A business facing economic or cash flow problems will sometimes keep its doors open by using Social Security, Medicare, and income taxes withheld from employees’ paychecks to pay other creditors, fully intending to make up the shortfall as soon as possible. While such actions may keep vendors, lenders, the landlord, or the electric company at bay — and may keep the enterprise afloat in the short run — the IRS takes a dim view of “borrowing” employee funds. After all, the employees receive full credit for these withholdings on their tax returns. For decades, the Service has imposed civil penalties; recently, the IRS announced it was stepping up its criminal enforcement of employment tax laws.
Internal Revenue Code Section 6672 authorizes the IRS to assess a penalty (known variously as the “Trust Fund Recovery Penalty,” the “Responsible Person Penalty,” or the “100% Penalty”) against certain individuals who willfully fail to “collect, account for, and pay over” employees’ share of withheld payroll taxes. While this liability generally attaches to high ranking officials such as CEOs, CFOs, vice presidents, etc., the IRS and the federal courts have adopted the broad proposition that anyone who wields the actual power or authority to oversee which creditors get paid can be a responsible person. A parallel statute (Section 3509) can make banks or other lenders that supply funds for payrolls liable if they know that payroll taxes are not being paid. However, it has long been IRS policy to only collect the penalty once.
It is important to understand that “willfulness” for this purpose does not require an evil motive or intent; rather, all the statute requires is that a person have the ability to control who gets paid and be aware that taxes are being diverted. Individuals with such authority may be liable even if they never exercise this authority. Moreover, if the Service assesses someone as a responsible person and assesses a penalty, he bears the burden of proving that his conduct was not willful. Cases have held that reckless disregard of a risk that payroll taxes will not be paid, coupled with a failure to investigate, may be deemed willful conduct. Under certain circumstances, the IRS can even assess volunteer charity board directors or trustees, although this rarely occurs if a paid executive was involved.
Although a new buyer of a business is not responsible for prior management’s failure to pay taxes, an owner or other person in control of an entity who learns of unpaid taxes immediately becomes liable if he fails to devote all available funds to pay the back taxes. Many owners, directors, and officers have set up installment agreements with the IRS, only to learn later that they have unwittingly placed their personal assets in jeopardy if all the back taxes are not paid.
Generally, the IRS has three years to assess a trust fund penalty; however, this period does not begin until April 15th of the year following the year in which the quarterly return was filed. Thus, unless and until the business entity files its return, the statute of limitations to assess a trust fund penalty does not begin to run. Once a penalty is assessed, things get worse. Unlike the original employment tax liability, payment of a Section 6672 penalty is not deductible as a business expense; rather, it is considered a nondeductible fine. Even worse, unlike most income taxes, trust fund liabilities are not dischargeable in bankruptcy.
Finally, the government may bring criminal charges for willfully failing to pay employment taxes. Although this power has always existed, the IRS utilized its criminal powers only in the most egregious circumstances, such as a person who demonstrated a pattern of such conduct in one company after another. Recently, however, the IRS Criminal Investigations Division announced its intention to focus on employment tax cases. Although the line between civil and criminal failures is fuzzy at best (the only additional legal requirement under the criminal statute is the violation of a “known legal duty”), the Department of Justice has been open about its view that a responsible person is not absolved of criminal conduct for failing to remit and pay employment taxes because he spent the money to keep the business afloat.
All this means that anyone considering using payroll tax funds to keep a struggling business alive — or anyone in management who learns that payroll funds have been diverted — must tread very carefully to avoid personal liability.