WHY YOU SHOULD ALWAYS PAY YOUR PAYROLL TAXES: A PRIMER ON TRUST FUND RECOVERY PENALTIES (PART 1)
By: Kevin Murphy, Esq.
When we discuss potential liability for the Trust Fund Recovery Penalty (TFRP)- I.R.C. § 6672, we often find the need to explain how payroll taxes work. Many clients, some lawyers and accountants and unfortunately even some IRS agents and Assistant U. S. Attorneys don’t really understand what constitutes a trust fund liability. Everyone has heard of and paid payroll taxes, but that doesn’t mean they grasp the mechanics of how it works.
An employer must pay federal payroll taxes on an employee’s wages. This payroll tax is reported on IRS Form 941. The tax consists of three parts:
- Withholding for employees’ income taxes
- Withholding for employees’ FICA (Social Security and Medicare)
- Employer’s contribution to FICA
The first two parts above make up the trust fund recovery penalty.
So, the employer must withhold income taxes from an employee’s pay based on the W-4 filed by the employee. The employer must also withhold 6.2% of wages for the employee’s portion of Social Security tax and 1.45% for the employee’s portion of Medicare tax. These amounts are withheld from an employee’s paycheck and are then held in trust by the employer to be paid over to the government with the filing of the 941 form.
The employer must also contribute an amount equal to the employee’s contribution for FICA (Social Security tax and Medicare). This amount does not come out of the employee’s paycheck and is paid directly by the employer. This amount is owed by the employer to the government, but it is never part of the trust fund recovery penalty and is known as the non-trust fund portion. The employer must also pay an excise tax for federal unemployment tax, (FUTA). This amount is also not included in the trust fund recovery penalty.
If the three parts above are not paid to the government, the IRS can take action to assess and collect against the employer. In the case of the trust fund portions, the IRS can also assess and collect not only from the employer, but from parties known as “responsible persons”.
I.R.C. § 6672 allows the IRS to hold an individual personally liable for the amount required to be withheld and turned over to the government. In effect, the statute allows the IRS to “pierce the corporate veil”, and the business does not have to be a corporation. Any employer, no matter what type of business entity have people who are responsible for payroll and financial decisions. Any and all of those people could be held to be “responsible persons” by the IRS.
It often happens like this, a business experiences cash flow problems for any number of reasons, so that quarter, in order to keep the business afloat, you pay net payroll to your employees and use the money that you would ordinarily withhold in taxes for other pressing needs-like your mortgage. In that instant you have in effect stolen from the employee and the government. If you are deemed to be a “responsible person”, you may be personally liable for the trust fund taxes. This could also open you up to potential criminal liability. More on that later.
The IRS needs to establish two elements in order to determine that an individual is liable:
The determination that you are a responsible person is fact specific and generally breaks down into three factors:
- Individual status within the business.
- Involvement in day to day operations.
- Involvement in financial affairs.
The Internal Revenue Manual, IRM 18.104.22.168.1, contains guidance for IRS revenue officers in making their determination. Does a person have the duty to perform? Do they have the power to direct the act of collecting trust fund taxes? Do they have the authority to pay trust fund taxes? Do they have the authority to determine payment of creditors? In other words, does the person have the decision- making authority to pay another creditor before they pay the government?
Many times, the IRS will look at who has signatory authority within the business. That provides good evidence to support their determination. But we need to caution you that responsible person status is not limited to officers. A mere employee can be a “responsible person” if they have authority over expenditures. Conversely, holding a title doesn’t guarantee that an officer is a “responsible person” without other factors. Unfortunately, without experienced counsel on board to present exculpatory evidence, many individuals who really don’t qualify as “responsible persons” are labeled as such.
The IRM also guides the RO in deciding whether your actions are willful. IRM 22.214.171.124.2, defines willful as intentional, deliberate, voluntary, reckless and knowing as opposed to accidental. The person must have been “aware” or “should have been aware” of the outstanding tax liability, but intentionally disregarded the law. Notice the IRM doesn’t say, that if you are a struggling business doing your best its ok and we won’t bother you again.
It often happens this way: An IRS Revenue Officer (RO) will show up at your door and begin to ask questions. Actually, before that you will probably receive some notices in the mail. Sometimes that notice is to tell you that the IRS is sending a summons to your bank for the bank signature cards on your account. DO NOT IGNORE THESE NOTICES. THE IRS DOES NOT GO AWAY EVEN IF YOU WANT THEM TO. They may forget for a while; it might take them a quarter or two to catch up to you, but they will catch up, guaranteed. And when they show up it will typically be unannounced.
The RO will be armed with an IRS Form 4180- “Report of Interview with Individual Relative to the Trust Fund Recovery Penalty or Personal Liability for Excise Taxes”. This is known as the 4180 interview. It’s supposed to be done on every person that may potentially be liable for the penalty. Its questions and answers guide the RO in making their determination. It is a four-page form with detailed questions regarding the financial aspects of your business. It doesn’t contain a jurat (penalty of perjury) like a tax return, but the person signing it, (if you are interviewed you must sign it), declares that the information given is true and correct.
We can’t stress enough that this is a serious matter. The RO may be friendly, most that I know are, and they are upstanding and honorable people with a difficult job. But they aren’t your friend. They have a job to do and most do it very well. We urge you not to ignore any IRS notice and to contact counsel with knowledge of the process before you submit to it.
It is no excuse if your business is struggling. It is no excuse if you needed to pay a supplier first. It is no excuse if you had to pay your mortgage first. The burden is on you to show that you aren’t willful and your defenses are very limited. It is beyond the scope of this blog, but a reasonable cause defense similar to that for other IRS penalties is not in the statute and is extremely limited or non-existent depending on what Circuit you reside in. Don’t rely on it.
If you are determined to be liable, the “penalty” is the withheld amount of income taxes, plus the withheld FICA that should have been paid over. It does not include FUTA or taxes, penalties or interest assessed against the employer. Also, even though it’s referred to as a “penalty”, there is no penalty on the TFRP and interest does not accrue on the liability until its assessed against you.
The TFRP can be, and often is, assessed against multiple individuals in a business. It is a joint and several liability, which means if the IRS assesses it against you and your two partners and your two partners head to Paraguay leaving you holding the bag, you are liable for the entire amount, not one-third. It is a very effective tool for the IRS. They can chase the business, one individual or several. We have had clients who might say, “The business is closed, the IRS can’t get blood from a rock”. They can. And often do. Oh yes, did we mention that the TFRP cannot be discharged in bankruptcy
The IRS will only collect the total liability once. And any payments toward it, either by the business or another individual will reduce the liability. But is crucial to understand that this TFRP assessment will be made against you personally and will be collected out of your personal assets, no matter your business structure. That means the IRS can place a lien on your bank accounts, your investment accounts and your house. And levy the same.
The general procedure goes like this:
- RO investigation
- 4180 Interview
- IRS Determination
- “60 day letter”- IRS 1153-Proposed Assessment of TFRP
- Taxpayer then has 60 days to protest the assessment with IRS Appeals
The filing of a protest stops the assessment and prevents collection and accrual of any interest. TFRP determinations are one of the most heavily litigated areas in tax law. The Appeals Officers have absolute authority to settle and will look at the determination objectively. As we’ve stated it is important that you retain counsel as early in the process as possible. Many times competent counsel can save you untold money and stress if brought in early enough. But it is absolutely imperative that you have counsel during the Appeals process. It is realistically your last bite at the apple before assessment.
Remember we mentioned criminal liability. I.R.C. § 6672-the civil statute is virtually identical to I.R.C. § 7202-the criminal statute. § 7202 states in effect that “any person” who fails to collect and pay over trust fund taxes, “shall” be guilty of a felony and be fined not more than $10,000 or imprisoned not more than five years or both. Both IRS Criminal Enforcement Division (CID) and the Department of Justice have made criminal enforcement of employment tax cases a priority, and officials from both agencies have stated that taxpayers with financial hardship are still committing a crime. We will explore this more in Part 2 of this blog.
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