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An employer is required to withhold federal income taxes, Social Security taxes and Medicare taxes from employees and to pay over employee withheld amounts to the IRS. In addition to employee Social Security and Medicare withholding, his employer is also responsible for and is required to forward Social Security and Medicare taxes of equivalent amounts to the IRS. These taxes will hereinafter be referred to as the "employee's share" (representing employee funds and commonly called trust fund taxes) and the "employer's share" of employment taxes.
New or struggling businesses often fall behind in business expenses. In order to continue in business, it is not uncommon for a business to pay other creditors before IRS payroll taxes. Individuals responsible for paying business bills hope that by the time the IRS takes action, the business will have turned around and will have sufficient funds available to pay off all past due employment tax liabilities.
What business people do not realize is that any person who makes the decision to favor business creditors over employment taxes is generally held personally liable for some or all unpaid employment taxes. Many businesses fail and business owners are left with personal tax liabilities for the unpaid business employment tax liabilities. This can be a burden for many years after the business has closed.
In this regard, sole proprietorships, one member LLCs and partnerships are treated differently than multi-member LLCs and corporations. With regard to sole proprietorships, one member LLCs and general partnerships, the IRC and regulations clearly indicate that the individual owner (or general partner) will be personally liable for both the "employer's share" and "employee's share" of all unpaid business employment taxes plus penalties and interest. Or, looking at it another way, these individuals are personally responsible for all taxes and penalties required to be paid by the business on Form 941 and 940 tax liabilities.
Responsible individuals and officers in corporations and multi-member LLCs, on the other hand, are subject to a different set of rules and regulations. In a corporate setting those individuals who are responsible for making disbursements to others (even payroll checks) in preference to paying IRS employment taxes (usually federal tax deposits) will be held personally liable under the "trust fund recovery penalty statute" (IRC 6672). This liability, however, is limited to the "employee's share" or "trust fund" portion of employment taxes. In other words, responsible business officers are personally liable for unpaid corporate employment taxes to the extent the non-payment represents taxes "withheld" from employees for Social Security, Medicare and federal income taxes. They are not personally liable for the "employer's share" of Social Security Taxes and Medicare taxes nor for unpaid federal unemployment (Form 940) taxes.
In the "choice of entity" selection process in starting a new business, this is an often overlooked planning consideration. This issue is underscored by the fact that once an individual is held personally responsible under the above trust fund rules, he will find that unpaid employment taxes are not dischargeable in a personal bankruptcy. Individual income taxes, on the other hand, under certain circumstances, are dischargeable in a Chapter 7 bankruptcy.
Generally, two conditions must be met in order for the IRS to assess unpaid corporate and multi-member LLC (or limited liability partnership) employment taxes on the responsible individual, usually a company officer:
- The officer or owner must be a "responsible" person. The key to responsibility is control of the decision making process which results in the business disbursements to creditors (even net payroll to employees) in preference to paying Form 941 tax obligations (federal tax deposits) to the Internal Revenue Service.
- The taxpayer's conduct must be willful. Inherent in the willfulness standard is the requirement that the responsible officer have knowledge that the employment taxes are due and have not been paid. Unfortunately, the Internal Revenue Service has taken a very simplistic approach to willfulness. Generally if business bank records indicate that other liabilities were paid during the time of the accrual of the unpaid employment taxes, then the responsible officer is automatically deemed willful and held personally liable. The IRS often uses identifying signatures on bank account signature cards and on employment tax returns as an indicator of knowledge and willfulness. The signing of business checks is a clear indication of wilfulness in trust fund failure to pay cases. The IRS, after a minimal investigation, simply makes the personal assessment against responsible parties. There is no Tax Court review. On occasion the "responsible party" is not even aware of the assessment due to an incorrect address.
In the case of sole proprietorships and general partnerships, the business owner and/or all general partner is held personally liable without the requirement for the IRS to meet the "responsible person" and "willfulness" standards. These liabilities are statutory in nature and liabilities are automatically assessed.
Prior to the enactment of the IRS Restructuring and Reform Act of 1998, taxpayers had no clear rights when the IRS proposed the assessment of the trust fund recovery penalty taxes against the taxpayer. Taxpayers and tax practitioners could challenge the assessments with seemingly valid business reasons and excuses but historically taxpayer victories were rare. Essentially the IRS made its own rules. The IRS was not subject to judicial review (review by a party outside of the agency) except in unusual and costly United States District Court procedures. A taxpayer could undertake complex and expensive refund litigation by suing the Internal Revenue Service in United States Disctict Court. This was rarely done and taxpayers found themselves essentially at the mercy of the IRS' discretion of personal liability for unpaid employment taxes. The IRS often took a shotgun approach and freely assessed personal liability, often times on multiple parties.
The IRS Restructuring and Reform Act of 1998 brought in modest changes in taxpayer's rights with regard to trust fund recovery penalty matters. As it stands now, the IRS cannot assess the trust fund recovery penalty against "responsible corporate officers" without sending preliminary notices informing the individual taxpayer of the proposed penalty and appeal rights. What does this all mean to the unfortunate individual who finds himself involved in trust fund recovery penalty issues?
The IRS must notify the taxpayer in writing of their right to an appellate hearing. Clients now can, and routinely do, request that hearing. With the hearing, the client is given the right to have the matter heard by an independent Appeals Officer. While still an Internal Revenue Service employee, the Appeals Officer is now prohibited from having any pre-hearing conferences with the IRS Revenue Officer who is responsible for the proposed trust fund recovery penalty. Prior to the new legislation, many Appeals Officers, in conference with the assigned Revenue Officer, were predisposed to agree with personal assessments. At the current time, however, Appeals Officers are acting with greater independence and are taking into consideration a wider range of issues as to the validity of proposed individual trust fund recovery penalty assessments.
Also new are taxpayer friendly mediation and arbitration proceedings available in "trust fund" matters. IRS Announcement 2008-11, 2008-48 I.R.B. 1224. Since the results of mediation and arbitration proceedings are not public it is difficult to judge taxpayer success. Historically, responsible company owners have routinely ended up with closed businesses and individual "trust fund" tax assessments. The government is moving slowly away from hardline positions on the assessment of trust fund penalties on individual taxpayers.