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General Partner Can't Use State Law to Escape Partnership's Federal Tax Debt.
(Parker Tax Publishing September 10, 2014)

In 2004, the Supreme Court resolved numerous issues relating to general partner liability for unpaid partnership tax debts. However, in U.S. v. Galletti, 541 U.S. 114 (2004), the Court left unresolved several key issues. For example, when a general partnership fails to pay required federal taxes, how can the IRS recover those obligations from general partners? Can the IRS file liens against the general partner's personal property? And which statute of limitations applies federal or state? Those issues were squarely before a California district court in In re Wendy K. Pitts, 2014 PTC 420 (C.D. Calif. 8/12/14), where a partnership's general partner appealed a bankruptcy court decision holding that liens filed by the IRS against her personal property were valid because she was liable for the partnership's employment tax debts under state law.


Wendy Pitts was a general partner of DIR Waterproofing, a California general partnership. In March 2012, Wendy filed for Chapter 7 bankruptcy in a California bankruptcy court. As of that date, DIR had unpaid Federal Insurance Contribution Act (FICA) taxes and unpaid Federal Unemployment Tax Act (FUTA) taxes for various quarters in 2005, 2006, and 2007. DIR also had unpaid penalties under Code Sec. 6721 for filing its 2005 Form 1065 late and intentionally failing to file correct return information. In total, DIR failed to pay over $106,000 and $2,000 in FICA and FUTA taxes, respectively, and almost $3,000 in late-filing penalties.

Between 2007 and 2008, the IRS recorded a total of four Notices of Federal Tax Liens (NFTLs) naming DIR and Wendy. The IRS identified Wendy as a DIR partner on the NFTLs and the NFTLs encumbered Wendy's property. In June and August of 2007, the IRS issued Notices of Federal Taxes Due naming DIR as the taxpayer and Wendy as a partner.

In May 2012, Wendy filed an adversary proceeding against the IRS to determine (1) the dischargeability of debts under Bankruptcy Code Section 523, (2) the nature, extent, and validity of liens under Bankruptcy Code Section 506, and (3) whether the IRS violated the discharge injunction in Bankruptcy Code Section 524. In June of 2012, Wendy received a bankruptcy discharge.

As of June 2013, DIR still owed almost $115,000 in tax debt plus unassessed interest. But the IRS never assessed DIR's taxes against Wendy. The IRS also never brought a judicial action against Wendy. Wendy and the IRS both filed motions for summary judgment in the bankruptcy court and, in October 2013, the bankruptcy court issued a judgment in favor of the IRS. The court included a detailed table determining which taxes and amounts were dischargeable under Bankruptcy Code 523 and concluded that the IRS's NFTLs against Wendy's property were valid and perfected and that the IRS did not violate the discharge injunction under Bankruptcy Code 524. Wendy appealed the decision.

General Rule for Liability for Employment Taxes

Under Code Sec. 3402, an employer is required to deduct and withhold employment taxes from the wages it pays its employees. The employer is then liable, under Code Sec. 3403, for paying those withholdings to the IRS. Code Sec. 6672(a) provides that any person required to collect, account for, and pay over any tax required by the Code who willfully fails to do so is liable for a penalty equal to the tax amount (i.e., the "responsible person" penalty). Code Sec. 6672(b) sets forth a notice system and a three-year statute of limitations. Under Code Sec. 6502(a)(1), if the IRS assesses a tax to a responsible person within three years, the IRS then has 10 years from the assessment date to collect the tax.

Arguments Before the District Court

The question presented to the district court was whether a general partner of a partnership that failed to pay several employment taxes could invalidate liens filed against the partner's personal property and discharge any tax liability stemming from the partnership as a result of the nonpayment of employment taxes.

Wendy's arguments before the district court centered on the notion that, since California law created her liability for DIR's debts, the IRS could not use federal remedies against her. Wendy also argued that the federal tax collection statute of limitations did not apply.

Wendy admitted that she was liable for DIR's obligations as a general partner per California partnership law. But the threshold issue she raised was whether she was liable under the Internal Revenue Code for DIR's unpaid employment tax withholdings and thus subject to the Code's collection remedies. Wendy argued that in U.S. v. Galletti, 541 U.S. 114 (2004), the Supreme Court held that a general partner is not a "taxpayer" with respect to payroll tax withholding liabilities of a general partnership under Code Sec. 3403. She therefore contended that the IRS cannot rely on Code Sec. 3403 to create her liability for DIR's tax debts.

According to Wendy, the IRS's whole administrative-enforcement scheme depends on the creation of liability under Code Sec. 6321 the statute automatically creating tax liens for unpaid tax debts. She asserted that because she is not the "taxpayer" liable for the employment tax withholdings under Code Sec. 3403, she cannot be held liable for them under federal, as opposed to state, law. She noted several Code sections that created secondary liability for tax obligations and argued that since none of those sections applied to her, she was not secondarily liable under federal law for DIR's Code Sec. 3403 debts and, thus, not subject to federal administrative enforcement.

Wendy also argued that the IRS had two main ways of making her liable: either under federal or state law. To make her a responsible party under Code Sec. 6672, Wendy asserted that the IRS had to separately assess her within the applicable three-year statute of limitations period. Since it was undisputed that the IRS never assessed Wendy's tax liability, she argued that she was not responsible for DIR's tax debt under federal law. Additionally, she contended that since general partners are not "taxpayers" under Code Sec. 3403, the IRS cannot separately assess them when it assesses the partnership for those tax withholdings.

The IRS argued that, once the IRS assesses a tax against a general partnership, it need not separately assess the general partners to make them liable. According to the IRS, since Wendy was liable for DIR's debts under California law, the tax assessment against DIR for its unpaid employment tax withholdings suffices to create a tax debt owed by Wendy to the IRS.

District Court's Decision

The district court held that Wendy was liable for the general partnership's federal employment taxes. The court also found that the federal tax collection statute of limitations applied, and that the bankruptcy court did not err in finding that certain of Wendy's tax debts were nondischargeable.

The court noted that, in U.S. v. Galletti, 541 U.S. 114 (2004), the Supreme Court specifically left open the issue of whether the IRS may use administrative collection procedures to collect a tax debt from a general partner. However, the district court observed, the Supreme Court in Galletti already weighed in on many issues relevant to Wendy's appeal. Interpreting Code Sec. 3403, the Supreme Court held that the "employer" liable for paying the tax withholdings to the IRS is the general partnership. The Court rejected the argument that imposing a tax on the general partnership was equivalent to imposing a tax directly on the general partners. In other words, the Court said, the general partners are not primarily liable for the tax because under California Corporations Code Section 16201, a general partnership is an entity distinct from its partners. However, the district court noted, the Supreme Court went on to hold that the general partners may be secondarily liable for the general partnership's Code Sec. 3403 tax debts by operation of state lawall without a separate tax liability assessment. According to the Supreme Court, once a tax has been properly assessed, nothing in the Code requires the IRS to duplicate its efforts by separately assessing the same tax against individuals or entities who are not the actual taxpayers but are, by reason of state law, liable for payment of the taxpayer's debt. This is true, the Supreme Court observed, because the assessment attaches to the debt without reference to the special circumstances of the secondarily liable parties. In sum, the district court noted, Galletti stands for the proposition that once the IRS assesses a general partnership for employment tax withholding liability under Code Sec. 3403, the 10-year statute of limitations for collection runs against the partners without separate assessment.

After Galletti, the district court stated, it is clear that the IRS may proceed via one of at least two paths to hold a general partner liable for the general partnership's tax liabilities under Code Sec. 3403. First, the IRS may assess the general partner under Code Sec. 6672(b) by giving the partner proper notice thereby making the partner a responsible person. Once the IRS complies with Code Sec. 6672(b), the general partner is then liable for the tax assessed in the partner's own right, i.e., the partner is primarily liable for the employment tax withholdings.

Second, the district court noted, the IRS can take a different route. The IRS can instead bypass Code Sec. 6672 by invoking state law to establish the general partner's liability for the general partnership's Code Sec. 3403 tax obligation. Since the general partnership is the "employer" for Code Sec. 3403 purposes, the district court concluded that the IRS need not comply with Code Sec. 6672(b) by separately assessing the general partner. The end result from either path, the court noted, is that the general partner becomes liable for the general partnership's Code Sec. 3403 employment tax withholding liability.

The district court concluded that when the IRS seeks to hold a general partner liable via state law for a general partnership's Code Sec. 3403 tax liability, the general partner is liable for a federal tax obligation. Since the underlying obligation (i.e., employment-tax withholdings under Code Sec. 3403) arose under federal law, the district court found Wendy liable under federal law.

The district court then addressed the statute of limitations argument, noting that Wendy's case presented another gap left open by the Supreme Court in Galletti: Which statute of limitations applies to the IRS's administrative collection efforts.

The court noted that California law provides conflicting statute of limitations provisions. However, the IRS argued that the collection of federal taxes is a sovereign function and state collection statutes cannot constrain the IRS's ability to collect taxes. Thus, a conflict in state statute of limitations provisions does not matter because the federal 10-year limitations period should apply. The district court agreed, citing the Supreme Court's decision in U.S. v. Summerlin, 310 U.S. 414 (1940), where the Court held that the federal government is not bound by state statutes of limitation in enforcing its rights.

The district court thus concluded that, when the IRS seeks to hold a general partner secondarily liable via state law for unpaid employment tax withholdings under Code Sec. 3403, the 10-year statute of limitations for collections applies if the IRS has already validly assessed the general partnership within Code Sec. 6672(b)(3)'s three-year statute of limitations. Stated differently, the court said, a state statute of limitations relating to secondary tax liability cannot cut off the IRS's right to collect tax from a general partner within 10 years of a valid assessment against the general partnership. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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