Beware of Failures to Remit Payroll Taxes

This is the twelfth in a series of brief articles that Moye White is sending to its clients and friends to provide practical advice about the opportunities and challenges presented by today's economy.

Beware of Failures to Remit Payroll Taxes

In difficult economic times, cash flow quickly becomes an issue. Businesses will understandably consider their options to conserve or protect cash flow, including slowing down the rate certain bills are paid. Some obligations are more ‘discretionary’ than others, however, as two federal tax cases released in January remind us.

What are Trust Fund Taxes?

Federal taxes are withheld from an employee’s paycheck generally for two reasons. First, under the familiar ‘pay as you go system’ applicable to wage earners, income taxes will be withheld at prescribed rates. Second, social security taxes are also withheld. These withheld amounts are referred to as ‘trust fund’ taxes because they are considered by federal law to be held in trust by the company for the federal government, until paid over to the IRS.

Who is Liable?

The employer itself is liable to collect and periodically remit trust fund taxes to the federal government, together with the employer’s matching portion of social security. However, the Internal Revenue Code also imposes liability for trust fund taxes on individuals who are ‘responsible persons.’ Specifically, Section 6672 of the Internal Revenue Code allows the government to assess a penalty against any ‘responsible person’ who ‘willfully’ fails to collect, account for, and pay the trust fund taxes over to the IRS. This is often referred to as the ‘100% penalty’ because the government can collect the entire amount of the trust fund taxes from the responsible person.

This means the IRS can impose personal liability on responsible persons for trust fund taxes even if the business is operated by a corporation, limited liability company, or other form of entity otherwise affording limited liability protection. The government has specific statutory authority to assess the 100% penalty directly against those liable. It does not have to “pierce” the corporate veil or do anything other than show that the person against whom the penalty is asserted was a responsible person who willfully failed to pay over the taxes. If the IRS assesses this 100% penalty against a person, the burden of proof is on that person to prove he was not a responsible person and the IRS does not have to prove that the person is a responsible person.

Who is a ‘Responsible Person’?

The determination of a ‘responsible person’ depends on the person’s status, duty, and authority. The crucial inquiry is whether the person had the ‘effective power’ to pay the taxes - that is, whether he had the actual authority or ability, in view of his status within the company, to pay the taxes owed. The courts will look to various factors in making this determination, including the holding of a titled office, board membership, control over day-to-day affairs, check signing authority, other authority to disburse company funds and make decisions regarding the payment of creditors, equity ownership, and the ability to hire and fire employees, however, no one factor controls. For example, one can be held to be a responsible person even if he does not have checksigning authority on a corporate account.

An officer or employee is therefore responsible if he has significant, though not necessarily exclusive, authority in the general management and fiscal decision-making of the company. If there is more than one responsible person at the company, they are all jointly and severally liable for the 100% penalty.

In a very recent case, the IRS successfully asserted the 100% penalty against a doctor who was the sole shareholder, sole director, and president of a small company. He never signed company checks; however, checks were issued using a rubber stamp with his signature on it. Day-to-day operations were in the hands of family members, and he never visited the company’s offices. He was aware that the company was in financial trouble, and frequently made loans to the company to keep it afloat. Despite his claim that he was not directly involved in the company, he was found to be a responsible person. The court noted that while he perhaps was not the most responsible person, he certainly was one of them, and so he was held liable for the 100% penalty of over $1 million in unpaid trust fund taxes and interest.

What Constitutes a ‘Willful’ Failure?

A responsible person's failure to pay over withholding taxes must be ‘willful’ in order for the 100% penalty to apply. Willfulness can be established under two theories. First, a responsible person's conduct is willful if she acts (or fails to act) consciously and voluntarily and with knowledge or intent that as a result of his action or inaction trust funds belonging to the government will not be paid over but will be used for other purposes. Second, a responsible person can also act willfully if she acts with a reckless disregard of a known or obvious risk that trust funds may not be remitted to the government.

In the case noted above, the court found the doctor to have acted willfully because he recklessly disregarded an obvious risk that trust fund taxes were not being collected or paid over. He knew or should have known this risk but nevertheless stood by – and in fact provided financial assistance – while the company operated “on the brink of disaster.”

In another recent case, two registered nurses jointly formed a company, and elected themselves as the president and vice-president. The nurses were clearly responsible persons, but tried to argue that they had not acted willfully in failing to pay the trust fund taxes. They contended that the government had caused their cash flow problems by failing to promptly pay for Medicare services rendered by the company. The court rejected this contention noting that any argument that a responsible person does not act willfully if the company had no assets to pay the payroll taxes “borders on the ridiculous.” Each of the two business owners was held jointly and severally liable for a $581,360 penalty, plus interest.

What’s to be Done?

Corporate officers with financial decision-making authority are clear candidates for imposition of the 100% penalty. If you are a ‘responsible person,’ do not stick your head in the sand. Inquire whether your company is current in its payroll tax filings, which are made using Form 941. If not, push for those taxes to be paid. Payroll taxes have a habit of adding up fast, and the personal exposure for responsible persons can be enormous.

For more information contact: Jim Serven or Ted White, Chair, Transactions Section at (303) 292-2900.

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Moye White LLP has prepared this bulletin to provide general information, however this bulletin does not provide legal advice and does not create an attorney-client relationship between the reader and Moye White. No legal or business decision should be based solely on the content of this bulletin.