DATELINE: March 26, 2008, Chicago
Think nonprofit directors can’t be held monetarily liable? You might want to ask one Stephen K. Verret before you take to that thought to the bank. Figuratively speaking, he just withdrew $408,918.66 from that same bank to pay taxes, interest, and penalties owed to the United States Treasury. You see, the IRS went after Verret for unpaid trust taxes, claiming that as chairman of Dcotors Hosptial's board, Verret was a responsible person. On February 14, 2008 United States District Court Judge Marcia A. Crone granted...
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the IRS summary judgment, thereby denying Verret's request for a refund of taxes paid.
In our view, Judge Crone made a serious mistake in granting summary judgment. That isn’t to say that Verret ultimately shouldn’t be held liable, but we think there were serious questions of fact that warranted further review. Whatever the outcome of this particular case, it holds important lessons for all volunteer directors.
THE FACTS: Here are the salient facts: Community Health Care Foundation was a Section 501(c)(3) organization which operated Doctors Hospital. The court’s decision is unclear, which is surprising, but it appears that Doctors Hospital was a separate corporation. Verret had been a Doctors Hospital board member for twenty-six years. At the relevant times for purposes of this case, Verret served as chairman of the Doctors Hospital board.
Verret also had financial relationships with Doctors Hospital. His firm, Stoneburner-Verret Electric Company performed electrical services for Doctors Hospital on repeated occasions. Verret’s wife was employed by Doctors Hospital as its chief operating officer from January through March 1999. In 1999, NewCare Hospital Corporaiton contracted with Verret to assist with the recruitment of specialized physicians to staff a lucrative venture for the hospital. Verret devoted a significant amount of time to this endeavor, laboring between 22 and 30 hours a week during 2001. He received annual compensation for his efforts of somewhere between $70,000 and $80,000 per year.
Despite its best efforts, Doctors Hospital's financial situation steadily deteriorated. During the first part of 2001, David Cottey, Doctors Hospital's Executive Director, informed Verret and the Board that Doctors Hospital had failed to remit employment withholding taxes totaling approximately $400,000. The outstanding tax liability was ultimately satisfied with borrowed monies appropriated for the procurement of medical equipment. Cottey was informed by Verret, individually, and by the Board, collectively, however, that the payment of employment withholding taxes was of paramount importance and that, under no circumstances, should he fail to pay them again.
Unfortunately, Doctors Hospital’s financial condition continued to deteriorate. Contrary to his prior assurances, Cottey informed Verret and the board in November 2001 that the income and FICA taxes for the employees were delinquent for the third and fourth quarters of 2001. It is those unpaid taxes that gave rise to the dispute between the IRS and Verret.
THE LAW: The Internal Revenue Code requires employers to withhold income taxes from the wages of employees, as well as the employees' share of FICA and Medicare taxes. These are referred to as trust fund taxes because the employer withholds these taxes on behalf of the federal government. This can be a tempting pool of funds for employers who find themselves in financial difficulties. On more than a few occasions, employers have borrowed the trust fund taxes to pay other creditors, with the hope of repaying the loan when financial conditions improve. All too often, that doesn’t happen. To protect itself, the government relies on Section 6672(a) of the Internal Revenue Code, which provides that the IRS can collect unpaid trust fund taxes from so-called responsible persons. There can be multiple responsible persons. State liability shields and the Volunteer Protection Act do not protect volunteer directors and officers from this liability.
The question as to whether someone is a responsible person is a question of fact. Responsible persons may include employees, stockholders, sureties, lenders and others outside the formal corporate organization. Responsibility for collecting, accounting for, or paying over employee withholding taxes is a question of duty, status, and authority. In determining responsible person liability, the law disregards mechanical titles and functions of corporate officers and instead focuses on individuals who actually could have ensured the satisfaction of tax obligations. Among the factors that the 5th Circuit examines in determining whether someone is a responsible person are the following: (i) Is the person an officer or member of the board of directors? (ii) Does the person manage the organization's day-to-day operations? (iii) Does the person have the authority to hire or fire employees? (iv) Does the person make decisions as to the disbursement of funds and payment of creditors? and (v) Does the person possess the authority to sign organizaiton checks?
LESSONS: Rather than proceed through the opinion line by line, here are some of the lessons that various references in the opinion suggest:
A. The Bylaws Can Make a Difference. The Dcotors Hospitals's bylaws provided that the board may
delegate the management of the day-to-day operation of the Hospital to a management company or other person, provided that the business and affairs of the Corporation shall be managed and all corporate powers shall be exercised under the direction of the Board of Trustees. The Board of Trustees shall have final responsibility for Hospital administrative activities and professional services, for the operation of the Hospital and for the quality of patient care at the Hospital.
Although we suspect it probably won’t matter all that much if a court is predisposed to finding responsible person liability, language in the bylaws might prove less problematic if it focuses on oversight rather than management.
B. Avoid Day-to-Day Involvment in Management. There was evidence that in his capacity as chairman, Verret became involved in day-to-day management activities. For example, Verret negotiated the terms of a $500,000 loan for equipment. The court viewed this as an indication that Verret was in a position to focus on the trust fund taxes. In some nonprofits, board members will have this sort of hands-on involvement. There is nothing necessarily wrong with this, but those board members who do gravitate toward managerial activities should recognize that they can’t have it both ways. As managerial involvement increases, so does risk of being treated as a responsible person.
C. Involvement in Tax Compliance Can Pose a Problem. The court pointed to Verret’s involvement in the hospital’s tax compliance. He signed the Form 990 for 1999 and 2000. After learning of Cottey’s initial failure to remit Doctors Hospital's withholding taxes in June or July 2001, the Board began requesting that Cottey provide proof that the payroll taxes were paid. Such "proof" primarily included oral assurances and the presentation of financial statements to the Board with separate line item disclosure of tax liability. Individually, Verret personally instructed Cottey to pay the taxes before he paid anyone else.
There are a couple of lessons here. First, many more boards will be reviewing the Form 990 beginning in 2009 because of the new question that asks whether the board has reviewed the return. At that point, boards should specifically ask about whether the trust fund taxes have been paid, requesting proof.
Second, if an director or officer asks questions about whether taxes have been paid, they had better then make sure that the taxes are paid. In other words, no good deed goes unpunished.
D. Avoid Dual Roles, Particularly If One Results in Payments of Compensation. Those wanting to reduce potential exposure should avoid acting as both board members and persons who provide services to the organization for compensation. This clearly factored into the court’s decision. The court wrote:
The record also reveals that Verret, unlike other board members, spent a significant amount of time at Doctors Hospital. In 1999, the management company asked Verret to assist in recruiting physicians in the "industrial occupation business." Industrial occupation, according to Verret, provided a "new stream of revenue that healthcare facilities were looking at bringing on board. It took care of drug screens, workmen comp injuries, and normally a hospital would contract directly with an employer to provide services at some rate." Verret's new role, for which he was compensated between $ 70,000.00 and $ 80,000.00 per year as a consultant, demanded "[b]etween 22 and 30 hours a week" during 2001 alone. This required Verret to spend a significant amount of time at Doctors Hospital, frequently eating breakfast and lunch at the hospital. Such activities overlapped with his duties as Chairman and were oftentimes indistinguishable. Massey, who understood Verret's role solely to be Chairman of the Board, stated that she saw Verret at the hospital often and that he would stop by "almost every day" and "talk with David Cottey." Verret's involvement in the development of new cash flow strategies, frequent presence, and nearly daily discussions with the Executive Director further demonstrate his participation in the operations of Doctors Hospital.
E. Immediately Fire People Who Do Not Remit Trust Fund Taxes. If the person responsible for remitting fails to remit trust fund taxes on a timely basis they should be immediately fired unless the failure is a clerical error that is quickly corrected once it is discovered. The person charged with remitting trust fund taxes should annually acknowledge the policy in writing. The court makes it clear why such a strict policy is essential, stating:
Verret presents no evidence disputing the Board's ability to hire and fire employees. Verret's own deposition testimony states that the Board, for which Verret served as Chairman, voted to allow Cottey to continue as Executive Director in 2001 even after Doctors Hospital's management company, NewCare, filed for bankruptcy. Verret indicates that the Board discussed terminating Cottey's employment after it learned of his first failure to remit withholding taxes./6/ Additionally, Massey indicated that Verret and the Board could "get rid of [her] in a heartbeat, and . . . could get rid of David [Cottey] . . . if the need arose." Thus, this factor also weighs against Verret.
F. Think Twice About Accepting Signature Authority Over Checkbooks. Board members should be careful about accepting authority to sign checks. The court, in focusing on Verret's authority, wrote:
Finally, Verret's authority to sign company checks is also indicative of his status as a responsible person under the statute. Verret argues, however, that Doctors Hospital's checkbooks were located in a locked closet in the accounting department and that the record is devoid of any instances where Verret signed a check on the company's behalf. He maintains that check-writing authority rested with Cottey and his staff. Nevertheless, signature cards for each of Doctors Hospital's three bank accounts have been provided by the Government. Interestingly, although each account has four signatories, Verret is the only individual to be listed as a signatory on all three accounts. In fact, Verret's signature appears first on each signature card. There is no evidence that Verret ever requested and was denied access to the checkbooks in order to satisfy outstanding liabilities, including employment taxes. Massey, who had unrestricted access to the checkbooks, admitted that if a disagreement arose between Cottey and Verret, Verret would prevail as Chairman of the Board. While not conclusive, this factor weighs against Verret.
G. Board Members Shouldn't Put Their Heads in the Sand. If the organization is experiencing financial difficulties, board members cannot put their heads in the sand to avoid exposure. The court, in finding that Verret acted willfully in not taking more actions to make sure that the trust fund taxes were paid, worte:
It should have been clear to any responsible person in Verret's position that Doctors Hospital was in financial trouble. He "must have known how tempting it is for a floundering company to use the money that it has withheld from its employees' paychecks for purposes seemingly more urgent that paying taxes currently…." At the very least, Verret should have been cognizant of a grave risk that the payroll withholding taxes would not be remitted to the IRS after being informed of the second delinquency in November 2001…. Despite this patent risk, Verret, who had the actual authority to inquire and to correct any tax problems, admittedly did nothing of substance…. Although the court acknowledges that Verret did not possess great financial expertise, he did not even undertake the simple tasks of requesting cancelled checks documenting the tax payments or contacting the IRS to verify such payments.
H. Institute Internal Controls. The board should institute internal controls to make sure that trust fund taxes are timely remitted. It might consider asking the outside auditor to perform specific tests to assure that the taxes have been paid.
As we said, boards must do what they must do in terms of running organizations. Consequently, a board should never adopt a hands off approach to oversight simply to reduce potential liability. It can avoid any problems by affirmatively making sure that trust fund taxes are always paid.
In closing, we would like to point Section 6672(e) which provides a shield for voluntary board members who are serving in an honorary capacity. The board refused to extend its relief to Verret. It clearly took this position because Verret did receive compensation. However, the court's lanuage is relatively clear: It would not have extended Section 6672(e) protection to an uncompensated board member who performed the normal functions associated with board membership. As we have always asserted, board membership must truly be honorary before someone can invoke this provision.
Internal Revenue Service - Circular 230 Disclosure: As provided for in Treasury regulations, any advice (but none is intended) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.
THE FOREGOING IS NOT AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. IF LEGAL ADVICE IS REQUIRED, THE NONPROFIT OR OTHER PARTY IN QUESTION SHOULD SEEK THE ADVICE OF QUALIFIED LEGAL COUNSEL. If you liked this post, please visit http://www.charitygovernance.com for a description of our training and consulting services. You will also want to acquire a copy of Jack Siegel's book, A Desktop Guide for Nonprofit Directors, Officers, and Advisors: Avoiding Trouble While Doing Good."
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