With local, state and federal governments suffering the effects of the economic downturn, it should come as no surprise to anyone in the industry that tax laws will be subject to stricter enforcement to shore up plummeting revenues. What might come as a surprise is just how far the tax collector’s reach can extend, however.
One of the nastiest and most feared taxes currently imposed is called the Trust Fund Recovery Penalty Tax, a whopping 100% penalty on payroll taxes withheld from employees but not forwarded to the Federal government. The fear stems from the Internal Revenue Service’s authority to assess the penalty on “responsible parties,” a label that can include the owners, shareholders, partners, members, managers and officers of a drycleaning business.
All businesses are required to collect and remit payroll taxes, including Federal income tax, Social Security and Medicare taxes, and unemployment taxes. The business does not pay all of these taxes itself, but must collect them as withholding and turn the money over to the IRS.
The legal presumption is that when a partial payment of withheld taxes is made to the IRS, the corporate or business portion is paid and the employee-withheld portion is retained. It is “unlawful retention” that forms the basis for the 100% penalty — a tax that accrues additional penalties and interest the longer it goes unpaid.
The penalty can be breathtakingly expensive. Whether the government has received the taxes withheld by employers or not, the IRS must pay tax refunds to employees whenever warranted. Since the government’s greatest source of revenue and immediate cashflow is employer payroll taxes, the IRS has been granted extraordinary powers to enforce their collection.
Because withheld payroll taxes are not the property of the business, tax laws have stripped away many protections formerly provided to business entities such as corporations and limited liability companies (LLCs). In other words, corporate officers and partners are liable for payment of employment taxes, and can’t hide behind a corporate “shield” to avoid payment.
The IRS is now willing to prosecute those who “willfully” fail to file payroll tax returns or pay payroll taxes. And often, the IRS will seek to collect unpaid taxes from anyone involved in running the business — particularly those who made financial decisions, handled the books or signed the checks.
Generally, the IRS uses two tests to determine if someone is subject to the Trust Fund Recovery Penalty. They are primarily questions of fact: (1) whether the party against whom the penalty is proposed had the duty to account for, collect and remit trust-fund taxes; and (2) whether he or she willfully failed to perform this duty.
The Trust Fund Recovery Penalty has even been assessed against bank officials and employees who have the authority to direct the financial affairs of the business. Of course, this individual is not responsible unless he or she furnishes funds to a business, directs how the funds are distributed, or directs the business not to pay the taxes.
It is not unusual for the IRS to assess the penalty against several responsible persons, and the IRS can collect the entire liability from any of those persons. The tax law also imposes liability on all responsible persons, not just the “most responsible” person.
The IRS then must prove the element of “willfulness” to assess a penalty. A “responsible” person need not have failed to pay the taxes with a fraudulent or evil purpose, that person must merely be shown to have knowingly and intentionally disregarded the duty to pay trust-fund taxes to the IRS.
“Willfulness” describes “an act is [that] is voluntary, conscious and intentional.” A responsible person acted willfully if he or she “knowingly” used available funds to pay expenses other than withholding taxes.
There is a loophole, of sorts. The IRS would have everyone believe they are liable for the trust fund tax if they have signature authority on the business’ bank account — or are shareholders, sign tax reports, and so on. The law, however, clearly states that an individual who signs checks as a convenience to the employer, does so only when instructed, and doesn’t have any authority to decide who, when or how much to pay, is not a “responsible” person.
Once the IRS determines responsibility, it will notify the person or persons, assess a penalty and begin collection actions against them. It can, for instance, file a Federal tax lien, levy, or seize the responsible party or parties’ personal assets.
The IRS views the Trust Fund Recovery Penalty as a collection tool, and believes (correctly) that the threat of personal liability will encourage business owners and operators to maximize their tax payments. Anyone about to be assessed such a penalty who believes they are not liable must attempt to prove this to the IRS collection personnel as soon as possible.
Why is proving a lack of responsibility important? Because of the “legal entity” concept and other rules, the IRS can only look to the assets of the company for payment of the debt. If the drycleaning business has minimal asset value, the IRS can only collect from the responsible parties.
Many experts advise anyone who might be labeled a “responsible person” to use their own money wisely and pay the trust-fund portion of the debt immediately. This offers personal protection and reduces further penalties and interest. Failure to tell the IRS how to apply the payment may result in the money going toward penalties and interest, however, leaving the individual on the hook for any remaining trust-fund portion.
When an employer fails to properly pay withheld payroll taxes, the IRS can seek a penalty equal to 100% of unpaid taxes from a “responsible person” — again, a person who: (1) is responsible for collecting, accounting for and paying these taxes; and (2) willfully fails to perform this responsibility.
Although a person must be both “responsible” and “willful” to be liable, the burden of the proof of innocence falls on the individual. While the IRS usually investigates readily, it is up to anyone targeted to prove, by a preponderance of evidence, that they are not a responsible person who willfully failed to collect, account for, or pay the drycleaning operation’s payroll taxes. And the best time to think about proving that is now.