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.
$12 Billion and Counting…
About 128,000 individuals have
outstanding trust fund recovery
penalties as a result of their failure
to pay payroll taxes. Including
accumulated interest, these penalties
average $93,750 a person and total
about $12 billion.
Source: IRS Chief Financial Officer’s
Office of Unpaid Assessment
Analysis,
www.irs.gov .
| 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.)
Trust
Fund Recovery
Penalty Litigation I n
the 12 months ended June 30, 2004, federal
courts decided 27 TFRP cases. Nine
involved preliminary legal issues such as
jurisdiction of the court to hear the
case, and did not disclose the amount of
the penalties that had been assessed. But
the 18 that disclosed the penalty amounts
assessed averaged $230,000 per case.
In four of these 18 cases, the
taxpayer had some measure of victory. In
one case, the taxpayer was able to avoid
a penalty of $48,265 by proving that he
was not a responsible person. In the
second the taxpayer was a “responsible
person” for only a limited period of
time. In the third the taxpayer
compromised a $500,000 debt for $30,838
and was able to avoid payment of
interest on the penalty. In the fourth
the taxpayer was able to have some
interest abated. Exhibit 1 provides a
summary of these tax cases and related
IRS statistics.
| 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.
Exhibit 1
: Federal Payroll
Tax TFRP Cases |
Court
decisions in latest 12 months
(July 1, 2003–June 30, 2004)
| Number
of TFRP cases decided | 27 |
Number of TFRP cases that
disclosed penalty amounts |
18 |
Total delinquent TFRP
assessments in sixteen recent
cases (rounded) | $4,134,000
| Average TFRP
assessment per person (rounded)
| $230,000
|
| |
| IRS
statistics as of September 30,
2003 |
Unpaid payroll taxes |
$58 billion
| Outstanding
TFRPs | $12
billion | Made
up of: initial assessments |
$8 billion
| accumulated
interest | $4 billion
| Number of TFRPs
outstanding | 318,882 |
Number of individuals
with a TFRP | 128,000 |
Average TFRP assessment
(some have multiple assessments)
| $37,631
| Average TFRP
assessment (including interest)
per responsible person | $93,750
| |
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.
Exhibit 2
: Criminal Cases
| The
courts assess criminal penalties, which
often involve prison time, against anyone
who intentionally violates a known legal
duty. In criminal payroll tax cases, the
individual often is found guilty of
intentionally failing to file payroll tax
returns or filing false returns. Any
prison sentence is in addition to the
requirement to pay the back taxes.
David Morrison struck out in the
Fourth Circuit Court of Appeals, where
he appealed his conviction on a criminal
charge of failing to pay more than $4.5
million in payroll taxes withheld from
the pay of employees of Logan General
Hospital. A criminal conviction for
failure to pay withholding taxes carries
a maximum prison sentence of five years;
Morrison was sentenced to 97 months for
failing to pay withheld payroll taxes to
the IRS and for other crimes involving
embezzlement of funds from the hospital.
In one of the more interesting
criminal cases, Richard Dvorak was
sentenced to 41 months in prison for
filing fraudulent payroll tax returns on
which he understated payroll taxes by
more than $13 million. With this money
he was able to buy a $1.2 million yacht,
a $1 million mansion and a farm. He
spent $4 million on renovations to his
properties. Federal
Criminal Payroll Tax
Cases–Fiscal Years 1998, 1999
and 2000 |
Criminal investigations
initiated | 112 |
Number of sentences |
127 |
Incarceration rate |
85.8% |
Average months of
incarceration | 17
| |
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. ”) Mr
. Crutcher’s
Million-Dollar Error
Who is Buford Crutcher?
Buford Crutcher recently
lost a battle when the court ruled he was
personally liable for more than $1 million
in payroll taxes that Science and
Technology (SciTek) Corp. should have
paid. The struggling company needed cash
for operating expenses and Crutcher
allowed it to use withheld payroll taxes
to keep the business going. Crutcher
was a 13% stockholder of SciTek and had
served as a member of the board of
directors for more than 25 years. He was
vice-president of operations until 1998.
In 1996 SciTek lost a government
contract that provided 85% of its
revenue, and struggled from that point
on. The corporation began bouncing
checks, its creditors started requiring
payment by certified bank drafts, and it
stopped depositing payroll taxes
withheld from employees. Ultimately,
SciTek owed the government more than $1
million. Crutcher argued he was
not a responsible person because his
brother, who was president and a 60%
shareholder, controlled corporate
operations. Crutcher said his job was to
obtain contracts and oversee performance
on some of them. He did not have any
control or direction over the accounting
department and never gave instructions
that specific checks be prepared. He
signed checks when the company president
was not available but only when the
president had preapproved them. The
president was the only one who ever gave
instructions to prepare checks.
After 1996 SciTek paid more than $4
million in salaries and expenses, while
allowing unpaid payroll taxes to grow to
more than $1 million. Because Crutcher
knew about this and actually signed some
of the checks, he was found to be a
responsible person who willfully failed
to see that the company paid payroll
taxes to the IRS. The bottom
line: Buford Crutcher personally owed
the IRS more than $1 million.
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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.
Taxpayer
Battle Can Drag On
T he legal costs were in
excess of $25,000 for Lemuel O. Nixon, who
served as a volunteer for a nonprofit
organization and was president of the
board of directors. The IRS determined the
entity had not paid payroll taxes and
proposed to assess Nixon a TFRP of
$38,651. Although Nixon had the
authority to sign checks, he was not
compensated for his service, was not
involved in the management of the
organization and did not know that the
payroll taxes were not being paid.
Accordingly, he qualified for protection
from such penalty under section 6672(e)
of the tax code, protection for
volunteers in nonprofit organizations
that was added by the Taxpayer Rights
Act of 1996. The IRS assessed
the 100% penalty against Nixon, even
though, according to the court, it had
no evidence Nixon had been guilty of
willfully failing to see that payroll
taxes were paid. The IRS continued to
pursue Nixon in court for payment, even
though it had fully collected the
penalty from another board member two
months earlier, and continued to levy
Nixon’s monthly IBM pension payment.
Eight months after the penalty had been
paid, the IRS brought court action
against two other board members to
collect the penalty. Almost four years
after the IRS assessment, Nixon finally
won his case in court and the government
was required to reimburse about $25,000
of his legal fees.
Lemuel O. Nixon
1999-2 USTC 50,673 and 1999-2 USTC
50,674.
| 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: Employee income
tax withheld | $300,000 |
FICA withheld | $100,000
| Employer’s FICA match
| $100,000 | Other
corporate tax liabilities |
$250,000
| 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.
RESOURCE |
AICPA
Resource |
CPE
Payroll Taxes and
1099s: Everything You Need to
Know (# 730754JA).
| |
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.
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