Avoid the Payroll Tax Trap

EXECUTIVE SUMMARY

AN EMPLOYER BECOMES A TRUSTEE FOR THE U.S. government when it distributes payroll checks to employees. Withheld payroll taxes are called “trust fund taxes” and, in the eyes of the IRS, belong to the government. Companies should not use these funds to pay salaries, business expenses or for any other purpose. WHEN AN EMPLOYER FAILS TO PAY ITS WITHHELD payroll taxes to the government, IRC section 6672(a) imposes a penalty equal to the entire amount of the trust fund taxes on every “responsible person” who “willfully” fails to see that the taxes are paid. The IRS may assess the penalty against a responsible person without first trying to collect the penalty from the employer. AFTER THE IRS INTRODUCES PROOF IN COURT that the penalty applies, the taxpayer has the burden of proving he or she is not a responsible person or that there was no willful payment of other creditors while payroll taxes remained delinquent. A responsible person can avoid a charge of willfulness by taking all reasonable efforts to see that the taxes are paid. IF A TRUST FUND RECOVERY PENALTY IS ASSESSED, the taxpayer can appeal, ask for a collection due process hearing, submit an offer in compromise, pay a representative penalty, file suit, seek reimbursement from other responsible persons or arrange to pay the assessment in installments.

HOWARD GODFREY, CPA, PhD, is a professor of accounting at the University of North Carolina, Charlotte. He recently completed a six-month internship with the AICPA tax division in Washington, D.C. His e-mail address is hgodfrey@email.uncc.edu .

he IRS assesses a trust fund recovery penalty (TFRP) against individuals it holds personally liable for their employer’s unpaid payroll taxes. This is a civil penalty imposed on anyone required to collect, account for or pay over the taxes and who willfully fails to do so. This article describes how CPAs in public practice and private industry can keep clients and employers from reaching the point where the IRS holds them responsible for unpaid payroll taxes.

THE NATURE OF THE PENALTY
When an employer distributes payroll checks to employees, it becomes a trustee for the U.S. government. Withheld payroll taxes are called “trust fund taxes,” and because they are held on behalf of the United States, they shouldn’t be used to pay salaries, expenses or for any other purpose. Unfortunately, a business in financial trouble can be tempted to use trust fund taxes to pay immediate expenses such as payroll, rent and utilities. CPAs should urge employers to avoid dipping into withheld payroll taxes for operating expenses by considering alternative sources of capital, such as the sale of excess assets, borrowing and additional corporate or partnership equity investments.

If they do use the trust fund for other purposes, officers and other company employees may have to pay a civil penalty of 100% of the employer’s delinquent trust fund taxes. The IRS imposes this TFRP on “responsible persons” under IRC section 6672, distinct from the employer’s responsibility to pay over the taxes it withholds from employees. The IRS can assess the penalty against a responsible person or persons even though it has not attempted to collect the taxes from the employer. (See “ Trust Fund Recovery Penalty Litigation ” and exhibit 1 for how taxpayers who litigated imposition of the penalty fared in court.)

The IRS imposes the 100% penalty even where there was no bad motive and even if the individual was valiantly trying to save a company from bankruptcy so it could pay all creditors in full and protect employee jobs.

The concept “innocent until proven guilty” that applies in criminal cases does not apply here. Since the TFRP is civil, the IRS may treat individuals as “guilty until proven innocent.” Criminal penalties also may apply for failing to deposit payroll taxes, and a person can be subject to both civil and criminal action. Exhibit 2 summarizes recent criminal cases.

CPAs need to remind employers and their employees that it’s in their best interests to make accurate reporting and payment of payroll taxes a top priority.

FACTORS DETERMINING LIABILITY
Status and authority. The first of two tests for applying the TFRP involves identifying those who are responsible persons. A court determines responsibility by looking at the individual’s status and authority as owner, officer, board member, executive, manager or employee. A person who owns controlling interest in a company generally is a responsible person. So, too, is anyone who can compel or prohibit the allocation of corporate funds. This is evident when he or she can sign checks or prevent their issuance or control disbursements for payroll and other expenses. A person is responsible if he or she is active in company management and can hire or fire employees, negotiate contracts, obtain financing or purchase assets. Responsibility may exist where an individual participates in important management decisions and can influence those who control the funds. Someone can be a responsible person even though his or her job involves outside sales or other functions not related to the payment of payroll and related taxes. Indeed, responsible persons may not even know they have that status or that the company’s payroll taxes are delinquent.

The concept of responsible person may go far beyond owners and managers, to include relatives of a deceased taxpayer who serve as executors of an estate that owns a business; or a company’s CPA who handles important tasks related to disbursements and can decide whether the business will pay certain liabilities instead of its payroll taxes.

The employer should limit the number of individuals who have the authority to approve invoices for payment and shouldn’t designate anyone as an authorized check signer unless he or she actually signs checks.

Substantial authority. Someone with substantial authority over business operations is a responsible person even if somebody else has the ultimate authority over which bills get paid, and remains responsible even when the company hires a CFO or other employee with complete responsibility for all payroll tax matters. A person remains responsible even when directed by the CEO or other manager to pay other expenses first, and even if threatened with being fired. When the unpaid payroll tax liability is substantial, employees may choose to be fired rather than fail to meet their responsibilities under the law.

The determination of whether someone is a responsible person is not necessarily based on any one factor alone. Under IRS policy P-5-60, nonowner employees who act under the control of others aren’t responsible persons if they are not in a position to make independent decisions on the entity’s behalf. The IRS will not recommend assessment of the TFRP until it has sufficient information to support the position that someone is a responsible person, unless he or she intentionally impedes the investigation by the IRS.

Willful behavior. The second test for applying the penalty is to determine whether a responsible person willfully paid other creditors, or allowed someone else to pay them, while payroll taxes remained unpaid. Willfulness is defined very broadly and may reach many individuals who are confident they’re innocent, such as a responsible person who fails to investigate or correct the mismanagement of funds after learning payroll taxes have not been paid. Knowing the employer is having financial difficulty places a burden on responsible persons to ensure the company isn’t violating the law. (See “ Mr. Crutcher’s Million-Dollar Error. ”)

Tax-exempt status. Congress has set a less rigorous standard in section 6672(e) for boards of tax-exempt organizations. The TFRP is not imposed on volunteer, unpaid members of a board of trustees or directors of tax-exempt organizations if they serve solely in an honorary capacity, do not participate in day-to-day operations and do not know about a failure to pay withholding taxes.

Partnership. Liability for withheld taxes arises when an entity pays wages. Owners of sole proprietorships have unlimited liability for business debts. The TFRP extends personal liability to corporate owners, officers, employees and other responsible persons. Partners face greater risks than corporate officers because officers are liable only when they are responsible persons. A partner who has no responsibility for payroll tax matters continues to be liable for unpaid taxes because state law generally makes partners liable for all partnership debts.

THE POWER TO COLLECT
IRC section 6331 provides the federal government with broad powers to seize and sell all property a taxpayer owns, to the extent of unpaid taxes. The IRS can seize assets of the estate of a responsible person who dies before resolution of the unpaid payroll tax issue, garnish salary or pension retirement payments or seize assets in an individual retirement account. Even filing for bankruptcy relief does not protect an individual from personal liability, though the IRS stops collection efforts while bankruptcy proceedings are in process. The service may resume collection efforts after the bankruptcy is finalized and may continue pursuit for up to 10 years after assessment.

The IRS may seek to collect trust fund taxes from the employer and from several responsible persons at the same time. For example, if an employer has unpaid payroll taxes of $20,000 and there are five responsible persons, the IRS conceivably can assess and collect as much as $100,000 in total TFRPs. “ Taxpayer Battle Can Drag On ” describes a case involving multiple collections. It is IRS policy to keep no more than 100% of the amount of unpaid employer trust fund taxes and interest. During a specific time period (statute of limitations) each of the five responsible persons has the right to file a refund claim and pursue court action, so it is IRS policy is to keep excess funds until the statute of limitations has expired and then refund them.

Be alert, therefore, for IRS errors in accounting for penalties. When a TFRP is partially or fully paid by the employer and by a responsible person, the IRS system may not reflect that information in the accounts of others from whom the IRS is seeking to collect. In the IRS audits for fiscal years 2000 and 2001, the GAO estimated that 37% of the unpaid payroll tax cases involving TFRPs “include payments that were not accurately recorded to reflect each responsible party’s [potential] reduction in tax liability.” The IRS has acknowledged these problems and is working to correct the errors.

STEPS TO MINIMIZE EXPOSURE
When money is tight and payroll taxes are delinquent, paying employees and creditors conflicts with protecting management from personal liability for unpaid payroll taxes. “ Questions in an Audit of Delinquent Payroll Taxes ” contains some key questions the IRS asks to determine whether an individual is liable for the TFRP. It is important to recognize that after the IRS introduces proof in court, the taxpayer has the burden of proving he or she was not a responsible person or that there were no willful payments made to other creditors while payroll taxes remained delinquent. A responsible person can avoid a charge of willfulness—and thus a TFRP—by taking all reasonable efforts to see that trust fund taxes are paid before other liabilities are paid.

Be alert to payroll tax delinquency. CPAs should make it clear to clients and employers that even if they do not have duties related to payroll and tax payments, responsible persons are still obligated to take necessary steps to determine whether payroll taxes are current when they know the employer is in financial difficulty. These steps may include obtaining a written confirmation from the person who has payroll tax responsibility that payroll tax deposits are not delinquent. Failure to take such action can be evidence of reckless disregard of duty, which is the equivalent of willful failure to pay the taxes.

Make required payments on mortgages. The Supreme Court has said the IRS interest in employer funds is not greater than IRS rights where there is a tax lien. According to the Court and to revenue ruling 68-57, IRS claims on employer funds are subordinate to collateral that is the subject of a purchase-money mortgage and perfected security interests in certain collateral, including inventory. It’s important for CPAs and other executives to identify the payments a company can make without risk of personal liability.

Carefully specify allocation of tax payments. Taxpayers often fall into a trap when they make payments on outstanding payroll tax liabilities. Assume the following information about an employer’s delinquent tax liability for the current year:

Trust fund taxes total $400,000—the total of the first two items. If the employer or a responsible employee makes a $400,000 payment to cover the trust fund taxes, the IRS may seek to apply the payment first to non-trust-fund taxes of $350,000 (last two items), leaving only a $50,000 reduction in the trust fund liability. By doing this the IRS preserves its right to seek payment for the remaining $350,000 from either the employer or the responsible employee.

The courts recognize a taxpayer’s right to designate how the IRS will apply a voluntary payment. However, it is important for the taxpayer to provide the IRS with the necessary information about the deposit and clearly designate how it wants the service to apply the funds. Otherwise, the IRS will apply the payment in a manner that maintains the liability of responsible persons for trust fund taxes.

Be ready to resign. Sometimes it is obvious that there is no relief in sight for a company with delinquent payroll taxes. As a last resort, employees and board members can resign to minimize their exposure. Ceasing to be responsible persons will shield them from liability for additional accruals of payroll taxes but will not provide protection for payroll taxes already accrued.

POTENTIAL RELIEF MEASURES
There are a number of steps CPAs can recommend individuals take to minimize a TFRP.

When the IRS proposes to assess the 100% penalty, Treasury regulations section 601.106 says taxpayers have the right to request an appeals conference with the IRS before it assesses the penalty. The IRS must assess a tax or penalty before starting collection action.

A taxpayer can have a collection due process hearing before any assets are seized by the IRS. At this hearing the taxpayers may challenge the appropriateness of collection actions or suggest alternatives such as an installment agreement or an offer in compromise (OIC).

When the IRS assesses the TFRP, an OIC may be the taxpayer’s best option, provided the business has filed all required tax returns. The IRS may compromise a tax liability because doubt exists as to the taxpayer’s liability, doubt exists as to collectibility, or collection would create an economic hardship or would be inequitable.

Collection activities (and the running of the period for collection) are suspended while the IRS processes the OIC. If the OIC is based on an inability to pay, the taxpayer must complete a form with information that shows he or she is able to pay only the amount proposed in the offer (form 433-A for individuals or form 433-B for businesses). Unless the offer is based on doubt as to liability, it will be valid only if the taxpayer files all required tax returns and pays all taxes for the following five years. If the IRS thinks a taxpayer has (or will have) the resources to pay the tax bill, it will not accept a compromise. The taxpayer is bound by the terms of an approved OIC.

Michael J. Roberts owed income taxes of $160,000; the IRS assessed a TFRP of $10,000. The IRS accepted an OIC under which Roberts made a $30,000 payment, waived the benefits of any capital losses realized from the disposal of certain businesses and agreed to comply with all tax code provisions related to filing returns and paying taxes for the next five years. However, on his next tax return, Roberts underpaid his income tax liability by about $250,000. The IRS declared the OIC in default and terminated it. The full amount of the liability, less payments Roberts already made, became due. The IRS requires convincing evidence a taxpayer is not able to pay the full liability before it accepts an OIC. Apparently, the IRS had been convinced Michael Roberts was unable to pay more than $30,000 of the $170,000 liability.

After the IRS has assessed a TFRP, a taxpayer can ask a court to determine that it does not owe the penalty—by carefully taking a series of steps. First, the taxpayer will pay a representative amount of tax—the trust fund tax owed for one employee. Then, the taxpayer will file a claim for refund, which the IRS will deny. At that point, the taxpayer can file a lawsuit against the federal government. The court’s decision regarding the refund claim settles the matter for the entire assessment. If the taxpayer wins the case and is entitled to a refund for one employee, the IRS loses on the overall issue regarding assessment of the penalty.

Section 6672(d) provides that a responsible person who pays the penalty can bring an action against other responsible persons for reimbursement for their shares. The IRS must disclose the names of others it has identified as being responsible persons.

The IRS has the authorization under section 6159 to enter into written installment agreements. Taxpayers may ask the IRS to approve such plans to pay a TFRP.

PRACTICAL TIPS TO REMEMBER

When the IRS proposes a TFRP assessment, CPAs should give the matter serious attention. Protracted legal action may result in substantial accounting fees, legal fees and other costs. CPAs should advise employers to consider these tips to minimize damage: Make accurate reporting and payment of payroll taxes a top priority. When faced with a choice of failing to pay the utility bills and other expenses or failing to pay payroll taxes, make every attempt to avoid borrowing from the payroll tax trust fund. Consider all alternative sources of funds, such as sale of excess assets, borrowing and additional equity investments by a proprietor, stockholders or partners. When sending a voluntary payment to the IRS, carefully designate the money as being for the “trust fund” tax liability and provide the IRS with the necessary information about the deposit. Limit the number of employees who are classified as responsible persons and the number of individuals who have authority to approve invoices for payment. Don’t designate employees as authorized check signers unless they actually sign checks. If there aren’t enough resources to pay a TFRP, consider an offer in compromise, installment agreement or similar arrangement. Seek reimbursement from other responsible persons for any TFRPs paid.

FACE THE MUSIC
One court has said the broad definition of responsible person has a prophylactic purpose of encouraging officers, directors and other high-level employees to stay abreast of the company’s withholding payments—even if it isn’t their direct responsibility. While the tax code’s seemingly unlimited penalty provisions do encourage compliance, the large numbers of individuals who face TFRPs means mistakes are made too frequently. Taxpayers that aren’t careful may be subject to significant penalties; those that engage in fraudulent or criminal behavior face even greater punishment. The best service CPAs can provide is to encourage clients and employers to comply with all payroll tax rules at almost any price or be prepared to face the consequences.

1. When and how did you first become aware of the delinquent payroll taxes?
2. What action did you take to see that the tax liabilities were paid to the IRS?
3. Were discussions or meetings ever held by stockholders, officers and other interested parties regarding the nonpayment of the taxes?
4. During the time the delinquent taxes were accruing, or at any time thereafter, did the company pay any financial obligations?
5. Which individual or individuals authorized or allowed the payment of any of these obligations?
6. During the time that delinquent taxes were accruing, or at any time thereafter, did the company meet all or part of its payroll?
7. When there was not enough money to pay all of the bills, what decisions did the company make and what actions did it take to deal with the situation?