"Reasonable cause" exception for failure to pay employment taxes requires examination of a taxpayer's total financial situation.

• Author: Fiore, Nicholas J.

The EW corporation manufactured military clothing for the U.S. Department of Defense (DLA). The manufacturing contracts for this clothing were administered by the DLA; all EW's contracts went through the DLA.

As early as 1976, certain employees at the DLA began soliciting bribes from EW ultimately, they sought compensation equal to half of EW's business. When EW declined to pay the bribes, the DLA did not award EW new contracts, unless it was the only bidder. As a result of refusing to pay bribes, EW was not paid for work completed and goods delivered; payments were intentionally and substantially delayed; inventory was wrongfully rejected; and orders were required to be reworked. The DLA did make some contract payments to EW after it refused to pay bribes, and EW did get some additional contracts.

In 1984, EW contacted the DLA legal staff, but nothing was done. To keep the business going, EW's vice president took out personal loans (including a mortgage on his home) to pay essential employees, creditors threatening to cut off services and payroll taxes. Subsequently, EW asserted claims for damages against the DLA.

In 1984, EW filed for bankruptcy protection. Late in 1984, it was approached by the FBI to gather information on the corrupt DLA employees. EW worked with the FBI for two years. During this time, the FBI instructed EW when to pay and not to pay bribes.

Ultimately, EW and the DLA reached a settlement, as a result of the bankruptcy court's enforcement of EW'S claims against the DLA. EW paid its outstanding employment taxes out of the settlement, as well as penalties and interest.

EW brought suit to recover the penalties paid, arguing that the deficiency was due to reasonable cause and not willful neglect. In 1999, the district court held for the IRS and dismissed EW's challenge. The Court of Appeals (opinion Mansmann, J.) reverses: Reasonable cause existed for EW's failure to pay and deposit its employment taxes timely; thus, EW is entitled to an abatement of the penalties.

Under Secs. 6651(a)(1) and (2) and 6656(a), the Service imposes mandatory penalties for failure to file returns, pay taxes or deposit employment taxes in a government depository, unless a taxpayer can show that such failure was due to "reasonable cause" and not "willful neglect." Thus, to succeed in obtaining an abatement of penalties imposed under Secs. 6651 and 6656, a taxpayer bears the burden of establishing that the failure did not result from "willful neglect" and was due to reasonable cause.

Neither "willful neglect" nor "reasonable cause" is defined in the Code. A definition of "willful neglect" was provided by the Supreme Court in Boyle, 469 US 241 (1985), which found that the phrase "willful neglect"...