Officers’ Personal Liability for Their Company’s Unpaid Taxes
By Stephen J. Dunn
Many a cash-strapped company fails to deposit its payroll taxes. Unlike other creditors, Federal and state taxing authorities are not at the company’s door demanding their money. The company resolves to pay the tax deficiencies later, when cash is available. Yet that day never arrives, and the problem only compounds. Eventually, tax collectors will appear and seek to collect the tax, penalties, and interest owing by the company. If immediate payment cannot be effected, the tax collectors will enter the company into an installment agreement. Liens in the company’s property arise in favor of the taxing authorities for the amount of the tax, penalties, and interest due them. The taxing authorities will record notices of their tax liens in the register of deeds’ office of the county where the company is located, disabling the company from selling or mortgaging interests in real property, and impairing the company’s credit. If the company does not cooperate with the taxing authorities, the taxing authorities will seize (“levy”) the company’s property.
The taxing authorities will also assess the company’s taxes due personally against the company’s “responsible persons”—those who controlled the company’s available cash, and used it to pay debts other than taxes. In the Federal scheme, such an assessment is called a “trust fund recovery penalty.” A misnomer, it consists of Federal income tax and Social Security tax withheld by the company from employees’ wages but not remitted to the Internal Revenue Service. It excludes employer matching Social Security tax, as well as penalties and interest accrued on the unpaid tax. From the time a trust fund recovery penalty is assessed, the IRS has ten years to collect it. A Federal tax lien encumbers all property owned by the responsible person at the time the trust fund recovery penalty is assessed, or acquired by the responsible person during the ensuing ten years. The IRS records notice of the Federal tax lien in the register of deeds’ office of the county of the responsible person’s residence. In addition to disabling the responsible person from selling or mortgaging interests in real property, and impairing the responsible person’s credit, a notice of tax lien recorded against a responsible person may affect his or her ability to secure new employment. A trust fund recovery penalty is not dischargeable in bankruptcy.
Under Internal Revenue Code Section 7202, anyone required to collect, account for, and pay over to the IRS any tax is guilty of a felony, punishable upon conviction by fine of up to $10,000, or imprisonment of up to five years, or both, for each offense.
States have parallel schemes for holding officers personally liable for their business’ undeposited taxes. Michigan law, for example, provides that any Michigan tax which a business incurs but fails to pay—whether it involves a trust fund or not―may be assessed personally against the business’ responsible persons.
Trust fund recovery penalties are bad stuff. Clearly, payroll taxes are the first obligation an employer should pay. An employer unable to pay its employment taxes should close its doors, immediately, rather that accrue additional trust fund recovery penalty assessments.
There are some things a company can do to protect its principals from personal liability for the company’s taxes:
• Keep spouse out of harm’s way. An assessment of corporate taxes against both spouses would wreak havoc on a marriage. The taxing authority will seek to collect the assessment against the spouses and each of them. If the assessment is not paid immediately, the taxing authority will seek to enter each spouse into an installment agreement. If a spouse refuses to cooperate with a taxing authority, the taxing authority will levy the spouse’s wages, bank accounts, and other property. The taxing authority will also record notice of its lien against the spouses, disabling the spouses and each of them from selling or mortgaging interests in real property. The recorded notices of tax lien will also impair each spouse’s credit, and possible affect each spouse’s ability to secure new employment.
If both spouses work for the same company, care should be taken to keep one of them out of harm’s way. If one spouse is an officer or a director of the company, the other spouse should not have any control over the company’s cash. In particular, the non-principal spouse should not be an authorized signer on any of the company’s checking accounts.
• Retain competent counsel. A company with tax delinquencies needs to consult competent tax counsel about the problem. Inappropriate tax assessments may have been made against the company. The company may have grounds for seeking relief from tax penalties which have been assessed against it. The company may have made tax payments for which it has not been given credit. Perhaps the company should be advised to abandon its business entity. Certainly the company should be advised to allocate its voluntary tax payments to the trust fund portion of its tax obligations. Perhaps the company should sue an embezzling employee, or have the employee criminally prosecuted. Potential targets of a trust fund recovery penalty assessment need to be advised that they are targets, of the consequences of such an assessment, and of available defenses.
• Allocate voluntary payments. Often the best advice I can give a company struggling to pay its payroll taxes is to allocate voluntary payments against the company’s outstanding trust fund obligations. Only a voluntary payment made by check (as opposed to electronic funds transfer) may be allocated. The front of the check should specify the usual identifying information for the taxpayer company, including the company’s name and taxpayer identification number (TIN), and the type of tax being paid. The front of the check should also state, “See restrictive endorsement on reverse.” On the back of the check, above where the first endorsement would be made, the taxpayer should write the following: “This check must be applied first against outstanding trust fund obligations of the taxpayer, [taxpayer’s name], TIN [taxpayer’s TIN].”
Only voluntary payments or payments made under an informal installment agreement can be allocated. Payments made under a formal installment agreement with the taxing authority cannot be allocated, as the terms of such installment agreements provide that the government may allocate payments in its best interests.
• Do not delay assessment without a good defense. A mistake commonly made by a company delinquent in paying its taxes is to avoid tax collection authorities. This is ill-advised, for many reasons. A cooperative working relationship with the taxing authority serves the taxpayer’s interests. There can be no such relationship if the taxpayer is evading the taxing authority. Taxpayer evasiveness will draw the ire of the taxing authority’s employees, prompting them to redouble their efforts against the taxpayer, and resolve doubts against the taxpayer.
Moreover, nearly every company has a “responsible person” subject to personal assessment for the company’s unpaid taxes. Delaying the inevitable assessment of such taxes personally against the company’s responsible persons delays the statute of limitations on collection of such assessments from beginning to run. It also causes the responsible person to needlessly incur legal fees. Neither is in the responsible person’s best interests. But an individual who has a defense to a trust fund recovery penalty assessment should contest assessment.
• Explore defenses. An appropriate target for a trust fund recovery penalty assessment, a responsible person, is individual who had ultimate authority over how the company used its available cash. Generally that means the company’s chief executive officer.
An intervening cause beyond an individual’s control can prevent the individual from being a responsible person. For example, a physician used a payroll service for his medical office. The payroll service automatically deposited the physician’s payroll taxes with the taxing authorities as they accrued. The physician hired an office manager who, unbeknownst to the physician, contacted the payroll service company and discontinued automatic depositing of the physician’s payroll taxes. The office manager then embezzled the funds that should have been used to pay the physician’s payroll taxes. The physician had a defense to a trust fund recovery penalty assessment—and a cause of action against the payroll service company.
In another case, the IRS audited a company and retroactively reclassified independent contractors of the company as employees, and, consequently, amounts paid by the company to the reclassified workers as wages subject to employment taxes (query how this could have happened given Section 530(a)(1) of the Revenue Act of 1978, which provides that any such reclassification of workers shall have prospective effect only, provided the employer has not previously classified the workers as employees for tax purposes, and classification of them as independent contractors was reasonable—I did not represent the employer in the audit). The IRS began a trust fund recovery penalty inquiry concerning amounts paid by the company to the reclassified workers. This was inappropriate, as 100% of the amounts earned by the reclassified workers was paid out to them—there was no trust fund retained by the company.