The Changing Structure of Agricultural Production and…the IRS

Overview

Several decades ago, many farmers had diversified crop and livestock operations.  It was not uncommon for a farmer to have cows, hogs, sheep, chickens and also grow row crops such as soybeans and corn along with having hayfields and wheat.  But, over time, the standard of living increased, agricultural production became increasingly mechanized and specialization took hold.  Grain farming became profitable enough on its own that many farmers no longer needed to also raise livestock.  Likewise, machinery costs rose to such a level that, for many farmers, it was no longer economical to have machinery for each of the separate facets of a diversified farming operation. 

With this transformation of production agriculture came complexity.  The process by which agricultural products are produced has become much more complex.  Likewise, the associated tax and legal issues have also become more numerous and complex.  In addition, farming operations are larger and also are more likely to employ others than in the past. 

That last point brings us to today’s topic.  Having employees means those employees need to get paid.  Paying employees obliges the employer to withhold payroll taxes.  Failing to withhold payroll taxes can lead to huge penalties, even if there was no intent to violate the tax law.

The Tale of Dr. McClendon

McClendon v. United States, No. H-15-2664,  2016 U.S. Dist. LEXIS 159271 (S.D. Tex. Nov. 17, 2016), involved a Texas doctor whose clinic got behind in withholding and paying payroll taxes – way behind.    The doctor founded his clinic in 1979 and hired a Chief Financial Officer (CFO) in 1995.  By 2009, the clinic had unpaid payroll and other withholding taxes exceeding $10 million.  The doctor learned about the unpaid taxes in May of 2009, and the CFO pleaded guilty to embezzlement.  The doctor ultimately shut the clinic down and sent the remaining receivables to the IRS in partial payment of the tax liability.  But, thinking of the clinic’s employees, the good doctor loaned the clinic $100,000 so that the clinic could make payroll before shutting down.  The employees got paid, but the IRS didn’t.  In addition, the IRS didn’t care that he was nice to his employees.  It assessed the good doctor a total of $4,323,343.70 in tax penalties under I.R.C. §6672.  The doctor paid a small part of that liability and then sued for a refund and abatement of the remaining penalty amount.  The IRS moved for summary judgment.  

Trust Fund Recovery Penalties

Under I.R.C. §§3102(a) and 3402(a), an employer must withhold their employees' share of federal social security and income taxes from the employees' wages.  The employer holds these "trust fund taxes" in trust for the benefit of the United States.  To ensure that the taxes are remitted to the United States, I.R.C. §26 U.S.C. § 6672(a) imposes a penalty equal to the entire amount of the unpaid taxes.  To be held liable for the penalty, the taxpayer must be a “responsible person” that willfully failed to collect, account for, or pay over the taxes. 

The “Willfullness” of Dr. McClendon

The doctor conceded that he was a responsible person, but claimed that the penalty didn’t apply because he didn’t willfully fail to collect, account for, or pay the taxes that the clinic owed the IRS.  The court disagreed.  The focus was on the $100,000 loan the doctor made to his clinic to make sure the employees got paid.  The doctor claimed (based on applicable Fifth Circuit caselaw) that because those funds were “encumbered” to cover payroll, he didn’t direct “unencumbered” funds away from the IRS.  Therefore, he claimed, he didn’t willfully not pay the IRS and the penalty shouldn’t apply.  However, the court rejected that reasoning because the doctor testified that the loaned the money so that the employees could get paid.  In other words, he paid the employees instead of the IRS and the funds, the court reasoned, were not “encumbered” in any relevant sense.  In addition, the court reasoned that “willful” only required a voluntary, conscious, and intentional act, not a bad motive or evil intent.  The doctor also claimed that he had reasonable cause to provide a way to get his employees paid because “he acted morally and generously in using his own money to make sure [clinic] staff . . . were paid for the work they had performed. . . .".  However, the court determined that the doctor’s motives were not relevant.  He didn’t pay the IRS.  He did pay another creditor (the employees).  That’s all that mattered.  So, the doctor was personally stuck with a tax penalty exceeding $4 million, plus pre-judgment and post-judgment interest until the penalty was paid.   The $100,000 loan bought him much more than he bargained for.  A small payment to someone other than the IRS can trigger a huge penalty.  The penalty isn’t limited to the amount paid to the other creditor(s), it’s the full unpaid amount.

Conclusion

So why is this case a big deal for agriculture?  As noted above, as farms have become more prosperous, the duties, obligations and responsibilities of a farmer are increasing.  In addition, an increasing percentage of farming operations have employees.  Thus, as more farmers shift the payroll compliance duties to others so that the farmer has more time to devote to conducting farming operations, this case sounds a loud warning - shifting the payroll duties does not shift the responsibility to see that trust fund withholdings have been paid to the IRS. The farmer will be held liable.  The responsibility can’t be delegated.  Make sure to watch payroll taxes.  This is also a problem to watch out for in times of financial distress, such as what much of agriculture is going through at the present time.

The Electronic Federal Tax Payment System (EFTPS) is a secure government website that allows users to make federal tax payments electronically.  That’s the system that IRS wants businesses to use to remit payroll taxes through.  EFTPS is also easy to check online to ensure that payments have been made.  Otherwise, there are firms that handle payroll taxes.  If you use a private firm, make sure it is reputable and bonded.

Just another thing for a farmer to think about.  Don’t forget the payroll taxes.