The Second Circuit recently ruled that the fraudulent acts of an employer’s accountant in filing payroll tax returns resulted in an open-ended statute of limitations, which allowed the IRS to go back beyond the three year statute of limitations to assess back taxes against the employer (City Wide Transit v Commissioner). This should be a reminder to all employers to establish strict accounting controls for all tax filing and payment functions.

In the case, the employer had engaged the accountant to negotiate a settlement of the employer’s payroll tax liabilities for prior tax periods. The accountant lied to the employer, saying that the IRS was willing to settle for the prior periods, provided that the accountant filed the payroll tax returns and remit the taxes on a going forward basis. The employer agreed, and had its payroll service company prepare the tax returns, and gave the returns to the employer together with a check payable to the IRS for the amount of the taxes. The accountant altered the payee on the check so that it was payable to his own company and deposited in his account. He then prepared fraudulent payroll tax returns, showing phony tax credits to reduce the amount of taxes owed, and filed the fraudulent tax returns with the IRS and wrote a check for the lower tax liability, pocketing the difference between the actual amount of tax due and the reduced tax bill because of the phony tax credits.

The IRS finally caught onto this fraud, but not until the three year statute of limitations had expired. The IRS said that the limitation period should be open-ended, because the filing of a fraudulent return tolls the statute. The Tax Court ruled in favor of the employer, finding that the fraud that was committed was not the fraud of the employer, but was the fraud to cover up the accountant’s embezzlement of the tax funds entrusted to him by the employer. On appeal, the Second Circuit reversed, finding that the accountant’s actions were intended to evade the tax obligations of the employer, and so the statute of limitations were tolled as a result of the accountant’s fraud.

The lesson to be learned from this case is that employers should have strict controls on their payroll tax functions, with layers of checks and balances. As this case demonstrates, it took the IRS over three years to uncover this problem. The potential liability to an employer who uses a crooked accountant can be huge, especially if the statute of limitations is tolled.