbered funds to pay a creditor other than the government cannot benefit from the reasonable-cause defense. The court found no basis for a different result in Dr. “A’s” situation.

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