The Federal Trust Fund Recovery Penalty
By Stephen J. Dunn
Payroll taxes are the bane of small, start-up businesses. Restaurants commonly have problems with them. The taxes are computed and withheld from employees’ wages. But the taxing authorities are not standing at the door demanding their money. So, the principals use the funds for other purposes, and put off paying the payroll taxes. The principals file quarterly payroll tax returns for the business. Each January, they prepare Forms W-2 for their employees, file the Forms W-2 with the IRS, and send copies of the W-2s to the employees. But unpaid payroll taxes accumulate.
Eventually the taxing authorities do come around. They assess monetary penalties against the business. They issue tax lien notices against the business, and record them in the local Register of Deeds’ office. They may attempt to levy (seize) the business’ bank accounts. If the taxing authorities are unable to collect the delinquent payroll taxes from the business, they will turn to the principals.
There are three components of Federal employment tax: Federal income tax withheld from employees’ wages; Federal Social Security and Medicare taxes withheld from employees’ wages; and employer matching Social Security and Medicare tax. The withheld Federal income tax and withheld Social Security and Medicare tax are called “trust fund” taxes. Trust fund taxes that are withheld from employees’ wages but not remitted to the Federal government can be assessed personally against the “responsible persons” of the business. Such an assessment is called a “trust fund recovery penalty.”
Every business that hires workers has at least one responsible person. Responsible persons are those who have authority to decide how the business’ available cash will be used; the power to prefer other creditors over the United States. Signature authority over a business’ bank accounts is a telltale indicia of responsible personhood. There are many other indicia. The chief executive officer of a business is almost always a responsible person. A business can have more than one responsible person.
The IRS aggressively seeks to assess trust fund recovery penalties. This is understandable, as the IRS must pay income tax refunds based upon Federal income tax withheld from employees’ wages. And eventually the Federal government must pay Social Security retirement benefits to workers, and pay their Medicare claims.
The assessment process begins with the appearance of an IRS Revenue Officer at the business. Generally, a taxpayer should not submit to an interview by the IRS without representation by qualified counsel. Each potential responsible person needs separate, qualified counsel. The potential responsible persons should politely decline an interview with the Revenue Officer.
A company that is unable to pay its withheld employment taxes should immediately cease operations. A company that opts to continue operating notwithstanding accrued, unpaid employment taxes should be sure to allocate its employment tax deposits against the trust fund portion of the employment taxes. Such allocations are done by endorsement on the checks paid against the taxes. Such allocations are binding upon the IRS, except under a formal installment agreement.
Defenses may be available against a trust fund recovery penalty assessment. For example, a physician client hired an office manager. The business manager constantly wanted more and more authority—a bad sign for an employee. Preoccupied with treating patients, the physician trusted the office manager. Later it came to light that the office manager embezzled large sums from the physician’s practice bank accounts. The office manager contacted the physician’s payroll servicer discontinued the physician’s automatic payroll tax deposit feature, without informing the physician. The office manager then embezzled the funds needed to pay income tax and Social Security and Medicare tax withheld from employees’ wages. The IRS assessed a trust fund recovery penalty against the physician. All of this happened years before I began representing the physician.
The physician had a defense to the trust fund recovery penalty assessment. The embezzlements by the office manager were an intervening cause that prevented depositing of the withheld taxes. Arguably the office manager was a responsible person, and the physician was not. The physician also had a cause of action against the payroll servicer.
Counsel may be able to persuade the Revenue Officer that a trust fund recovery penalty should not be assessed against his or her client—to the detriment of other candidates for the penalty. Such a conflict of interest prevents an attorney from representing more than one principal in the same business.
Where the IRS decides to proceed with a trust fund recovery penalty assessment, it notifies the candidate in writing of the proposed assessment, and requests the candidate’s written consent to it. A candidate who does not consent is given 30 days to request review by the IRS Appeals Office. A candidate generally should not consent to a trust fund recovery penalty assessment, and should seek Appeals Office review of a proposed assessment.
If the candidate is unable to persuade the IRS Appeals Office not to allow the proposed trust fund recovery penalty assessment, the assessment becomes final. Once the assessment becomes final, the assessed person can have judicial review of it by means of district court refund jurisdiction, as follows. The assessed person must pay at least a divisible portion of the assessment (generally, trust fund taxes for one employee for one quarter). The assessed person then files a claim for refund of the payment with the IRS. If the IRS denies the claim, or six months pass without IRS action on the claim, the assessed person may sue for refund of the payment in U.S. District Court. By adjudicating the claim, the District Court adjudicates the entire assessment, not just the divisible portion. The claimant can have a jury trial in District Court.
Once a trust fund recovery penalty is assessed, the IRS has ten years to collect it. The IRS issues a Notice of Federal Tax Lien against the assessed person. The IRS will begin seizing the assessed person’s wages and bank accounts, unless the assessed person pays the assessment, or enters into a formal or informal installment agreement with the IRS to pay it. A trust fund recovery penalty is not dischargeable in bankruptcy.
States have analogs to the Federal trust fund recovery penalty for their taxes which a business accrued but fails to deposit. The Michigan analog to the Federal trust fund recovery penalty is discussed under the Michigan business tax controversies heading.
In extreme cases, responsible persons are prosecuted for the willful failure to remit withheld employment taxes.