Sometimes, when businesses get in financial trouble, they are tempted to pay creditors or others instead of paying the government the income and employment taxes it has withheld from employees’ wages. This is a big mistake and can lead to large penalties against business owners or others who are responsible for paying over such taxes. In such situations, the IRS can levy on the individual assets of the responsible person. The IRS may even criminally prosecute the “responsible persons” who make this decision.

To encourage prompt payment of withheld income and employment taxes, including social security taxes, railroad retirement taxes, or collected excise taxes, Congress passed a law that provides for a trust fund recovery penalty (TFRP). Income and employment taxes are called trust fund taxes because you actually hold the employee’s money in trust until you make a federal tax deposit in that amount. The TFRP may apply to you if these unpaid trust fund taxes cannot be immediately collected from the business.

The amount of the penalty is equal to the unpaid balance of the trust fund tax. The penalty is computed based on the unpaid income taxes withheld, plus the employee’s portion of the withheld FICA taxes. For collected taxes, the penalty is based on the unpaid amount of collected excise taxes.

The TFRP may be assessed against any person who is responsible for collecting or paying withheld income and employment taxes, or for paying collected excise taxes, and willfully fails to collect or pay them.

For purposes of the TFRP, a responsible person includes, but is not limited to an officer or employee of a corporation, a partner or employee of a partnership, a member or employee of an LLC, a corporate director or shareholder, another corporation, or a surety or lender.

The IRS does not need to use the TFRP to assert liability against the owner of a sole proprietorship or a general partner of a general partnership, because the individual owner or the general partners are already personally liable for trust fund taxes. In fact, sole proprietors and general partners are liable for the WHOLE amount of unpaid payroll taxes, not only the trust fund portion withheld from employee wages. However, the IRS can use the TFRP to assert liability against an employee or other non-owner who exercises control over a sole proprietorship’s finances.

Regardless of a person’s corporate title, a person will not be held liable for the TFRP unless he or she is considered a “responsible person” (i.e., an individual who has the duty to account for, collect, and pay over the trust fund taxes to the government). There may be more than one responsible person in a business.

Most trust fund recovery cases involve corporate officers. A director who is not an officer or employee of the corporation may be responsible for the trust fund recovery penalty if he or she was responsible for the corporation’s failure to pay taxes that were due and owing.

I cannot over emphasize the importance of paying over to the IRS taxes that are withheld from your employees’ wages. As an officer/owner of your business, you are the first person the IRS will look to, to collect any unpaid withholdings. I cannot emphasize enough this point: If found to be the person responsible for withholding, collecting, and paying these taxes over to the IRS, you will be personally liable for any nonpayment that is considered to be willful. This means that you will have to pay the taxes out of your own pocket. In addition, there is the possibility of criminal prosecution for this failure, if you are found to be a “responsible person”.

Under the system established for withholding taxes, your employees are credited for any taxes withheld from their wages. Your company is deemed to hold the withheld taxes “in trust” for the federal government. This is why withholding taxes are referred to as “trust fund taxes.” Often times, businesses that experience financial trouble will use taxes withheld from employees’ wages to pay creditors and suppliers in order to keep the business afloat. However, if the business eventually fails, the employees are not liable for the unpaid taxes, and the business probably doesn’t have sufficient funds to satisfy the trust fund tax liability.

By enacting §6672 of the Internal Revenue Code, Congress made sure that the government would have the means to recover trust fund taxes if, for whatever reason, they are not paid. Section 6672 imposes personal liability on any person who is required to collect, truthfully account for, and pay over trust fund taxes but who willfully fails to do so. In the past,this has been referred to as the “100% Penalty” because the amount of liability is equal to 100% of the taxes withheld from the employees’ wages. More recently, the IRS calls this the “Trust Fund Recovery Penalty.”

Let us look at the elements for liability under §6672. First, to be liable, a person must be a “responsible person.” There is no one factor that makes an individual a responsible person. Generally, a responsible person is the one who has the power and authority to control the business’s decision-making process regarding the payment of creditors. In most cases, the IRS looks to officers and owners of a business as responsible persons because they are the ones who make the decision concerning which creditors to pay and which ones not to pay. Courts have found stockholders, directors, managers, bookkeepers, and people outside the business to be responsible persons because they had the ultimate authority over the disbursements of the business’s funds. More than one person can be held liable, too.

Still, there is a second element without which a responsible person is not liable for the Section 6672 penalty: Willfulness. Willfulness does not mean that there is some bad motive or intent. Rather, for these purposes, willfulness can be established if there is evidence that the responsible person(s) knew that payments were being made to other creditors or suppliers at a time when withheld taxes were not being paid to the IRS. In some cases, the responsible person does not actually have to be aware that the taxes are not being paid in a specific instance if there is a history of nonpayment of trust fund taxes at times of financial crisis.

It’s called the “trust fund recovery penalty” (or simply the “trust fund penalty“) because it applies to the Social Security and income taxes required to be withheld by a business from its employees’ wages. Since the taxes are considered property of the government, the employer holds them in “trust” on the government’s behalf until they are paid over. It’s also called the “100% penalty” because the person liable for the taxes (the “responsible person” described below) will be penalized 100% of the taxes due. Accordingly, the amounts IRS seeks when the penalty is applied are usually substantial, and IRS is very aggressive in enforcing this penalty.  The trust fund recovery penalty is among the more dangerous tax penalties because it applies to a broad range of actions and to a broad range of persons. What actions are penalized? The penalty applies to any willful failure to collect, or truthfully account for and pay over Social Security and income taxes required to be withheld from employee wages.

Who is at risk? The penalty can be imposed on any person “responsible” for collection and payment of the tax. This has been broadly defined to include a corporation’s officers, directors, and shareholders under a duty to collect and pay the tax as well as a partnership’s partners, or any employee of the business under such a duty. Even voluntary board members of tax-exempt organizations, who are generally excepted from responsibility, can be subject to this penalty under certain circumstances. Responsibility has even been extended in some cases to family members close to the business, and to attorneys and accountants.

IRS says responsibility is a matter of status, duty, and authority. Anyone with the power to see that the taxes are paid may be responsible. There is often more than one responsible person in a business, but each is at risk for the entire penalty. Although a taxpayer held liable may sue other responsible persons for contribution, this is an action he or she must take entirely on his or her own after he or she pays the penalty. It cannot be part of the IRS collection process. Note how broadly the net can be cast: You may not be directly involved with the withholding process in your business. But if you learn of a failure to pay over withheld taxes and have the power to have them paid and instead make payments to creditors, etc., you become a responsible person.

What is “willfulness?” For actions to be willful, they don”t have to include an overt intent to evade taxes. Simply bowing to business pressures and paying bills or obtaining supplies instead of paying over withheld taxes due the government is willful behavior for these purposes. And just because you delegate responsibilities to someone else doesn’t necessarily mean you are off the hook. Your failure to take care of the job yourself can be treated as the willful element.

Avoiding the penalty. Absolutely no failure to withhold and no “borrowing” from withheld amounts should ever be allowed-regardless of the circumstances. All funds withheld must also be paid over.

You can see from this brief discussion that it is not difficult for the IRS to impose personal liability for unpaid trust fund taxes on the person responsible for making the financial decisions in a business. Moreover, this liability never goes away. For instance, it would survive a personal bankruptcy. Yet, there are ways to structure business holdings to protect the family’s assets and home. I hope that your business will continue to enjoy its success, but I think it is a good idea for us to meet and make sure that you or your professional advisors are doing everything possible to protect you and your personal holdings from liability in the event something should go wrong.

If you have any questions regarding this penalty or have any concerns relating to any potential personal liability, please give us  a call at your earliest convenience so we can discuss your situation.