Could a closely held corporation avoid negligence penalty when its treasurer secretly failed to file and pay CRS taxes while telling the other officers everything was current?

Subject

Fluorescent Technology International, Inc. (D&O 98-40)

Plain-English summary

Fluorescent Technology International, Inc. was a small, closely held New Mexico corporation with three officer-shareholders. Its treasurer, John McEown, was a Canadian chartered accountant and licensed trustee responsible for accounting, finance, and all federal and state tax filing and payment.

McEown prepared tax returns and financial statements and told the other officers that taxes were current. But after withdrawing approximately $25,000 and leaving for Canada, he called to say he would not return. A later Department nonfiler notice led the remaining officers to discover that McEown had not actually filed the prepared returns or paid any federal or state taxes.

The corporation promptly filed New Mexico CRS returns reporting $3,726.50 for first-quarter 1996, $3,779.35 for the second quarter, and $3,009.95 for the third quarter. It could not pay in full and sought a payment plan. The Department assessed penalty and interest. At the hearing, the company acknowledged its interest liability, leaving only negligence penalty in dispute.

Hearing Officer Margaret B. Alcock found that the other two officers, Jeffrey Dixon and Daryl Masters, acted responsibly. Given McEown's professional background and the business's short operating history, they reasonably relied on him and moved quickly once they learned the truth. The decision said that if the assessments had been issued against them personally, their penalties would have been abated.

The taxpayer, however, was the corporation. McEown was its treasurer and acted in a managerial capacity, so his failure to report and pay was an act of the company itself. The corporation could not reject his conduct while treating the other officers' later remediation as its own. The same attribution rule applied to small and large corporations. The negligence penalties were therefore proper, and the protest was DENIED.

What this means for you

• A managerial officer's tax failures can be imputed to the corporation. The treasurer's responsibility for all financial affairs made his conduct corporate conduct.
• Innocent co-owners do not automatically erase the company's penalty. Dixon and Masters reasonably relied on McEown, but the assessments ran against the corporation rather than against them individually.
• A closely held corporation was not given a special exception. The decision found no legal or policy basis to treat small corporations differently from large ones.
• Prompt correction helped show the innocent officers acted responsibly but did not undo the original corporate negligence. The company filed the missing returns and pursued a payment plan after discovery.
• Interest was not decided in the corporation's favor. The taxpayer acknowledged at hearing that it owed interest, so only penalty remained contested.

Key questions answered

Were Dixon and Masters personally negligent?
The Hearing Officer found they acted responsibly and said she would have abated penalty if the assessments had been issued against them individually.

Why was the corporation still negligent?
McEown was the treasurer with managerial responsibility for tax and financial affairs. His acts while managing those affairs were treated as acts of the corporation.

Did McEown's deception separate his conduct from the company?
No. The decision did not allow the corporation to disavow one officer's managerial conduct while relying on the other officers' corrective conduct as its own.

Did the company's small size change the attribution rule?
No. The taxpayer supplied no authority or policy reason for a closely held corporation to avoid penalties that would apply to a larger corporation.

Verbatim citations

The regulatory definition of negligence:

failure to exercise that degree of ordinary business care and prudence which reasonable taxpayers would exercise under like circumstances;

The decision on the innocent officers:

Had the assessments been issued against Mr. Dixon and Mr. Masters individually, I would have no hesitation in abating the penalty.

The corporate-attribution holding:

Mr. McEown's failure to report and pay New Mexico CRS taxes was as much an act of the corporation as Mr. Dixon's and Mr. Masters's later efforts to correct the problem.

The conclusion:

The Taxpayer was negligent in failing to pay its CRS taxes for the first, second and third quarters of 1996 in a timely manner, and the negligence penalty was properly imposed under Section 7-1-69(A), NMSA 1978.

Source

• Listing: New Mexico Decisions & Orders
• Decision post: Fluorescent Technology International, Inc.
• Decision PDF: D&O 98-40

Original ruling text

BEFORE THE HEARING OFFICER
OF THE TAXATION AND REVENUE DEPARTMENT
OF THE STATE OF NEW MEXICO

IN THE MATTER OF THE PROTEST OF
FLUORESCENT TECHNOLOGY INTERNATIONAL, INC. No. 98-40
ID NO. 02-277192-00 1
ASSESSMENT NOs. 2078950, 2078951 and 2078952

DECISION AND ORDER

A formal hearing on the Taxpayer's protest was held on July 16, 1998, before Margaret B.

Alcock, Hearing Officer. Fluorescent Technology International, Inc. ("Taxpayer") was represented by

Jeffrey A. Dixon and Daryl Masters, its corporate officers. The Taxation and Revenue Department

("Department"), was represented by Frank D. Katz, Chief Counsel. Based on the evidence in the

record and the arguments presented, IT IS DECIDED AND ORDERED AS FOLLOWS:

FINDINGS OF FACT

1. The Taxpayer is a small closely-held corporation doing business in New Mexico and is

registered with the Department for quarterly payment of gross receipts, compensating and withholding

taxes, which are reported under New Mexico's Combined Reporting System (CRS).

2. The Taxpayer was incorporated in March 1995 and began doing business in July

3. Until July 1996, Daryl Masters, Jeffrey A. Dixon and John McEown were the shareholders,

directors, officers and employees of the corporation: The three had previously been in business

together in Vancouver, Canada.

3. Mr. McEown was a chartered accountant in Canada, which is the equivalent of a

certified public accountant in the United States. Mr. McEown was also a licensed trustee, which is

the equivalent of a bankruptcy trustee in this country.

4. Mr. McEown was treasurer of the corporation and was responsible for the Taxpayer's

accounting and financial affairs, including the preparation, filing and payment of federal and state

taxes.

5. Mr. McEown prepared returns reporting the Taxpayer's unemployment taxes, federal

income taxes and New Mexico CRS taxes. Mr. McEown reported to Mr. Masters and Mr. Dixon

that all taxes were current and submitted financial statements showing that taxes had been paid.

6. In July 1996, the financial statements prepared by Mr. McEown showed a surplus in

the Taxpayer's bank account, and Mr. McEown withdrew approximately $25,000 to repay his share

of various expenses before he left on a vacation to Canada.

7. On July 25, 1996, a few days after leaving on his vacation, Mr. McEown called from

Canada to say he was not coming back to New Mexico and was resigning from his positions with the

corporation.

8. About a month later, the Taxpayer received a nonfiler notice from the Department

stating that no CRS-1 returns had been filed for the quarters ending March and June 1996.

9. After hiring an outside accountant and examining the Taxpayer's books and records,

Mr. Dixon and Mr. Masters determined that Mr. McEown had not actually filed the tax returns he

prepared, nor had he paid any of the Taxpayer's federal and state taxes.

10. On October 3, 1996, Mr. Dixon filed the Taxpayer's CRS-1 returns for the first,

second and third quarters of 1996, showing taxes due in the following amounts:

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Quarter ending March 1996: $ 3,726.50
Quarter ending June 1996: $ 3,779.35
Quarter ending September 1996: $ 3,009.95

Mr. Dixon included a letter explaining that the Taxpayer was currently unable to pay the taxes shown

on the reports and asking that a payment plan be established.

11. On October 17, 1996, the Department issued Assessment Nos. 2078950, 2078951 and

2078952 assessing penalty and interest on the unpaid balance shown on the Taxpayer's returns.

12. On November 26, 1998, Mr. Dixon requested a retroactive extension of time to file a

protest to the Department's assessments. An extension was granted, and on January 8, 1997, the

Taxpayer filed a formal protest to the penalty and interest assessed on its unpaid taxes.

13. On December 20, 1996, the Taxpayer paid $2,630.00 of back taxes under a four-month

payment plan entered into with the Department. The Taxpayer has been unable to make subsequent

payments due under the plan, but is continuing to work with the Department to pay off its outstanding

liability.

DISCUSSION

The Taxpayer's protest requested abatement of the penalty and interest assessed on its late

payment of CRS taxes for the first, second and third quarters of 1996. At the July 16, 1998 hearing,

Mr. Dixon acknowledged the Taxpayer's liability for payment of interest. The only issue remaining

in dispute is whether the Taxpayer is liable for the negligence penalty assessed under Section 7-1-

69(A) NMSA 1978 (1995 Repl. Pamp.), which imposes a penalty of two percent per month, up to a

maximum of 10 percent:

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in the case of failure, due to negligence or disregard of rules and
regulations, but without intent to defraud, to pay when due any amount
of tax required to be paid... 1

Taxpayer "negligence" for purposes of assessing penalty is defined in Regulation 3 NMAC 1.11.10

(formerly GR 69:3) as:

(1) failure to exercise that degree of ordinary business care and
prudence which reasonable taxpayers would exercise under like
circumstances;

(2) inaction by taxpayers where action is required;

(3) inadvertence, indifference, thoughtlessness, carelessness,
erroneous belief or inattention.

In this case, the Taxpayer's late payment of CRS taxes was due to Mr. McEown's failure to report and

pay taxes when due and his misrepresentations concerning the Taxpayer's financial condition, which

ultimately left the Taxpayer without sufficient funds to pay current taxes. Under the facts presented,

Mr. McEown's conduct may well have amounted to fraud. Without question, his actions come within

the definition of negligence set out in the Department's regulations.

Mr. Dixon and Mr. Masters argue that they reasonably relied on Mr. McEown to handle the

Taxpayer's financial affairs and should not be held liable for his negligence. They point out that Mr.

McEown was a licensed accountant and trustee and had fulfilled his financial duties in their Canadian

business in a responsible manner. Based on Mr. McEown's representations and the financial statements

he prepared, Mr. Dixon and Mr. Masters had no reason to suspect that taxes were not being paid in a

timely manner. As soon as they discovered the problem, they acted promptly to bring the Taxpayer's

CRS filing current and try to work out a payment plan.

1
Section 7-1-69 was amended effective July 1, 1996. The amendment did not change the quoted language of
Subsection A, which was taken from the 1995 Replacement Pamphlet.

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In closing argument, the Department acknowledged that it has abated the negligence penalty in

some cases involving embezzlement or other illegal acts of a taxpayer's employees. The Department

did not abate penalty in this case because the law treats the conduct of corporate officers differently

than the conduct of lower level employees when determining whether a corporation is liable for

penalties. This distinction goes back to the 1800s. In Lake Shore & Michigan Southern Railway

Company v. Prentice, 147 U.S. 101 (1893), the United States Supreme Court held that a railroad was

not liable for punitive damages for the illegal conduct of one of its conductors. The Court differentiated

between the actions of a corporate officer "wielding the whole executive power" of the corporation and

the actions of an employee or subordinate agent. The conduct of the corporation's president or vice

president

may well be treated as so far representing the corporation and identi-
fied with it that any wanton, malicious, or oppressive intent of his, in
doing wrongful acts in behalf of the corporation to the injury of others,
may be treated as the intent of the corporation itself; but the conductor
of a train, or other subordinate agent or servant of the railroad
corporation, occupies a very different position...."

147 U.S. at 114. In Coulliard v. Bank of New Mexico, 89 N.M. 179, 548 P.2d 459 (Ct. App. 1976), the

New Mexico Court of Appeals applied the Lake Shore approach to hold that the Bank of New Mexico

was not liable for punitive damages for the fraudulent conduct of a corporate officer who did not

represent "the whole executive power" of the bank. In the later case of Cornell v. Albuquerque

Chemical Co., Inc., 92 N.M. 121, 126, 584 P.2d 168, 173 (Ct. App. 1978), the court reached the

opposite result, finding that the defendant's vice president "wielded the executive power of the

corporation" and that his wrongful acts "were the acts of defendant."

In 1994, the New Mexico Supreme Court expressly rejected the rule that a corporation can be

held liable for punitive damages only for the conduct of officers or agents who wield the "whole

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executive power" of the corporation. In Albuquerque Concrete Coring Company, Inc. v. Pan Am

World Services, Inc., 118 N.M. 140, 146, 879 P.2d 772, 778 (1994), the court adopted the broader rule

set out in Section 217(C) of the Restatement (Second) of Agency, holding that liability for punitive

damages can be based on evidence that the wrongdoer was acting in a managerial capacity: "When a

corporate agent with managerial capacity acts on behalf of the corporation...his acts are the acts of the

corporation; the corporation has participated."

Reviewing the evidence in this case, I find that Mr. Dixon and Mr. Masters acted responsibly in

their roles as directors and corporate officers. Given Mr. McEown's financial training, it was

reasonable for them to rely on his expertise. The business was in operation barely a year when Mr.

McEown resigned. This was not so long a period that the other officers should be considered negligent

for failing to discover the Taxpayer's accounting problems. Had the assessments been issued against

Mr. Dixon and Mr. Masters individually, I would have no hesitation in abating the penalty. In this case,

however, the assessments were issued against the corporation—not against its individual officers and

directors.

Until July 1996, the Taxpayer had three corporate officers. There is no question that John

McEown, as treasurer, acted for the Taxpayer in a managerial capacity. Mr. McEown's failure to

report and pay New Mexico CRS taxes was as much an act of the corporation as Mr. Dixon's and Mr.

Masters's later efforts to correct the problem. Although Mr. Dixon argues that the test used to

determine corporate liability should not apply to small closely-held corporations, he has not provided

legal authority to support this position. Nor is there any apparent policy reason for holding that a large

corporation is liable for penalties arising out of the misconduct of its corporate officers while a small

corporation is not. The law does not allow the Taxpayer to disavow the actions of one corporate officer

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and ask the Department to make its determination of negligence based solely on the actions of the other

two. The Taxpayer is liable for penalties attributable to the negligent acts of Mr. McEown.

CONCLUSIONS OF LAW

1. The Taxpayer filed a timely, written protest to Assessment Nos. 2078950, 2078951 and

2078952, and jurisdiction lies over the parties and the subject matter of this protest.

2. The Taxpayer was negligent in failing to pay its CRS taxes for the first, second and

third quarters of 1996 in a timely manner, and the negligence penalty was properly imposed under

Section 7-1-69(A), NMSA 1978.

For the foregoing reasons, the Taxpayer's protest IS DENIED.

DONE, this 21st day of July 1998.

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