If a trusted office manager embezzles and secretly stops paying a company's withholding taxes, can the company avoid interest and penalty on the late payments?

Plain-English summary

A company whose trusted office manager embezzled cash and secretly stopped paying its withholding taxes for more than two years still owed interest and penalty on the late payments — because the company's own lack of accounting controls was negligent. Protest DENIED.

Pat Campbell Insurance, a Las Cruces agency in business since 1946, filed monthly combined-reporting (CRS) returns whose only regular tax was withholding. Its office manager of many years handled all accounting — preparing returns and checks, entering data, and generating the financial statements. She was not authorized to sign, so she brought returns and checks to a corporate officer to sign, then was responsible for mailing them. Beginning in December 1998 and for over two years, she stopped mailing the returns and payments to the Department, the IRS, and the Department of Labor, while diverting company cash to herself. She entered data to make the computer show the taxes as paid, was the only person reconciling the bank statements, and intercepted the past-due notices before they reached the officers (mail was opened by college-student employees unlikely to question her). The outside CPA relied on her forms and never audited the original bank statements. The scheme surfaced in 2000 through a Department of Labor notice; the company then contacted the Department, which assessed $33,574.80 of tax, $6,292.71 of interest, and $3,282.76 of penalty. The company protested only the interest and penalty.

Interest is mandatory — the reason for the delay does not matter

Section 7-1-67 says that if tax is not paid when due, interest "shall" be paid from the day after the due date until it is paid. The hearing officer explained that "shall" makes interest mandatory, not discretionary, with no exceptions (State v. Lujan). Interest is not a punishment; it compensates the state for the time value of money it was owed but did not have. Because the company failed to pay withholding tax for more than two years, interest was properly assessed regardless of why the payments were late.

The embezzlement was not charged to the company — but its weak controls were

The negligence penalty under Section 7-1-69(A) turned on two things: the office manager's failure to pay, and the company's own accounting weaknesses. On the first, the hearing officer applied respondeat superior: an employer is liable for an employee's acts only within the scope of employment, and an employee who steals or embezzles acts from a personal motive outside that scope (Los Ranchitos v. Tierra Grande; UJI 13-407). So the manager's cover-up of her theft was not attributed to the company.

But the company was independently negligent. Its officers gave a single employee complete, unsupervised control over cash deposits, bank reconciliations, and the accounting data that fed the financial statements — and assigned the mail to inexperienced students who let her intercept the tax notices. They recognized the need for someone else to reconcile the accounts but never implemented it. A small business that cannot separate these duties must arrange a regular independent audit; relying on financial statements built entirely from the suspect employee's own entries is not enough. The company was a genuine victim of a dishonest employee, but the scheme succeeded only because of the missing controls, so the penalty was proper.

Result: protest DENIED. Both interest and the negligence penalty were upheld.

What this means for you

Interest on late tax is automatic — hardship or fraud won't waive it

Interest under Section 7-1-67 is mandatory and simply compensates the state for the delay. It cannot be abated because the lateness was someone else's fault, even an embezzler's. If tax is paid late for any reason, expect interest.

Being defrauded by an employee does not excuse the penalty if your controls were weak

An employee's theft is not attributed to you (respondeat superior), but that cuts both ways: you cannot hide behind it either. If your own failure to supervise and separate financial duties let the fraud go undetected, the negligence penalty can still apply to you.

Separate duties — and if you can't, get an independent audit

Do not let one person control cash handling, bank reconciliation, and the bookkeeping that produces your financial statements. If a small staff makes separation impossible, arrange a periodic audit by an outside accountant or a qualified, independent person inside the company. Clean-looking financial statements prove nothing if the person who could steal is the one preparing them.

Don't assume a CPA's involvement is an audit

The company's CPA relied on the office manager's forms and never checked the underlying bank statements. Using an accountant to prepare returns is not the same as an independent audit of your records and does not, by itself, catch this kind of scheme.

Common questions

Q: What was assessed, and what did the company contest?
A: The Department assessed $33,574.80 of withholding tax, $6,292.71 of interest, and $3,282.76 of penalty. The company paid/accepted the tax and protested only the interest and penalty.

Q: Why did interest apply when the company was defrauded?
A: Section 7-1-67 makes interest mandatory whenever tax is paid late, with no exceptions. It compensates the state for the lost use of the money, so the reason for the delay — even embezzlement — is irrelevant.

Q: Wasn't the embezzling office manager's conduct the company's responsibility?
A: Not under respondeat superior. An employee who embezzles acts for a personal motive outside the scope of employment, so her theft and cover-up were not attributed to the company.

Q: Then why did the company owe the negligence penalty?
A: Because of its own negligence — giving one employee unsupervised control over cash, reconciliations, and the books, and never arranging an independent audit. The fraud succeeded only because of those missing controls.

Q: Did having a CPA protect the company?
A: No. The CPA relied on the office manager's own forms and financial statements and never audited the original bank records, so the CPA's involvement did not detect or excuse the problem.

Citations and references

Statutes and regulations:

• NMSA 1978, § 7-1-67 — interest on late-paid tax is mandatory ("shall"), running from the day after the due date until paid
• NMSA 1978, § 7-1-69(A) — negligence penalty (2% per month, up to 10%) for failing to pay or file when due
• NMSA 1978, § 7-1-17(C) — a Department assessment, including interest and penalty, is presumed correct
• NMSA 1978, § 7-1-3(V) — "tax" includes related interest and civil penalty
• Regulation 3.1.11.10 NMAC — definition of taxpayer negligence

Cases and authorities cited:

• State v. Lujan, 90 N.M. 103, 560 P.2d 167 (1977)
• El Centro Villa Nursing Center v. Taxation and Revenue Department, 108 N.M. 795, 779 P.2d 982 (Ct. App. 1989)
• Los Ranchitos v. Tierra Grande, Inc., 116 N.M. 222, 861 P.2d 263 (Ct. App. 1993)
• UJI 13-407 NMRA — uniform jury instruction on scope of employment

Source

• Listing: New Mexico Decisions & Orders
• Decision post: Pat Campbell Insurance
• Decision PDF: D&O 02-03

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
PAT CAMPBELL INSURANCE, INC. No. 02-03
ID NO. 01-507916-00-3
ASSESSMENT NOS. 2700898-2700921 & 2703246-2703247

DECISION AND ORDER

A formal hearing on the above-referenced protest was held January 7, 2002, before Margaret

B. Alcock, Hearing Officer. Pat Campbell Insurance, Inc. (“Taxpayer”) was represented by Kerry D.

Hixon, its president. The Taxation and Revenue Department ("Department") was represented by

Javier L. Lopez, Special Assistant Attorney General. Based on the evidence and arguments presented,

IT IS DECIDED AND ORDERED AS FOLLOWS:

FINDINGS OF FACT

1. Since 1946, the Taxpayer has been engaged in the insurance business in Las Cruces,

New Mexico.

2. The Taxpayer is registered with the Department for payment of gross receipts,

compensating and withholding taxes, which are required to be paid monthly under the Department’s

combined reporting system (“CRS”). Given the nature of the Taxpayer’s business, the only CRS

taxes due on a regular basis are withholding taxes.

3. Sometime in the mid-1980s, the Taxpayer hired an office manager.

4. At the time Kerry Hixon joined the firm as an owner and corporate officer in 1991,

the office manager had been with the firm for about six years and was responsible for all of the

Taxpayer’s accounting procedures. This included preparing tax returns, making out the checks to
pay taxes and other bills, and entering information into the Taxpayer’s computerized cash

management system, which she then used to prepare monthly and year-end financial statements.

5. The office manager was not authorized to sign tax returns or checks on behalf of the

Taxpayer. Once the returns and checks were prepared, she brought them to Mr. Hixon or the other

corporate officer for review. Once the returns and checks were signed, the office manager was

responsible for making sure they were mailed in a timely manner.

6. Beginning in December 1998 and continuing for a period of more than two years, the

office manager stopped mailing tax returns and payments to the Department, the Internal Revenue

Service, and the New Mexico Department of Labor. She continued to bring the prepared returns and

checks to Mr. Hixon for signature and entered information into the Taxpayer’s computer system to

make it look as though the taxes had been paid.

7. During the period the office manager failed to file tax payments, she was diverting

many of the Taxpayer’s cash receipts to her own use.

8. It was not unusual for some of the Taxpayer’s customers to pay their insurance

premiums in cash. Such cash payments, which could be as much as $3,000, were accepted by a

customer service representative. The cash was then turned over to the office manager for deposit.

9. The office manager entered the correct information in the Taxpayer’s computer

system and credited the customer with the payment. It appears she then kept some or all of the cash

and substituted other checks received by the Taxpayer to make up the difference on the deposit slip.

10. There was no procedure requiring an employee other than the office manager to

reconcile daily cash received with daily cash deposited in the Taxpayer’s bank account.

11. Because the diverted cash deposits were offset by the amount of unpaid taxes that

remained in the Taxpayer’s bank account, and because the Taxpayer had large sums of money

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flowing through its bank account each month, the nonpayment of taxes did not result in noticeably

incorrect bank balances.

12. Although the Taxpayer’s corporate officers recognized that it would be advisable to

assign another employee to reconcile the Taxpayer’s monthly bank statements, this task often fell to

the office manager when no one else was available. During the period at issue, the office manager

was the only person to reconcile the bank statements on a regular basis.

13. For this reason, no one discovered that none of the checks made out to state and

federal tax agencies were clearing the Taxpayer’s bank account or noticed the discrepancy between

the cash deposits shown in the Taxpayer’s computer system and the cash deposits shown on the bank

deposit slips.

14. When past due tax notices were mailed to the Taxpayer, the office manager

intercepted the notices, preventing them from going to the corporate officers. Most of the employees

opening and distributing the mail were college students who might not have understood the

significance of the tax notices and would have been unlikely to question the office manager

concerning the notices.

15. Although the Taxpayer consulted with a certified public accountant concerning tax

matters, the CPA relied on the tax forms and financial statements prepared by the office manager.

The CPA did not review the Taxpayer’s original bank statements or conduct an audit of the

Taxpayer’s records.

16. In July 2000, one of the Taxpayer’s customer service representatives discovered a

notice from the New Mexico Department of Labor stating that it had not received the Taxpayer’s

March 31, 2000 and December 31, 2000 quarterly reports. The customer service representative gave

the notice to Mr. Hixon.

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17. When Mr. Hixon asked the office manager about the notice, she said she had mailed

the reports and tax payments on time. Mr. Hixon subsequently learned this was not true and

personally saw to it that the required forms and payments were filed.

18. After this incident, Mr. Hixon began to look into other areas of potential problems.

He discovered that the Taxpayer’s checking account had not been reconciled for more than two years

and that checks issued to state and federal tax agencies were very old and had never cleared the

Taxpayer’s bank account.

19. Mr. Hixon notified the Taxpayer’s CPA of the situation and immediately contacted

the various tax agencies to determine the extent of the Taxpayer’s outstanding liabilities.

20. On August 29, 2001, after being contacted by Mr. Hixon, the Department issued

Assessment Nos. 2700898-2700921 & 2703246-2703247 to the Taxpayer for reporting periods

December 1998 and May 1998 through May 2001 in the amount of $33,574.80 of tax principal,

$6,292.71 of interest and $3,282.76 of penalty.

21. On September 28, 2001, the Taxpayer filed a written protest to the interest and penalty

portions of the assessments.

DISCUSSION

The issue to be determined is whether the Taxpayer is liable for interest and penalty on the

late payment of withholding taxes due for reporting periods December 1998 and May 1999 through

May 2000. Section 7-1-17(C) NMSA 1978 provides that any assessment of taxes made by the

Department is presumed to be correct. Section 7-1-3(V) NMSA 1978 defines tax to include not only

the amount of tax principal imposed but also, unless the context otherwise requires, “the amount of

any interest or civil penalty relating thereto." See also, El Centro Villa Nursing Center v. Taxation

and Revenue Department, 108 N.M. 795, 779 P.2d 982 (Ct. App. 1989). Accordingly, the

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presumption of correctness applies to the assessment of interest and penalty at issue in this case, and

it is the Taxpayer’s burden to present evidence and legal arguments to support an abatement.

Assessment of Interest. Section 7-1-67 NMSA 1978 governs the imposition of interest on

late payments of tax and provides, in pertinent part:

A. If any tax imposed is not paid on or before the day on which it
becomes due, interest shall be paid to the state on such amount from
the first day following the day on which the tax becomes due, without
regard to any extension of time or installment agreement, until it is
paid.... (emphasis added).

The legislature’s use of the word “shall” indicates that the assessment of interest is mandatory rather

than discretionary. State v. Lujan, 90 N.M. 103, 560 P.2d 167 (1977). The legislature has directed the

Department to assess interest whenever taxes are not timely paid and has provided no exceptions to the

mandate of the statute. The assessment of interest is not designed to punish taxpayers, but to

compensate the state for the time value of unpaid revenues. Section 7-1-67 NMSA 1978 requires

interest to be paid for any period of time during which the state is denied the use of the funds to which

it is legally entitled. Here, the Taxpayer failed to pay withholding tax due for a period of more than

two years. Accordingly, interest was properly assessed against the Taxpayer and there is no basis for

abatement.

Assessment of Penalty. Section 7-1-69 NMSA 1978 governs the imposition of penalty.

Subsection A imposes a penalty of two percent per month, up to a maximum of ten percent when a

taxpayer fails “due to negligence or disregard of rules and regulations” to pay taxes or file required

tax reports in a timely manner. Taxpayer negligence for purposes of assessing penalty is defined in

Regulation 3.1.11.10 NMAC as:

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

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2. inaction by taxpayers where action is required;

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

In this case, the Taxpayer’s failure to timely report and pay its monthly CRS taxes was attributable to

two factors: (1) the office manager’s failure to pay the Taxpayer’s withhholding taxes; and (2) the

lack of safeguards in the Taxpayer’s accounting system.

Inaction of the Office Manager. During the period December 1999 through May 2001, the

Taxpayer’s office manager stopped mailing required CRS returns and payments to the Department.

Under the doctrine of respondeat superior, an employer may be liable for the acts of its employee if

the wrongful acts are committed in the course and scope of employment. As a general rule, an

employee's act is within the course of employment if: (1) it is something fairly and naturally

incidental to the employer's business assigned to the employee, and (2) it is done while the employee

is engaged in the employer's business with the view of furthering the employer's interest and does not

arise entirely from some external, independent and personal motive on the part of the employee.

See, UJI 13-407; Los Ranchitos v. Tierre Grande, Inc., 116 N.M. 222, 227, 861 P.2d 263, 268 (Ct.

App. 1993). There are numerous cases holding that an employee who steals or embezzles is not

acting in the interests of his or her employer, but is acting from some independent, personal motive.

Id. In this case, the Taxpayer’s officer manager was not acting in the scope of her employment when

she withheld payment of the Taxpayer’s tax payments as a means of covering up her ongoing

diversion of cash deposits. Accordingly, these acts cannot be attributed to the Taxpayer under the

doctrine of respondeat superior.

Lack of Safeguards in Accounting System. While the most direct cause of the Taxpayer’s

failure to file tax returns was the illegal acts of its office manager, the failure was also attributable to the

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lack of accounting safeguards maintained by the Taxpayer. The evidence establishes that the corporate

officers delegated responsibility for many key aspects of the business to the office manager.

Although the corporate officers recognized the importance of assigning other employees to reconcile

the Taxpayer’s monthly bank statements and to open and distribute the mail, no steps were taken to

implement an adequate system of checks and balances. As a result, the office manager had complete

and unsupervised control over the deposit of large amounts of cash, the reconciliation of the

Taxpayer’s bank statements, and the entry of data into the computer system used to generate the

Taxpayer’s financial statements. Because mail duties were assigned to inexperienced college

students, who were unlikely to question the authority of the office manager or recognize the

significance of past due tax notices, the office manager was also able to intercept any notices that

would have alerted the corporate officers to her activities.

It is understandable that a small business may not have the resources to assign more than one

employee to perform the company’s routine bookkeeping and office duties. When that is the case,

however, it is incumbent on the business to arrange for a regular audit of the company’s records.

This could be done by an outside accountant or by someone within the company, provided that

person was both qualified and independent of the daily financial operations of the business. At the

administrative hearing, Mr. Hixon testified that he did not think an outside audit was necessary

because the monthly and year-end financial statements did not indicate any problems. He failed to

appreciate the fact that the financial statements were based entirely on information entered into the

computer system by the office manager—the same person who had control over the Taxpayer’s cash

deposits and the reconciliation of the Taxpayer’s bank statements.

In this case, the Taxpayer was the victim of an unscrupulous employee and had no intention

of cheating the state or federal government of taxes due. The fact remains, however, that the

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employee could not have carried out her scheme (and probably would not have tried) if procedures

had been in place to detect her manipulation of the Taxpayer’s accounting system. Given the large

sums of money that routinely flowed through the Taxpayer’s business—at least some of it in cash—

the Taxpayer was negligent in giving such complete and unsupervised control over its accounting

system to a single employee.

CONCLUSIONS OF LAW

1. The Taxpayer filed a timely, written protest to Assessment Nos. 2700898-2700921 &

2703246-2703247, and jurisdiction lies over the parties and the subject matter of this protest.

2. Pursuant to Section 7-1-67 NMSA 1978, interest is due on the Taxpayer’s late payment

of withholding taxes.

3. The Taxpayer was negligent in failing to properly supervise its office manager’s

activities over a period of more than two years, and penalty is due under Section 7-1-69 NMSA 1978.

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

DATED January 9, 2002.

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