East Wind Industries, Inc. v. United States

Opinions of the United
1999 Decisions States Court of Appeals
for the Third Circuit

11-16-1999

East Wind Ind Inc. v United States
Precedential or Non-Precedential:

Docket 99-5116

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Filed November 16, 1999

UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT

No. 99-5116

EAST WIND INDUSTRIES, INC.;
DELAWARE EAST WIND, INC.

v.

UNITED STATES OF AMERICA

(District of New Jersey (Trenton) Civil 97-2615)

DELAWARE EAST WIND, INC.

v.

UNITED STATES OF AMERICA

(District of New Jersey (Trenton) Civil 97-2617)

(East Wind Industries, Inc.,

Appellant

Appeal from the United States District Court
for the District of New Jersey
District Judge: Honorable Mary Little Cooper

ARGUED
September 13, 1999

Before: MANSMANN, McKEE and STAPLETON,
Circuit Judges.

(Filed November 16, 1999)
 Lowell E. Mann, Esquire (Argued)
Gretchen S. Kolb, Esquire
Mann Law Associates
One Oxford Valley
Suite 850
Langhorne, PA 19047

COUNSEL FOR APPELLANT

Loretta C. Argrett
Assistant Attorney General
Kenneth L. Greene, Esquire
Jeffrey R. Meyer, Esquire (Argued)
United States Department of Justice
Tax Division
P.O. Box 502
Washington, DC 20044

Of Counsel:

Faith S. Hochberg
United States Attorney

COUNSEL FOR APPELLEE

OPINION OF THE COURT

MANSMANN, Circuit Judge:

This appeal arises out of a judgment of the United States
District Court for the District of New Jersey granting the
Government's motion for summary judgment and denying
the Taxpayers' cross-motion for summary judgment in their
action seeking a refund of tax penalties. The Taxpayers
contended before the District Court, as well as on appeal,
that reasonable cause existed for the late payment and
deposit of employment taxes under 26 U.S.C. #8E8E # 6651(a)(2)
and 6656(a), respectively and, therefore, they are entitled to
an abatement of the penalties assessed under those
provisions. The District Court, relying on the bright line test
set forth in Brewery, Inc. v. United States, 33 F.3d 589 (6th
Cir. 1994), that financial difficulties alone can never
constitute reasonable cause for abatement of a penalty
assessed pursuant to sections 6651 and 6656 of the

2
Internal Revenue Code, concluded that reasonable cause
was not established by the Taxpayers because financial
distress was the only fact and circumstance supporting
their failure to pay and deposit employment taxes timely.

Because we believe the Brewery bright line test is
inconsistent with both Congress' creation of a reasonable
cause exception and Treas. Reg. S 301.6651-1(c)(1), we find
that the District Court erred as a matter of law in adopting
the bright line rule in Brewery. We believe the better
reasoned approach is the one set forth in Fran Corp. v.
United States, 164 F.3d 814 (2d Cir. 1999), which requires
us to examine all the facts and circumstances of the
Taxpayers' financial situation. After reviewing all of the
facts and circumstances, we have concluded that
reasonable cause existed for the Taxpayers' failure to pay
and deposit their employment taxes timely. Thus, we will
reverse the judgment of the District Court and enter
judgment for the Taxpayers.

I.

The following facts are undisputed and have been largely
stipulated to by the parties. East Wind Industries, Inc.
("East Wind") and Delaware East Wind, Inc. ("Delaware East
Wind") (collectively referred to as the "Taxpayers") were
incorporated under the laws of Delaware in 1966. At all
relevant times, East Wind manufactured military clothing
and goods for sale to the United States Department of
Defense ("USDOD"). From 1982 through 1986, Delaware
East Wind operated as a holding company that owned the
manufacturing plant of East Wind. Consequently, East
Wind paid rents to Delaware East Wind for the
manufacturing plant. Delaware East Wind began to bid on
government contracts when East Wind ceased operations in
1986. All business activities of the Taxpayers were
controlled by Mario D'Antonio, Vice-President of East Wind.

The Taxpayers manufactured the military clothing and
goods for purchase by the federal government through its
Defense Personnel Support Center ("DPSC"), and the
Defense Contract Administration Services ("DCAS") agency
administered the contracts.1 Both DPSC and DCAS are
_________________________________________________________________

1. The DPSC is the Defense Department supply center located in
Philadelphia, Pennsylvania, responsible for the purchase and

3
branches of the Defense Logistics Agency ("DLA")
(collectively referred to as the "Defense Agencies"). All of the
Taxpayers' contracts went through these Defense Agencies.
Any other defense departments for whom the Taxpayers
could have manufactured goods were administratively
handled by DCAS.

From 1966 through 1981, East Wind had a 15-year
history of obtaining and completing government contracts.
During that same period, the Taxpayers had a history of
timely filing payroll tax returns and paying their
withholding taxes. Beginning with the tax period ending
June 30, 1982, through the tax period ending December
31, 1986, (the "periods in question"), East Wind timely filed
all of the appropriate tax returns but failed to pay its
employment withholding taxes when such taxes became
due and owing. Beginning with the tax period ending
December 31, 1986, through the tax period ending June
30, 1988, (the "periods in question"), Delaware East Wind
timely filed all of the appropriate tax returns but failed to
pay its employment withholding taxes when such taxes
became due and owing. The Taxpayers ultimately paid their
delinquent employment taxes in full and certain penalties
owing to the Internal Revenue Service ("IRS" or "Service")
pursuant to a reorganization plan approved by the
Bankruptcy Court.2

As early as 1976, certain employees at the Defense
Agencies began soliciting illegal bribes from the Taxpayers.
Initially, these bribes were in the nature of certain favors to
be provided by the Taxpayers, such as assisting an
employee of the Defense Agencies in obtaining a mortgage
or in gaining admittance to a certain school for a son or
_________________________________________________________________

distribution of food, clothing and medical supplies for the armed forces
of the United States. The DCAS is responsible for contract management,
quality assurance and financial management of contracts awarded by
USDOD supply centers, such as DPSC. As part of its responsibilities,
DCAS oversees the performance of contracts to assure compliance with
contract terms and USDOD regulations through a network of regional
offices and management areas.

2. The parties disagree as to the exact amount of the penalties paid by
the Taxpayers. This issue is irrelevant for purposes of this appeal.

4
daughter. Eventually, the bribes being solicited took the
form of monetary compensation. The amount demanded by
these corrupt employees amounted to 50% of the
Taxpayers' business. When the Taxpayers declined to pay
the bribes, they did not receive new contracts from the
Defense Agencies unless they were the only bidder on a
particular contract. As a result of refusing to pay the illegal
bribes to the corrupt employees of the Defense Agencies
during the periods in question, (1) the Taxpayers were not
paid monies due and owing to them for work which was
successfully performed and for goods delivered to and
accepted by the Defense Agencies; (2) payments were
intentionally and substantially delayed; (3) inventory was
wrongfully rejected and (4) orders were required to be
reworked according to the "trumped up" false specifications
of the government inspectors. The Defense Agencies did,
however, make some contract payments to the Taxpayers
after they refused to pay the bribes. Moreover, the
Taxpayers were awarded some additional contracts by the
Defense Agencies during this time period, but only when
the other companies who were paying off the corrupt
employees had not bid on the contract.

The Taxpayers attempted to put a stop to the bribery
activities of the Defense Agencies' employees by contacting
the DPSC legal staff in August, 1984, the Commanding
Officer, DCASMA -- Philadelphia, in August, 1983, Quality
Assurance -- DCASR, and their Congressman. The
Taxpayers expected that in doing so, they would mitigate
the negative economic effect on their business.
Unfortunately, the Taxpayers' expectations were unrealistic.

East Wind's Vice-President Mario D'Antonio consulted
with several professionals regarding financial and legal
concerns in light of the bribery and cash flow problems. In
particular, he consulted with accountants regarding such
matters as cash flow, payables, cash conservation, payroll,
personal loans and payment of taxes. He also consulted
with attorneys regarding such legal matters as the
collection of receivables, forwarding claims against the
government, analyzing legal strategies to maintain the
company, debtor's rights, and legal responsibility for taxes.
D'Antonio also consulted with other manufacturers to learn

5
how they responded to the bribery demands in order to
determine how to proceed with the Taxpayers' business
given the illegal action of the employees of the Defense
Agencies. Moreover, D'Antonio and his wife took out
numerous personal loans, including a mortgage on their
personal residence, to provide additional cash to pay
essential employees, those creditors who were threatening
to cut off their services, or to pay some of the payroll taxes.

As a consequence of the Defense Agencies' actions in
response to the refusal to pay the illegal bribes, the
Taxpayers sustained monetary damages in an amount in
excess of $5.1 million. Subsequently, the Taxpayers
asserted claims against the Defense Agencies to recoup
their damages.3 In addition, the Taxpayers brought tort
claims against the Defense Agencies.

In 1984, East Wind and Delaware East Wind filed
separately for protection under Chapter 11 of the
Bankruptcy Code. During the periods in question, Delaware
East Wind timely filed its payroll tax returns but continued
to accrue employment tax liabilities until it ceased
operations in 1988. The claims register in the Bankruptcy
Court substantiates that the Taxpayers had not been
paying amounts owed to their suppliers and other creditors
during the periods in question.

The certified public accountant ("CPA") appointed by the
Bankruptcy Court noted that the cash flow of a company
such as the Taxpayers' is essentially within the inventory.
Inventories in the amount of $750,000, which had been
wrongfully rejected by the Defense Agencies, remained in
the Taxpayers' warehouse.4 The CPA found that the
Taxpayers' employees were compensated on an hourly basis
at little more than the minimum wage and, without that
_________________________________________________________________

3. Claims made by the Taxpayers against the Defense Agencies included
matters brought before the Armed Services Board of Contract Appeals
("ASBCA"). One such dispute arose between the parties with regard to an
unexecuted written settlement agreement concerning the claim, which
agreement was enforced against the Government by the Bankruptcy
Court.

4. The inventory was eventually reworked by the Taxpayers for which
they received payment.

6
pay, would have left the Taxpayers' employ. In the CPA's
opinion, the Taxpayers would have had to shut down
operations without these employees. Nonetheless, between
1982 and 1988, D'Antonio had to lay off a substantial
number of employees because the Taxpayers were not being
awarded any new contracts. The reduction in employees
was reflected in the payroll tax returns for the successive
periods.

Late in 1984, D'Antonio was approached by the Federal
Bureau of Investigation ("FBI") and was asked to cooperate
in an investigation of the corrupt employees of the Defense
Agencies. D'Antonio went undercover for the FBI in 1985 in
order to gather information on the Defense Agencies'
employees involved in the bribery scheme and worked with
the FBI for a period of two years. During this time, the FBI
instructed the Taxpayers when to pay and when not to pay
bribes to top-ranking employees of the Defense Agencies.
Moreover, D'Antonio withdrew the Taxpayers from
competitive bidding on DPSC procurements which were
tainted by corrupt DPSC contractors and their consultants
in order to expose this criminal misconduct. D'Antonio's
cooperation with the FBI far exceeded the Initial
Memorandum of Understanding as to his participation in
the undercover investigation. For his part in the illegal
procurement activities, D'Antonio pled guilty to two counts
of violating the False Claims Act, 18 U.S.C. S 287. He paid
$2,000 in fines but was not sentenced to a period of
incarceration.

A global settlement agreement was reached between the
Taxpayers and the Defense Agencies as a result of the
Bankruptcy Court's enforcement of the Taxpayers' claims
against the Defense Agencies. The Taxpayers received a
total of $2.1 million from the Defense Agencies, $1.3 million
of which was paid to East Wind and $800,000 of which was
paid to Delaware East Wind. Out of this settlement, which
was administered by the Bankruptcy Court, the Taxpayers
paid all of the outstanding employment taxes, as well as
penalties and interest, to the IRS.

Thereafter, the Taxpayers commenced this suit in the
District Court seeking a refund of the penalties assessed
and paid on the delinquent employment taxes. The

7
Taxpayers alleged they were entitled to an abatement of the
penalty because the delinquency was due to reasonable
cause and not due to willful neglect. The matter was
submitted to the District Court on cross-motions for
summary judgment. On January 15, 1999, the District
Court granted summary judgment in the Government's
favor and dismissed the Taxpayers' summary judgment
motion as moot. See East Wind Industries, Inc. v. United
States, 33 F.Supp.2d 339 (D. N.J. 1999).

The Taxpayers filed this timely appeal. We have
jurisdiction pursuant to 28 U.S.C. S 1291.

II.

The issue before us is whether the District Court erred in
applying the bright line test set forth in Brewery, Inc. v.
United States, 33 F.3d 589, 592 (6th Cir. 1994), that
financial difficulties per se can never constitute reasonable
cause for abatement of a penalty assessed pursuant to
sections 6651 and 6656 of the Internal Revenue Code, in
light of the pertinent statutory language and Treasury
Regulations thereunder. If we determine that the District
Court erred in applying the Brewery standard, then we
must also consider whether, based upon all the facts and
circumstances, the Taxpayers' failure to pay their
employment taxes timely was due to reasonable cause and
not willful neglect pursuant to sections 6651 and 6656 of
the Internal Revenue Code and the Treasury Regulations
thereunder.

We exercise de novo review over the District Court's order
granting the Government's motion for summary judgment.
Greenberg v. United States, 46 F.3d 239, 242 (3d Cir. 1994)
(citing United States v. Carrigan, 31 F.3d 130, 133 (3d Cir.
1994)). De novo review requires us to apply the same test
used by the District Court, "namely, whether there is `no
genuine issue as to any material fact and that the moving
party is entitled to a judgment as a matter of law.' " Tolchin
v. Supreme Court of the State of New Jersey, 111 F.3d
1099, 1106 (3d Cir. 1997) (quoting Fed.R.Civ.P. 56(c))
(other citation omitted). Thus, we must review all of the
facts and inferences in the light most favorable to the

8
Taxpayers in order to determine whether there is a genuine
issue of material fact. Greenberg, 46 F.3d at 242. If we find
that no genuine issue of material fact remains, then we
must determine whether the Government is entitled to
judgment as a matter of law. Id.

A determination of the elements required to prove that
failure to pay employment taxes was due to reasonable
cause is a question of law subject to plenary review. United
States v. Boyle, 469 U.S. 241, 249 n. 8 (1985) (citations
omitted). Whether the required elements are present in a
particular case is a question of fact which we review for
clear error. Id.

A.

Under sections 6651(a)(1), (a)(2) and 6656(a) of the
Internal Revenue Code of 1986, as amended (the "Code" or
"IRC"), the Service imposes mandatory penalties for the
failure to file returns, pay taxes, or deposit employment
taxes in a government depository unless the taxpayer can
show that such failure was due to "reasonable cause" and
not due to "willful neglect." Thus, to succeed in obtaining
an abatement of penalties imposed under sections 6651
and 6656, the taxpayer bears the heavy burden of
establishing that (1) the failure did not result from "willful
neglect," and (2) the failure was "due to reasonable cause."
United States v. Boyle, 469 U.S. 241, 245 (1985) (citing IRC
S 6651(a)(1)). Neither "willful neglect" nor "reasonable
cause" is defined in the Code.

A definition of "willful neglect" was provided by the
Supreme Court in Boyle, which found that the phrase
"willful neglect," as used in section 6651(a)(1), had been
construed over the years to mean "a conscious, intentional
failure or reckless indifference."5 Id. (citations omitted).
_________________________________________________________________

5. The Court's analysis in Boyle addressed penalties for failure to file
tax
returns under section 6651(a)(1). The language concerning the standard
for failure to file a return is identical to the language in sections
6651(a)(2) and 6656 for failure to pay and to deposit. We see no reason
why the Court's analysis under section 6651(a)(1) should not guide our
analysis of sections 6651(a)(2) and 6656.

9
Stated another way, the taxpayer must show that the
failure to file a return timely was the result"neither of
carelessness, reckless indifference, nor intentional failure."
Id. at 246 n. 4.

The Treasury Regulations provide an explanation of the
other required element, "reasonable cause":

If the taxpayer exercised ordinary business care and
prudence and was nevertheless unable to file the
return within the prescribed time, then the delay is due
to a reasonable cause. A failure to pay will be
considered to be due to reasonable cause to the extent
that the taxpayer has made a satisfactory showing that
he exercised ordinary business care and prudence in
providing for payment of his tax liability and was
nevertheless either unable to pay the tax or would
suffer an undue hardship (as described in S 1.6161-1(b)
of this chapter) if he paid on the due date. In
determining whether the taxpayer was unable to pay
the tax in spite of the exercise of ordinary business care
and prudence in providing for payment of his tax
liability, consideration will be given to all the facts and
circumstances of the taxpayer's financial situation,
including the amount and nature of the taxpayer's
expenditures in light of the income (or other amounts)
he could, at the time of such expenditures, reasonably
expect to receive prior to the date prescribed for the
payment of the tax. Thus, for example, a taxpayer who
incurs lavish or extravagant living expenses in an
amount such that the remainder of his assets and
anticipated income will be insufficient to pay his tax,
has not exercised ordinary business care and prudence
in providing for the payment of his tax liability.
Further, a taxpayer who invests funds in speculative or
illiquid assets has not exercised ordinary business care
and prudence in providing for the payment of his tax
liability unless, at the time of the investment, the
remainder of the taxpayer's assets and estimated
income will be sufficient to pay his tax or it can be
reasonably foreseen that the speculative or illiquid
investment made by the taxpayer can be utilized (by
sale or as security for a loan) to realize sufficient funds

10
 to satisfy the tax liability. A taxpayer will be considered
to have exercised ordinary business care and prudence
if he made reasonable efforts to conserve sufficient
assets in marketable form to satisfy his tax liability
and nevertheless was unable to pay all or a portion of
the tax when it became due.

Treas. Reg. S 301.6651-1(c)(1) (emphasis added). The term
"undue hardship," for purposes of determining whether
"reasonable cause" has been established, has been defined
as follows:

The term "undue hardship" means more than an
inconvenience to the taxpayer. It must appear that
substantial financial loss, for example, loss due to the
sale of property at a sacrifice price, will result to the
taxpayer for making payment on the due date of the
amount with respect to which the extension is desired.
If a market exists, the sale of property at the current
market price is not ordinarily considered as resulting
in an undue hardship.

Treas. Reg. S 1.6161-1(b).

Moreover, in determining whether a taxpayer has
exercised "ordinary business care and prudence" in
providing for the payment of its tax liability, courts must
consider the nature of the delinquent tax. The regulations
specifically provide that:

In determining if the taxpayer exercised ordinary
business care and prudence in providing for the
payment of his tax liability, consideration will be given
to the nature of the tax which the taxpayer has failed
to pay. Thus, for example, facts and circumstances
which, because of the taxpayer's efforts to conserve
assets in marketable form, may constitute reasonable
cause for nonpayment of income taxes may not
constitute reasonable cause for failure to pay over
taxes described in section 7501 that are collected or
withheld from any other person.

Treas. Reg. S 301.6651-1(c)(2).

The taxes that the Taxpayers failed to pay to the IRS
timely were section 7501 taxes. Under IRC S 7501,

11
employers are required to collect or withhold the employee's
portion of employment taxes as salaries are disbursed.
These taxes are commonly referred to as "trust fund taxes"
because the amounts withheld from employees' wages or
salaries for employment taxes are to be held in a special
fund in trust for the United States.

The parties disagree as to the appropriate legal standard
to be applied to determine reasonable cause, as well as to
the application of that standard to the facts and
circumstances here. The Taxpayers maintain that their
failure to pay taxes and make deposits on time was due to
the fraudulent criminal activities of top officials at the
Defense Agencies which so permeated the DLA that despite
their ordinary business care and prudence, they were
disabled and could not pay the payroll taxes when due
without suffering undue hardship. The Taxpayers challenge
the District Court's refusal to consider any financial
difficulties in determining whether reasonable cause had
been established. In support of their argument, the
Taxpayers rely primarily on Fran Corp. v. United States, 164
F.3d 814 (2d Cir. 1999), as well as a number of district
court and bankruptcy court decisions.6

On the other hand, the Government contends that the
Taxpayers' failure to pay their employment taxes timely was
due to willful neglect because they chose to pay other
creditors and employees instead of the IRS. The
Government further argues that the Taxpayers failed to
establish reasonable cause. Relying on the Sixth Circuit's
decision in Brewery, Inc. v. United States, 33 F.3d 589 (6th
Cir. 1994), the Government takes the position thatfinancial
distress alone does not establish reasonable cause. Relying
on the language in the Treas. Reg. S 301.6651-1(c)(2), the
Government maintains that when trust fund taxes are at
issue, a more stringent standard is applied. The
Government contends that the need for operating capital
_________________________________________________________________

6. See Glenwal-Schmidt v. United States, 78-2 U.S.T.C. P 9610 (D. D.C.
1978); In re Arthurs Industrial Maintenance, Inc., 92-1 U.S.T.C. P 50242
(Bankr. W.D. Va. 1992), aff'd, 93-1 U.S.T.C. P 50092 (1993); In re Pool
and Varga, Inc., 60 B.R. 722 (Bankr. E.D. Mich. 1986); and In re Slater,
190 B.R. 695 (Bankr. S.D. Fla. 1995).

12
necessary to prevent insolvency is not reasonable cause for
failing to pay over the trust fund taxes at issue. The
Government submits that because financial distress was
the only fact and circumstance supporting the Taxpayers'
failure to pay trust fund taxes timely, Brewery is
dispositive. Thus, the Government concludes that the
Taxpayers have failed to establish reasonable cause under
the test set forth in Brewery.7

The District Court applied the bright line test set forth in
Brewery, which provided that "financial difficulties can
never constitute reasonable cause to excuse the penalties
for nonpayment of withholding taxes by an employer." 33
F.3d at 592. Our sister court of appeals in Brewery based
its adoption of the bright line standard upon both the trust
language of section 7501 and Treas. Reg. S 301.6651-
1(c)(2), which provides that circumstances which, because
of the taxpayer's efforts to conserve marketable assets, may
constitute reasonable cause for failure to pay income taxes,
may not constitute reasonable cause for failure to pay trust
fund taxes. The Brewery court, agreeing with the District
Court there, held that since the trust fund taxes were for
the government's exclusive use, the taxpayer's use of the
trust funds for the payment of other creditors could not, as
a matter of law, constitute reasonable cause for abating the
penalties assessed under sections 6651 and 6656. Id. In so
holding, the Brewery court found persuasive the reasoning
of its court in an earlier decision, Collins v. United States,
in which it opined that:

It is no excuse that, as a matter of sound business
judgment, the money was paid to suppliers and for
wages in order to keep the corporation operating as a
_________________________________________________________________

7. The Government further maintains that even if the District Court had
followed the test applied in Fran Corp. v. United States, supra, the
result
would have been the same. In support of its position, the Government
proffers the Taxpayers' six year history with the corrupt government
officials, that the Defense Agencies would refuse to pay on the contracts
and unjustifiably reject the goods was foreseeable, and the Taxpayers
were not without fault. Thus, the Government alleges that the Taxpayers'
course of conduct did not constitute ordinary business care and
prudence.

13
 going concern -- the government cannot be made an
unwilling partner in a floundering business.

Brewery, 33 F.3d at 593 (quoting Collins v. United States,
848 F.2d 740, 741-42 (6th Cir. 1988)) (internal citation
omitted).

In the case before us, the District Court also found this
reasoning persuasive in imposing a more stringent
standard for abating penalties assessed for non-payment of
trust fund taxes. What the District Court failed to consider,
however, is that here the Government was not an unwilling
partner in a floundering business but, indeed, an active
participant.

The Brewery court's decision is troubling on a number of
grounds. First, the application of such a bright line rule
when a tax payment is delayed due to financial difficulties
is inconsistent with Congress' creation of a "reasonable
cause" exception, as well as the Treasury Regulations
which set forth the factual circumstances that must be
alleged to establish reasonable cause. Fran Corp., 164 F.3d
at 818. Neither the penalty provisions of the Code nor the
Treasury Regulations supports the bright line rule.

The Code does not bar consideration of financial
difficulties in determining whether reasonable cause has
been established, and it does not differentiate between trust
fund taxes and nontrust fund taxes. Id. In this regard, the
Second Circuit noted in Fran:

This is particularly significant with respect to Section
6656, which specifically addresses the failure to
deposit employment taxes yet requires neither a higher
standard in such cases nor that courts turn a blind
eye to a taxpayer's financial circumstances. The
"reasonable cause"/"wilful neglect" standard has been
part of the penalty provisions of the tax statutes since
1916, and Congress has not amended these provisions
to create a different standard for the failure to pay
trust fund taxes.

Id. (citing Boyle, 469 U.S. at 245 n.3).

Moreover, Treas. Reg. S 301.6651-1(c)(1) specifically
directs courts to examine "all the facts and circumstances

14
of the taxpayer's financial situation." Similarly, under
Treas. Reg. S 1.6161-1(b), we are required to determine
whether the taxpayer would have suffered "undue
hardship," i.e., "substantial financial loss," from the
payment of taxes. As noted by the court in Fran, neither of
these portions of the Treasury Regulations has changed
since at least 1973, and with regard to Treas. Reg.
S 1.6161-1, since 1960. 164 F.3d at 818. Where regulations
have continued over a long period of time without
substantial change and have applied to unamended or
substantially reenacted statutes, they are deemed to have
received the approval of Congress and thus have the effect
of law. Id. (citation omitted). Thus, the court of appeals in
Fran concluded that "[t]hese regulations clearly require a
factual assessment of the taxpayer's financial situation to
determine whether it has exercised ordinary business care
and prudence in responding to competing financial
obligations." Id. at 819.

The Fran court also found fault with the Brewery court's
reliance on Treas. Reg. S 301.6651-1(c)(2) for support of a
bright line rule. The Fran court found that the regulation
simply provides that the court:

consider, among other factors in [its] analysis of the
taxpayer's care and prudence, "the nature of the tax
which the taxpayer has failed to pay," and provides an
illustrative example to suggest that "facts and
circumstances which . . . may constitute reasonable
cause for nonpayment of income taxes may not
constitute reasonable cause for failure to pay over
taxes described in section 7501 that are collected or
withheld from any other person."

Id. (quoting Treas. Reg. S 301.6651-1(c)(2)). Thus, the Fran
court concluded that although courts must take into
account the obligations to pay section 7501 trust fund
taxes in their determination of reasonable cause, their
analysis must not stop there. Id. Accordingly, the court
held:

We recognize that it will be the rare case where the
government is made the "unwilling partner in a
floundering business" . . . without the employer

15
 incurring the duty to pay a penalty for having made
such a choice, but it nonetheless remains for the court
in each case to weigh all of the factors identified in the
Regulations. To hold otherwise would effectively read
out of the statute the "reasonable cause" exception to
mandatory penalties in many employment tax cases.

Id.

We believe that the decision of the court of appeals in
Fran is the better reasoned approach since it gives meaning
to sections 6651 and 6656 of the Code and the regulations
interpreting them. Brewery forecloses consideration of the
facts and circumstances of the taxpayers' financial
situation in contravention of the clear language of Treas.
Reg. S 301.6651-1(c)(1). Thus, we conclude that the District
Court erred as a matter of law in applying the bright line
rule in Brewery.

B.

Having concluded that the test applied by the Second
Circuit in Fran is the proper standard for evaluating
reasonable cause, we now turn to the second issue
presented -- whether, under the facts and circumstances
here, the Taxpayers' failure to pay and deposit their
employment taxes timely was due to reasonable cause and
not willful neglect. If the evidence establishes that the
Taxpayers exercised ordinary business care and prudence
and that they would have suffered undue hardship if they
would have paid the taxes when due, then reasonable
cause will exist for the Taxpayers' failure to pay the tax
timely. The Taxpayers will not be entitled to abatement of
the penalties, however, if the delinquent payment was due
to willful neglect. As a preliminary matter, therefore, we will
address whether the Taxpayers' failure to pay the
employment taxes timely was due to willful neglect.

The Government urges us to rule that any taxpayer who
consciously chooses to pay other creditors over the IRS will
have intentionally and willfully neglected to pay its
employment taxes. At oral argument, the Government
conceded that the only instance where nonpayment of trust
fund taxes would not constitute willful neglect would be

16
where the nonpayment results through no fault of the
taxpayer, or, in other words, is caused by some act of
nature or other act beyond the taxpayer's control. Here, the
Government contends, the Taxpayers created their financial
predicament by participating in the bribery scheme.
Because such activity is not devoid of fault, the
Government argues, the nonpayment of taxes constitutes
willful neglect. In support of its position, the Government
relies on Boyle, which equated willful neglect with an
absence of fault. 469 U.S. at 246 n. 4.8

If we were to endorse the Government's position,
however, we would have to ignore the plain language of
6651 and 6656, as well as the interpreting regulations. The
regulations clearly anticipate that a taxpayer will be forced
to decide during times of financial distress how to
distribute any available cash. Indeed, the regulations direct
the courts to inquire as to the amount and nature of the
taxpayer's expenditures in light of the income (or other
amounts) it could reasonably expect to receive prior to the
tax payment due date. Treas. Reg. S 301.6651-1(c)(1).

We are not convinced the Taxpayers' failure to pay trust
fund taxes under the circumstances here amounted to
willful neglect. Although the Taxpayers are not entirely
innocent, their financial viability and cash flow was entirely
dependent on the government contracts and the corrupt
employees of the Defense Agencies. Thus, the Taxpayers'
ability to pay its debts, including trust fund taxes, was
controlled by the Defense Agencies. Indeed, the
circumstances suggest that the Government was not an
unwilling partner in a floundering business, but an active
participant. Moreover, the deposition testimonies of Roger
Mooney and D'Antonio indicated that the Taxpayers chose
to pay only those creditors whose services were essential to
maintaining and reworking the inventory. Both testified
that maintaining minimal business operations was required
to institute adversary proceedings against the Defense
Agencies and collect the $2.1 million settlement. Without
_________________________________________________________________

8. The question to be resolved in Boyle was whether under section
6651(a)(1) the taxpayer's reliance on an attorney to file an estate tax
return timely was reasonable cause for the failure to meet the deadline.

17
the settlement, sufficient funds would not have existed to
pay the delinquent trust fund taxes. D'Antonio further
testified that he felt he had no choice but to pay employees
from the funds received under government contracts
because Delaware law makes it a criminal violation not to
pay employees for time worked.

Although we recognize the need for stringent standards
where trust fund taxes are involved, we cannot ignore the
negative impact the Government's position has on public
policy. The IRS has consistently taken the position that if a
taxpayer cannot afford to pay trust fund taxes, no matter
what the cause, it should close up shop. Both the economy
and the federal fisc are negatively impacted by such an
approach -- the amount of money flowing into the economy
and the fisc is reduced as a result of increased
unemployment, idle buildings and plants, and decreased
sales of goods and services. Under this approach, no one
benefits. Where, however, a taxpayer keeps its business
operating at a minimal level in order to collect monies
contractually due so that it can pay trust fund taxes and
other debts, and does in fact collect the funds owed and
pays its back taxes and other debts, the economy and
federal fisc, including the IRS, benefit.

We cannot say, therefore, that under these circumstances
choosing to pay those creditors, whose services were
essential to maintaining and reworking the inventory, over
the trust fund taxes constituted a conscious, intentional
failure or reckless indifference. For this reason, we find that
the Taxpayers' failure to pay trust fund taxes timely did not
amount to willful neglect.

Having found that the Taxpayers' delinquency was not
due to willful neglect, we must now determine whether
reasonable cause existed for the untimely payment and
deposit of employment taxes. Reasonable cause will exist if
the taxpayer establishes that (1) it exercised ordinary
business care and prudence, and (2) that undue hardship
would have resulted if it paid the tax liability when it
became due. Because our discussion of the undue hardship
requirement will not detain us long, we will turn to that
element first.

18
The Taxpayers make a persuasive argument in support of
their position that they have established that payment of
the taxes when due would have resulted in undue
hardship. This position is supported by the following facts:
(1) Mr. and Mrs. D'Antonio incurred substantial personal
debts by obtaining loans and a mortgage on their residence
in order to provide additional cash for the taxpayers to stay
in business; (2) the personal funds were used to pay
essential creditors and a small number of employees
retained to re-work the inventory; (3) rent was not paid; (4)
without the reduced staff, the Taxpayers would have to had
shut down their operation; (5) the Taxpayers needed to stay
in business so that they could collect on their claims
against the government and obtain the funds needed to pay
the IRS and other creditors. The evidence shows that if the
Taxpayers had paid their employment taxes when due, they
would have had insufficient funds to pay the reduced work
force and essential creditors to enable them to remain a
going concern. Moreover, the only markets for the $750,000
of inventory in the Taxpayer's warehouse were the Defense
Agencies. The Taxpayers have clearly shown that they were
at the mercy of the Defense Agencies as to whether they
would have sufficient cash flow to operate the business.
Under these facts and circumstances, we find that the
Taxpayers have established that undue hardship would
have resulted if they had paid their employment taxes on
time.

Having concluded that the Taxpayers have satisfied the
undue hardship requirement, we now turn to a
consideration of whether the Taxpayers exercised ordinary
business care and prudence under the facts and
circumstances here. The District Court focused almost
exclusively on the undue hardship requirement of
reasonable cause and, having found that financial
difficulties alone can never constitute reasonable cause,
determined that there was no reason for it to consider
whether the Taxpayers had met the other requirement of
establishing reasonable cause -- ordinary business care
and prudence.9
_________________________________________________________________

9. The District Court commented in a footnote, however, that had it
considered all the facts and circumstances surrounding the non-

19
In determining whether the Taxpayers exercised ordinary
business care and prudence, we must consider all the facts
and circumstances bearing on its financial situation.10 The
record before the District Court contains substantial
evidence that the Taxpayers exercised ordinary business
care and prudence. In particular, the evidence shows that
the Taxpayers did not incur any lavish or extravagant living
expenses which caused the remainder of its assets and
income to be insufficient to pay taxes. This conclusion is
supported by the following evidence:

1. Any income received by Taxpayers on government
contracts was used to pay either taxes owed to the
IRS or employees' wages.

2. Consequently, the Taxpayers did not pay suppliers,
rent, health and welfare premiums, employees'
union dues, and workers' compensation insurance
premiums.

3. Utility companies were only paid from D'Antonio's
personal funds at the eleventh hour after the
companies threatened to shut off service.

4. Suppliers were not paid any amounts owed from
1982-1986. Ultimately the Taxpayers owed
approximately $7 million to their suppliers.
D'Antonio had to personally guarantee payment to
the suppliers so that they would continue providing
suppliers without payments. As a result, D'Antonio
was sued and several liens were placed against his
personal assets.
_________________________________________________________________

payment of the employment taxes, it would have reached the same
conclusion. East Wind Industries, 33 F.Supp.2d at 346 n.6. The only
factor that the District Court appears to have considered, however, is the
Taxpayers' participation in the bribery scheme.

10. The dissent implies that we have construed Treas. Reg. S 301.6651-
1(c)(1) to create a general "ordinary business care and prudence"
standard for judging how a taxpayer has conducted its business. We do
not intend to create such a general standard in applying the regulation
to the Taxpayers' case. Rather, we have evaluated whether the Taxpayers
exercised ordinary business care and prudence in providing for payment
of the trust fund taxes in light of all the facts and circumstances
bearing
on their financial situation.

20
 5. D'Antonio secured a mortgage on his personal
residence and sold several personal assets to
obtain cash to pay creditors. In return, D'Antonio
accepted several notes from the Taxpayers which
became worthless.

6. The Taxpayers' bookkeeper lent $65,000 of her
personal funds to Taxpayers to pay creditors after
D'Antonio's personal funds were depleted.

None of these actions reveals any spendthrift tendencies on
the part of the Taxpayers.

Moreover, D'Antonio sought the advice of professional
consultants on financial and legal matters with regard to
the bribery scheme and the cash flow problems. He also
consulted with similarly situated manufacturers to learn
how they dealt with the bribery demands of the Defense
Agencies' employees.

D'Antonio testified that he was required to keep the plant
operating so that the Defense Agencies would pay for the
inventory. Inspectors from the Defense Agencies visited the
plant frequently to make sure the work was being
completed. Even when the Taxpayers were unable to
procure new government contracts they were required to
retain a reduced workforce to rework inventory that had
been unjustifiably and wrongly rejected by the Defense
Agencies. At the time the Taxpayers filed for bankruptcy,
inventory worth $750,000 was sitting in the Taxpayers'
plant.

Finally, the evidence shows, by virtue of the testimonies
of both D'Antonio and Mooney, that if the Defense Agencies
had paid the Taxpayers what was owed under the
contracts, the Taxpayers would have had sufficient funds to
pay their employment taxes and other debts when due.
Thus, it appears that the Taxpayers made reasonable
efforts to conserve sufficient assets in marketable form, by
maintaining $750,000 of inventory for the Defense
Agencies, to satisfy their tax liability and, despite such
efforts, were unable to pay their employment taxes when
they became due.

Although all of these factors support a finding that the
Taxpayers exercised ordinary business care and prudence,

21
the Taxpayers' participation in the bribery scheme raises
some concern. The District Court concluded, as a matter of
law, that the Taxpayers' course of conduct in initially
acceding to the demands of the corrupt officials, and later
refusing to pay when the demands became unrealistic,
established that the Taxpayers failed to exercise ordinary
business care and prudence during the periods in question.
33 F. Supp.2d at 346 n.6. In reaching this conclusion, the
District Court was influenced by the fact that the Taxpayers
had a long history of problems with the corrupt employees
of the Defense Agencies and, therefore, the District Court
opined that the employees' actions in rejecting goods and
holding back payments should have been foreseen by the
Taxpayers (as distinguished from the Navy's refusal to
comply with the requirements of the Disputes Clause and
of the Armed Services Procurement Regulations in Glenwal-
Schmidt, 78-2 U.S.T.C. P 9610, which was not foreseeable).
East Wind Industries, 33 F. Supp.2d at 346 n.6. The
District Court also found significant the fact that the
Taxpayers' delinquencies spanned a period of six years. Id.
In this appeal, the Government raises the same bases as
the District Court in support of its argument that the
Taxpayers failed to exercise ordinary business care and
prudence.

The Taxpayers counter that the payment of bribes by
companies doing business with the Defense Agencies was
considered the ordinary business practice in the industry.
D'Antonio testified in his deposition that the bribery
scheme was widespread and the only way to obtain
government contracts with the Defense Agencies was to
participate in the bribery scheme. His testimony is borne
out by the sworn statement of Special Agent Ford of the
FBI, in which Agent Ford indicated that D'Antonio, in an
undercover capacity:

recorded conversations with DPSC contractors who
freely admitted to the payments of bribes and illegal
gratuities to DPSC and DCAS employees. In most
cases, D'ANTONIO travelled outside the Philadelphia
metropolitan area to meet with the government
contractors. The contractors' admissions widened the
investigation and initiated new investigation [sic] of

22
 DPSC contractors and DCAS employees in other FBI
Field Offices, DCIS Field Offices and U.S. Attorneys'
Offices.

Affidavit of Joseph L. Ford, dated May 13, 1987, at p. 4.

While not directly on point, we held in In re American
Biomaterials Corp. 954 F.2d 919, 927 (3d Cir. 1992), that
where the failure to file timely returns, make deposits and
pay taxes was the result of embezzlement by the company's
officers, the failure was due to reasonable cause since their
criminal actions prevented the corporation from fulfilling its
duties under the Code. Our decision was predicated upon
our conclusion that the officers acted without apparent
authority when they committed the embezzlement and the
corporation could not be vicariously responsible for the
penalties resulting from the failure to file returns, make
deposits and pay taxes. Id. At the very least, American
Biomaterials held that criminal conduct does not
automatically foreclose a finding of reasonable cause. Thus,
based on our holding in American Biomaterials, we cannot
automatically conclude that the Taxpayers' participation in
the illegal procurement scheme warrants a finding that they
failed to exercise ordinary business care and prudence.

Moreover, we are not persuaded by the Government's
arguments that the facts established that the Taxpayers did
not exercise ordinary business care and prudence. With
regard to the Taxpayers' six-year history with corrupt
officials, we must consider this period in the proper
context. The delinquency began in 1982, sometime after the
Taxpayers refused to pay the bribes. The Taxpayers
attempted to put a stop to the bribery scheme beginning in
1983 when they contacted the legal staff at the Defense
Department, and again in 1984, when they contacted other
authorities. The Taxpayers filed a bankruptcy petition in
1984, and the FBI began its investigation later that same
year. The Taxpayers eventually paid off their delinquent
employment taxes, plus penalties and interest after the
Bankruptcy Court enforced the Taxpayers' claims against
the Defense Agencies, resulting in the $2.1 million
settlement in 1991.

The Government also contends the Defense Agencies'

23
refusal to pay on the contracts and unjustified rejection of
goods was foreseeable to the Taxpayers. Essentially, the
Government contends that because the Taxpayers
participated in the bribery scheme, they should have
foreseen the consequences. We disagree that these actions
were necessarily foreseeable. The bribery scheme started in
1976 and consisted of requests for minor favors and
gratuities, which the Taxpayers apparently provided. The
Taxpayers did not start to experience financial difficulties,
however, until 1982.11 In light of these facts, we do not
believe the Taxpayers could have anticipated that providing
minor favors and gratuities to the corrupt employees would
eventually result in the financial ruin of their business.

Although the Taxpayers' participation in the bribery
scheme presents a close question, we nonetheless conclude
that in light of all the facts and circumstances, the
Taxpayers exercised ordinary business care and prudence.
The parties should not read our decision as condoning the
Taxpayers' conduct. We do not. We believe, however, that
the Taxpayers have made a substantial attempt at righting
their wrongdoing -- D'Antonio entered guilty pleas to two
counts of violating 18 U.S.C. S 287, the False Claims
statute, and he assisted the FBI in obtaining sufficient
evidence of criminal activity to indict the corrupt officials
and in bringing a stop to the bribery scheme. Moreover, the
Taxpayers paid the ultimate price -- financial ruin of their
business.

In reality, the illegal conduct of the corrupt employees of
the Defense Agencies, after the Taxpayers refused to accede
to the bribery demands, caused the financial distress which
resulted in the Taxpayers' inability to pay its employment
taxes timely. By its actions, the Government, through the
Defense Agencies, became a willing partner in afloundering
_________________________________________________________________

11. It appears that the Taxpayers' cash flow problems began after the
bribery demands took on a new dimension -- demands for cash
payments approximating 50 percent of the profits from the Taxpayers'
business. When the Taxpayers refused to pay the demands for cash
payments, the corrupt employees of the Defense Agencies refused to pay
on the government procurement contracts and unjustifiably rejected the
Taxpayers' goods. Consequently, inventory began to accumulate, cash
flow was severely reduced, and new contracts were not forthcoming.

24
business. Therefore, this case presents that rare situation
described in Fran, supra, where the Taxpayers should be
relieved of the penalty for failing to pay and deposit their
employment taxes when due. 164 F.3d at 819.

We therefore hold that because the Taxpayers exercised
ordinary business care and prudence and would have
suffered undue financial hardship if they would have paid
their taxes when due, the nonpayment of trust fund taxes
was due to reasonable cause and not willful neglect.
Accordingly, the Taxpayers are entitled to an abatement of
the penalties.

III.

For the reasons set forth above, we will reverse the
judgment of the District Court and enter judgment for the
Taxpayers.

25
STAPLETON, Circuit Judge, Dissenting:

This is one of those proverbial "hard" cases that makes
"bad" law. The Taxpayers have apparently been grievously
wronged by corrupt government officials. If that be the
case, the Taxpayers should be entitled to recover
compensation from the wrongdoers for all the losses that
they have suffered, including, perhaps, tax penalties that
would not have been incurred but for the wrongdoers'
actions. But the Taxpayers' entitlement to compensation is
not the issue before us. Rather, we must decide whether
the Taxpayers' failure to pay trust fund taxes from 1982
through 1988 was due to "reasonable cause" and not to
"willful neglect" within the meaning of IRCSS 6651 and
6656.

I agree with the Court that financial difficulties can and
must be considered in determining whether a taxpayer is
entitled to a refund of penalties under IRC #8E8E # 6651 and
6656. I do not agree, however, that consideration of the
financial difficulties experienced by the Taxpayers in this
case demonstrates that they are entitled under Treasury
Regulation S 301.6651-1(c)(1) to the relief that they seek.

Section 301.6651-1(c)(1) of the Regulations provides
examples of situations in which "reasonable cause" for non-
payment exists and situations in which it does not exist. As
the Court notes, the regulation provides, in part, that "a
failure to pay will be considered to be due to reasonable
cause to the extent that the taxpayer has made a
satisfactory showing that he exercised ordinary business
care and prudence in providing for payment of his tax
liability and was nevertheless either unable to pay the tax
or would suffer an undue hardship . . . if he paid on the
date due." Treas. Reg. S 301.6651-1(c)(1). This provision
and the remainder of the section make it clear that: (1)
"reasonable cause" will exist where the taxpayer has made
a good faith effort to set aside the resources necessary for
the satisfaction of its tax liability but cannot pay when the
due date arrives because of unanticipated events beyond its
control; and (2) "reasonable cause" will not exist where a
taxpayer fails to husband its resources so that the requisite
funds will be available for payment when the tax is due,
e.g., when "a taxpayer . . . incurs lavish or extravagant

26
living expenses in an amount such that the remainder of
his assets and anticipated income will be insufficient to pay
his tax." Id.

Contrary to the Court's suggestion, S 301.6651-1(c)(1)
does not create a general "ordinary business care and
prudence" standard for judging how a taxpayer has
conducted its business. It speaks solely to situations in
which the taxpayer has (or has not) "exercised ordinary
business care and prudence in providing for payment of his
tax liability," only to have his efforts thereafter frustrated by
unanticipated events beyond his control. Id. (emphasis
added). Accordingly, S 301.6651-1(c)(1) provides no relief for
a taxpayer who makes a deliberate decision to continue in
business with no reasonable expectation that it will have
the resources to satisfy its tax liability when due.

The record in this case strongly suggests that the
Taxpayers made a deliberate decision (or series of deliberate
decisions) to continue in business for most, if not all, of the
period from 1982 to 1988 without making any provision for
the payment of trust fund taxes and without any
reasonable expectation that funds would be available to pay
them when they were due. I would remand this case to the
District Court for further proceedings and factfinding.
While I think it unlikely that the Taxpayers will be able to
establish that their failures to pay were due to"reasonable
cause" and not "willful neglect," it is not inconceivable to
me that they will be able to make such a showing for at
least some portion of the period in question.1
_________________________________________________________________

1. The most likely candidate would seem to me to be the period from
early 1985 through a portion of 1986 during which the FBI was directing
Mr. D'Antonio's undercover activities. Since continuing in business
would appear to be a necessary predicate for such activities, it may be
that there was "reasonable cause" for the failure to pay and no "willful
neglect" during this period. In this regard, I note that S 301.6651 of the
Regulations does not purport to be an exclusive list of situations in
which a failure to pay is due to "reasonable cause" and not "willful
neglect" under IRC SS 6651 and 6656.

27
A True Copy:
Teste:

Clerk of the United States Court of Appeals
for the Third Circuit

28