PAYROLL TAX PROBLEMS
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, the 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. The employer’s share of payroll taxes are generally not subject to owner employer or personal liability.
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.
Failure rate for business taxpayers is more than 65% if significant multiple year unpaid payroll taxes have been assessed. This is partly due to an IRS payroll initiative in April of 2015 referred to as “FTD Alert X Coded Pilot”. There are few viable options for businesses with unfiled/significant unpaid payroll taxes other than closure.
What business taxpayers must realize is that any person who makes the decision to favor personal draw and/or business creditors over payment of 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 proprietors and general partnerships are treated differently than LLCs and corporations. With regard to sole proprietors and general partnerships, the IRC and regulations clearly indicate that the individual owners (and 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 immediately and always personally responsible for all taxes and penalties required to be paid by the business for Form 941 and 940 tax liabilities.
Responsible individuals and officers in corporations and LLCs, on the other hand, are subject to a different set of rules and regulations. In corporate and LLC settings 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 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 incomes taxes, on the other hand, under certain circumstances, are dischargeable in a Chapter 7 bankruptcy.
One member LLC’s are automatic as to personal assessments if the IRS issues a personal tax assessment for employment taxes within a legislative required three (3) year limitation period. Not required are the separate IRS “responsible party inquiries” before personal assessments under IRC 6672 as with corporations and multi-member LLC’s.
Generally, two conditions must be met in order for the IRS to assess unpaid corporate or multi-member LLC employment taxes (employee’s share) 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 known 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 but 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 officer is automatically deemed willful and held personally liable. The IRS often uses identifying signature authority on bank account signature cards and on employment tax returns as an indicator of knowledge and willfulness. The signing of business checks and knowing of unpaid payroll tax assessments is a clear indication of willfulness in trust fund cases. The IRS, after a minimal investigation, simply makes the personal assessment against responsible parties. On occasion the “responsible party” is not even aware of the assessment due to an incorrect address or failure to respond.
In the case of sole proprietorships and general partnerships, the business owners are 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 rate. Essentially the IRS made its own rules. The IRS was not subject to judicial review 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 State District Court. This was expensive and rarely done with taxpayers finding themselves essentially at the mercy of IRS discretion on personal liability assessments 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 “responsibly 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 issues?
The IRS must notify the taxpayer in writing of hisr 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 and Internal Revenue Service employee, the Appeals Officer is now prohibited from having any prehearing conferences with the IRS Revenue Officer who is responsible for the proposed trust fund recovery penalty. Prior to the 1998 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 appropriateness 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 with continuing individual “trust fund” tax assessments. The government is moving slowly away from hardline positions on the assessment of trust fund penalties on individual taxpayers.
The IRS recognizes a broad spectrum of employer payroll non-compliance:
- Non-filing of Forms 940/941.
- Worker’s classification as to employees or independent contractors.
- Officer compensation.
- Fringe benefits.
- Officer income reporting by Sub-Chapter S corporations.
- Non-payments of tax amounts due.
- Non-resident aliens who are present in the U.S. without proper documentation.
Historically, underlying worker classification problems were simple, usually involving under-the-table and/or cash payments. A good example is having subcontractors provide services through their own business entities when the actual work performed would be classified as an employee under the IRS “control” test. Details can be found in the Internal Revenue Manual (I.R.M. 1.2.1) statement of policies.