Where is the Economy Heading?
According to the data released Friday by the Department of Labor, the U.S. economy added approximately 528,000 jobs in July, reducing the unemployment rate to 3.5 percent.[i] Although this figure was certainly better than what was expected by many economists, it seems to belie other signs of economic weakness.
Many states, for example, have reported recently that they are experiencing significant declines in estimated tax payments or that they expect declines in revenue from the withholding of personal income taxes.[ii] These developments are being attributed to the performance of the stock market[iii] and to the fact that wages have not kept in step with inflation.[iv]
Speaking of inflation,[v] the Federal Reserve has already increased the federal funds rate by 75 basis points at each of its June and July meetings and will probably do so again at its open market committee meeting in September.[vi]
The increased rate will make it more expensive for U.S. businesses to borrow. It may also attract capital into dollar-denominated assets, which strengthens the dollar and hurts U.S. businesses that rely on foreign markets to purchase their products.
And don’t forget that the gross domestic product has decreased during each of the first two quarters of 2022.
At this point, where we are in the business cycle? Are we “technically” in a recession or not? It appears that the answer depends upon whom you ask; specifically, a Democrat or a Republican.[vii]
Regardless of how the factions within the Washington crowd try to characterize the state of the economy, at some point the owners of many closely held businesses may find themselves in economic straits. Their businesses may be suffering; they may not be able to afford, or to even qualify for, a bank loan.
What will these owners do?
Damned if You Do, . . . ?
The typical owner of a business will do what they can to keep their business viable.
Although the great majority of owners will remain within the law as they consider means by which to salvage their business, a not insignificant[viii] number may adopt a “strategy” that is not infrequently utilized by businesses in distress: instead of remitting to the taxing authorities those taxes that the business has withheld or collected on behalf of the government – typically, the employee’s share of employment taxes on wages paid by the employer, and state and local sales taxes – they will use those funds to satisfy business operating expenses.
Why would a business engage in such obviously illegal behavior? After all, these are funds that the business collected from other taxpayers on behalf of the government.
The reasoning goes something like this: “Revenues were down. We just needed some time to recover – the tax money was going to help us sustain the business until it became profitable once again. At that point, we would have paid the taxes owing.”
As you can imagine, it rarely works out that way; instead, the business fails, the government comes around looking for its taxes, and the owners (or former owners) are left holding the proverbial bag.
There are times, however, in which this so-called strategy is not implemented by the owner from whom the government subsequently seeks to collect the unpaid taxes but, rather, by someone else in the business and unbeknownst to the owner.
As the former co-owner of one New York business recently discovered, their inability to control the business may not be a defense against personal liability for such unremitted taxes.[ix]
Careful Choosing Your Partners
Taxpayer formed Corp to have the corporation certified as a minority business enterprise to gain access to state contracts with minority access goals.
Thereafter, Taxpayer and the owners of Business (unrelated to Taxpayer and Corp) arranged for Taxpayer to assume Business’s minority subcontracts. Taxpayer was the president and a 51 percent shareholder of Corp, with the remaining shares belonging to family members and owners of Business.[x]
Shortly thereafter, according to Taxpayer, one of the owners of Business (“Nasty”)[xi] eventually took over the financial affairs and management of Corp. In addition, Corp and Business entered into an agreement providing that, upon Nasty’s written demand, Taxpayer would immediately resign as president of Corp.
At some point, Corp began to encounter economic difficulties, and fell behind certain tax obligations, including the payment of employee withholding taxes.
A couple of years later, Nasty terminated Taxpayer pursuant to the terms of their agreement, purchased Taxpayer’s shares of Corp stock, and became Corp’s sole owner.
The State Comes “a Knocking”
Around the time that Taxpayer ceased to be associated with Corp, the Department of Taxation and Finance (the “Department”) issued three notices of deficiency to Taxpayer for outstanding withholding taxes owed by Corp. The Department sought to hold Taxpayer personally liable for these taxes, claiming Taxpayer was a “responsible person” and had acted “willfully” in failing to remit such taxes.
Taxpayer thereafter filed a petition with the Department seeking to challenge the notices of deficiency and to absolve himself of liability on the grounds that Taxpayer was not a responsible person of Corp, notwithstanding he was its president and majority owner.[xii]
In a parallel proceeding before the IRS, the IRS Appeals Office determined that Taxpayer should be relieved of liability for certain federal trust fund recovery penalties assessed for the same periods addressed by the department’s notices of deficiency, as well as several preceding periods, as it found Taxpayer was not a “responsible person” of Corp.[xiii]
ALJ and TAT
Following a hearing, an Administrative Law Judge (ALJ) sustained the Department’s notice for one of the periods, partially sustained the notice for another period, and cancelled the third notice of deficiency.[xiv]
Upon administrative appeal,[xv] however, the Tax Appeals Tribunal (TAT) found that, based upon various factors, Taxpayer was a responsible person on behalf of Corp, and determined that he was personally liable.[xvi]
Additionally, the TAT found that Taxpayer’s failure to pay the withholding taxes was willful.
Lastly, the TAT held that it was not obligated to defer to the IRS’s parallel determination because the Department may conduct its own examination and reach its own factual conclusions.
Taxpayer then commenced a CPLR Article 78 proceeding,[xvii] in the Appellate Division of the Third Department, challenging the TAT’s determination.[xviii]
The Court’s Analysis
As an initial matter, the Court disagreed with Taxpayer’s contention that the TAT’s determination was irrational in light of the IRS’s determination absolving Taxpayer of liability as a responsible person for purposes of Corp’s federal withholding tax liabilities.
The Court conceded that the applicable federal[xix] and the New York statutes at issue are parallel statutes, and that both require a showing that the taxpayer has actual authority in order to be a person responsible for collecting and remitting the corporation’s withholding taxes.
That said, the Court stated that the TAT’s determination was not based upon an erroneous legal standard that was contrary to that found under federal law; rather, it was based upon the TAT’s numerous factual findings derived from the extensive record before it.
Turning to the merits, the Court explained that “[i]n cases where, as here, the issues argued before the [TAT] involved the specific application of broad statutory terms in a proceeding in which the agency administering the statute must determine it initially, this Court accords deference to the [TAT’s] interpretation of the statute  at issue and will not disturb the [TAT’s] determination if it has a rational basis and is supported by substantial evidence.”
In view of the foregoing, the Court continued, the TAT neither incorrectly interpreted the applicable law, nor applied an improper test in determining who was a responsible person.[xx]
According to the Court, any person required to collect and pay over the tax imposed, but who willfully fails to do so, will be liable to a penalty equal to the total amount of the unpaid tax. This includes an officer or employee of a corporation who is under a duty to perform or ensure the performance of the required collection and payment.
The Court explained that, in determining whether Taxpayer was a responsible person for the time periods in question, the test was “a factual one to be determined after consideration of a myriad of factors, including whether [Taxpayer] signed the tax return, derived a substantial part of his income from the corporation, or had the right to hire and fire employees. While no one factor is controlling, all must be considered.”
Notwithstanding evidence that could support a contrary determination, it was undisputed, the Court stated, that Taxpayer was president, the majority shareholder, had check signing authority, was involved in daily field operations, and derived a substantial part of his income from Corp. Additionally, Taxpayer intentionally held himself out to third parties, as well as to the Division of Taxation itself, as the contact person and responsible person for New York taxes by signing state tax returns and checks accompanying the returns, executing a sales tax certificate of authority listing himself as the corporation’s responsible person, filling out the Department’s “Responsible Person Questionnaire,” and maintaining communication with the Department.[xxi]
Accordingly, the Court decided that the TAT’s determination that Taxpayer was a responsible person had a rational basis, was supported by substantial evidence, and must be upheld.
Although Taxpayer provided evidence that Nasty exerted control over Corp’s financial responsibilities, the Court pointed out that it “may not disturb the [TAT’s] determination despite the existence of evidence in the record to support a contrary conclusion.”
The Court then addressed the question of willfulness. Taxpayer contended that the TAT erred in finding a willful failure on his part because, according to Taxpayer, he was powerless to direct payment of the taxes because Nasty was in complete financial control of Corp and directed what bills should be paid.
“Willfulness . . . may be found when the act, default or conduct is consciously and voluntarily done with knowledge that as a result, trust funds belonging to the [g]overnment will not be paid over but will be used for other purposes. Something more than accidental nonpayment is all that is required”
According to the Court, although Taxpayer may not have initially known that the taxes were not paid due to Nasty’s writing and directing the checks that Taxpayer should sign, it was undisputed that Taxpayer became aware of the tax liabilities from employees of the corporation and the Department yet failed to take affirmative steps to ensure payment.
Despite Nasty’s repeated representations that he would obtain credit to pay off the tax liability, Taxpayer himself did not seek to obtain financing to pay the taxes, nor did he attempt to correct Nasty’s mismanagement in failing to collect and remit the taxes. Instead, Taxpayer disregarded Nasty’s mismanagement and continued delegating to Nasty the responsibility of remitting payment of the taxes to the Department.
Cut and dried, right? Not quite.
One of the Justices who heard Taxpayer’s case disagreed with their colleagues. The basis for their disagreement? The interplay between the federal outcome and the state proceeding and a finding of fact, neither of which was discussed in the majority’s opinion.The Federal Proceeding
The dissent began by highlighting that the federal and New York provisions at issue were nearly identical. Given that they are parallel statutes, the dissent explained that their terms “must be construed in conformity unless a different meaning is clearly required.”
The dissent then observed that “while this rule does not preclude the state and federal taxing authorities from coming to different conclusions on an identical set of facts, it does require the state authority to apply the same standard as the federal authority when construing the meaning of responsible person . . . , as there is no clear indication that the Legislature intended the term to have a different meaning from how it is used in” the federal statute.
After reviewing the relevant factors, the dissent pointed out that the “core question is whether the individual has significant control over the enterprise’s finances.” This test “is meant to encompass all those connected closely enough with the business to prevent the tax default from occurring.”
According to the dissent, the record demonstrated that Nasty, rather than Taxpayer, was the person who had significant control over Corp’s finances during the tax years in question. To that end, the record contained an exhibit memorializing the agreement between Taxpayer and Nasty by which Taxpayer effectively ceded control of the business to Nasty, agreeing that, upon Nasty’s written demand, Taxpayer would resign as president of Corp and sell his shares to Nasty for the nominal sum of one dollar per share.
During the administrative hearing, the dissent continued, Taxpayer explained that Nasty was responsible for “[e]verything inside the office as far as payments and all the liabilities and distributions as far as checks and taxes,” and Taxpayer mainly became responsible for field operations. The dissent added that two other witnesses who worked with Corp during the relevant timeframe corroborated that contention, explaining that Nasty decided what tax liabilities to pay on behalf of Corp and that Taxpayer did not have any authority in that regard.
Also received into evidence at the hearing was the IRS Appeals protest Taxpayer filed in the federal tax proceeding. That submission, the dissent explained, included two affidavits from Nasty in which Nasty himself averred that Taxpayer “handled the operating activities of [Corp], but did not handle the financial responsibilities and the decisions of [Corp].”
In this affidavit, Nasty further explained that Taxpayer had “signature authority on the bank accounts only to enable him to handle items related to running the operations of [the business; h]is authority did not include payment of . . . accrued liabilities, tax obligations, or anything beyond the company’s general operations.”
Notably, Nasty admitted that, during his tenure as director of the corporation, he “exercised control over the financial policies of [Corp],” including “authorizing payments for tax obligations . . . and accrued liabilities.”
Based on that information, the dissent stated, the IRS determined that Taxpayer was not personally liable for Corp’s failure to make trust fund payments.
The dissent observed that, rather than analyzing Taxpayer’s control over Corp’s finances, the TAT framed the issue as “whether [Taxpayer] presented facts showing that [he] lacked control and authority over the affairs of [Corp],” ultimately finding that Taxpayer was a responsible person insofar as he: (1) held himself out as an officer and the majority shareholder of the business; (2) managed the field operations; (3) had check-signing authority; (4) filed tax returns on behalf of the business; and (5) had a considerable interest in the company.
According to the dissent, the “affairs” of a business is a much broader concept than the “finances” of the business. Although the factors cited by the TAT were relevant to the finance analysis, “titular authority,” it stated, “is insufficient” and the TAT’s characterization of the question before it “raised uncertainty as to whether it applied the correct standard.” Indeed, the dissent continued, “the [TAT] did not make any specific findings that Taxpayer had ‘significant control over the enterprise’s finances’” — the “core” component of the inquiry.
Turning to the issue of willfulness, the dissent explained that “the test is whether the act, default, or conduct is consciously and voluntarily done with knowledge that as a result, trust funds belonging to the [g]overnment will not be paid over but will be used for other purposes.”
The dissent then alleged that, after concluding that Taxpayer acted willfully in failing to remit the required taxes, the TAT relied on a series of cases holding that an individual “cannot absolve [himself or herself of liability] merely by disregarding [his or her] duty and leaving it to someone else to discharge.” Using this reasoning, the dissent explained, the TAT found that Taxpayer’s “continued reliance on another [i.e., Nasty,] to pay withholding tax constituted a reckless disregard of his duty to act,” satisfying the willfulness requirement.
After conceding that the TAT was correct that a responsible person will not be absolved of their duty to pay withholding taxes simply by delegating that authority to another individual, the dissent explained that this position presupposes that the responsible person retained actual authority over the payment of the taxes at the time the tax liability was incurred.
“Here, by comparison,” the dissent continued, “Taxpayer ceded control to [Nasty] years before the subject tax liability came to fruition. As defined above, willfulness requires a showing that the delegation of control was done with knowledge that the trust funds would not be paid to the state. There is nothing in the record to indicate that [Corp] was not paying withholding taxes” when Taxpayer entered into the agreement with Nasty. Moreover, as the ALJ recognized, the agreement gave Nasty “carte blanche over the finances of the corporation.”
The operative point, the dissent concluded, was that Taxpayer had no actual authority to compel Nasty to make the required payments once Taxpayer learned that Corp was in default. Notwithstanding that the agreement with Nasty was “one of [Taxpayer’s] own making,” as the TAT observed, the wisdom of that agreement was not the issue, the dissent stated. Thus, the TAT’s determination that “[Taxpayer’s] continued reliance” on Nasty constituted willfulness was not rational, because Taxpayer had no authority to intervene.
Seems harsh, doesn’t it? Setting aside the “wisdom” of Taxpayer’s having agreed to help Nasty secure MWBE work for which Nasty did not qualify[xxii] – talk about poor judgement – the fact remains that Taxpayer contractually ceded control of Corp’s finances to Nasty.
The IRS found that the agreement with Nasty, supported by other evidence, including Nasty’s affidavit, sufficed to absolve taxpayer from liability as a responsible person for federal taxes. Small comfort, it turns out when one is dealing with New York.
It was clear that Nasty controlled Corp’s purse strings. However, from New York’s perspective, the fact that Taxpayer decided to relinquish control over Corp’s finances appears to have been enough to doom him, notwithstanding that, as a practical matter, he could not compel payment of the delinquent withholding taxes.
May one deduce from this outcome that the Department is predisposed toward finding “willfulness”? Not necessarily but, then again, we’re talking about New York. Its posture in this case in the face of a very different federal outcome should convince the owners of any closely held business of the need to implement safeguards to ensure that no one of them, or any of the business’s key employees, is able to unilaterally divert any kind of withholding taxes toward the payment of business expenses.
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[i] https://www.bls.gov/news.release/pdf/empsit.pdf .
[ii] This includes New York. The State’s principal source of revenue is the personal income tax.
[iii] The S&P 500, for example, is down more than 13% for the year-to-date.
[iv] In addition, new jobless claims have generally been rising, while the number of persons employed “part time for economic reasons” has also increased; i.e., those whose hours were cut due to slack work or business conditions.
Ah, the social sciences. I encourage you to at least glance at the various categories of “worker” identified in the Department of Labor’s news release.
[v] I know, I shouldn’t worry. The soon-to-be enacted Inflation Reduction Act is just what we need. Somebody pass the Dewars, please.
Speaking of the “Act,” what happened to the House’s so-called “no SALT, no deal” caucus? All that bluster.
[vi] https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm .
[vii] Get a load of this: https://www.whitehouse.gov/cea/written-materials/2022/07/21/how-do-economists-determine-whether-the-economy-is-in-a-recession/ .
[viii] Does that mean “significant”? Not necessarily. From a navigational perspective, think of it as north by northeast – it lies somewhere in between.
[ix] In the Matter of Black v New York State Tax Appeals Tribunal, Supreme Court of New York, Appellate Division, Third Department 532477, June 30, 2022.
[x] It should be noted that Taxpayer falsely held himself out as Corp’s financial decision-maker for purposes of retaining its status as a minority-owned business enterprise. That was why Taxpayer retained the office of president of, and a 51% ownership interest in, Corp.
[xi] Actually, the name was Nastasi. Anyone remember Ilie Nastase? Now you see why I chose “Nasty”? No?
[xii] N.Y. Tax Law Sec. 685(g).
[xiii] Under IRC Sec. 6672(a).
See what the dissent said about the federal government’s findings, below.
[xiv] Based upon Nasty’s termination of Taxpayer, and the sale of Taxpayer’s shares of stock to Nasty, the Administrative Law Judge.
[xv] Both the taxpayer and the Department may appeal an ALJ decision.
[xvi] Tax Law Sec. 685(g), (n).
[xvii] Tax Law Sec. 2016.
[xviii] Only the taxpayer may appeal a TAT decision.
[xix] IRC Sec. 6671(b) and Sec. 6672(a).
[xx] Thus, the Court skirted any Supremacy Clause issue. See Article VI, Par. 2 of the U.S. Constitution. The IRS and the state court had not interpreted their respective (but nearly identical) statutes inconsistently; rather, the findings of the state court allowed it to reach its particular decision.
[xxi] The Court does not mention Taxpayer’s arrangement with Nasty by which Taxpayer held himself out as a decision-maker only for purposes of retaining Corp’s status as a minority-owned business enterprise.
[xxii] And which may have affected the majority’s opinion of Taxpayer.