As a rule, workers look forward to payday, even if their meager restitution isn’t as much as they would like it to be. Visions of sugarplums dance in their heads, or at least visions of one less bill emblazoned with the dreaded “Past Due, Please Remit” stamp.

As a rule, employers dread payday. Even if there is enough money in the account to cover payroll, and that is often a big “if,” payday is an immense compliance burden. The Department of Labor has rule upon rule regarding wages paid to workers (i.e. is the worker exempt, nonexempt, an independent contractor, or an intern). Furthermore, judges, lawmakers, and bureaucrats change these rules constantly and sometimes even cancel out one another.

The IRS has an entirely different stack of rules on this subject, and it is important to not only understand employers’ rights and responsibilities in this area as financial professionals, but also to be able to communicate these principles in a clear and concise manner, because the penalties for noncompliance are significant, and we all know who employers will try to blame if things go sideways.

Trust Fund Taxes

Although source withholding seems to be the lynchpin for the entire income tax system, this tool is a relatively new invention. The first income tax did not include such a provision and was difficult to collect, which is probably the main reason that no one in Washington was terribly upset when the Supreme Court invalidated the income tax in 1895, because it did not apportion taxes evenly among the states as required by Article I, Section 8.

After lawmakers fixed this minor technicality with the Sixteenth Amendment in 1913 and then enacted a modest income tax almost before the ink was dry, another thirty years passed before Congress passed the Current Tax Payment Act of 1943. Income taxes skyrocketed to help finance World War II, and source withholding essentially meant that the IRS could close its collection arm and focus on enforcement. At the time, the Treasury Department hailed the law as a way to collect revenue more easily and raise future taxes more surreptitiously, as unsuspecting taxpayers would see their tax liabilities as lines on forms as opposed to greenbacks from their pockets.

The phrase “trust fund” is a bit of a misnomer, as there is no requirement to place withheld taxes in a different account or segregate them in any way, because it is still the employer’s money until the tax bill arrives. As a result, some employers are tempted to use this trust fund money to help them get through a rough patch or two. Nevertheless, the phrase also denotes a special responsibility which, according to Judge Benjamin Cardozo, is “stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is the standard of behavior.”

The TFRP

The nasty Trust Fund Recovery Penalty usually means personal liability, even if the entity that wrote the paycheck is a corporation, an LLC, a partnership or an agency. For penalties to attach, the Service must establish a “willful” failure to pay, and in this context, that means the employer paid any other vendors aside from the IRS; the Service must also prove that the employer had a duty to collect and account for the tax.

It’s important to distinguish between trust fund (employee income and FICA taxes) and non-trust fund taxes (employer FICA taxes), as the penalty applies to the former but not the latter. The TFRP is actually only an additional collection tool as opposed to a “penalty” that involves additional payments. That comes later.

Liability Issues

According to Section 6672, any person who must “collect, truthfully account for, and pay over any tax imposed” is subject to the TFRP. Companies used to argue that they were not liable because they did not have a responsibility in all three of these areas. The Supreme Court closed this loophole in United States v. Sotelo by holding that “and” really means “or” in this statute.

That being said, a liability issue remains, viz, who (or what) is a responsible person?

In labor law, although there is some uncertainty, an employer is usually an entity that exercises control over the workers. That same analysis applies in this context, as the IRS determines who has both policy control and practical control over the organization’s purse strings. IRS Policy Statement P-5-60 offers some additional guidance. The penalty normally does not apply to persons who perform “ministerial acts without exercising independent judgment;” rather, responsibility is a matter of “status, duty and authority.”

As normally happens in these situations, courts have established a non-exhaustive list of factors to consider, including:

• Ownership stake or operating interest,
• Day-to-day management responsibilities,
• Ability to hire and fire, and
• Decision-making power over expense matters.

A person does not need to be an officer or director to be a “responsible person,” since the test is extremely broad and rather vague. However, non-officers rarely have the requisite amount of authority. As one court succinctly put it, anyone who “could have impeded the flow of business to the extent necessary to prevent the corporation from squandering the taxes” could be liable. Ouch.

The government must prove willfulness, and once again, this term has a very specific meaning in this context. For TFRP purposes, willfulness basically means ignoring a legal duty, i.e. the responsibility to withhold money, give an accounting, and pay taxes. Willful blindness isn’t normally a defense, because the jury may also consider evidence of dogged indifference as willfulness.

In sum, there are few controls at the front end of the trust fund process, as employers need not follow any specific protocol in setting aside employee taxes. However, Judgement Day cometh soon, and the IRS will almost certainly hold violators strictly and painfully accountable for any shortfall.

Delinquency and Collections Procedure

The Service only pursues a TFRP if the initial collection efforts against the employer fail, so unfortunately for the defendant, the revenue agent attached to the prosecution is already out for blood.

The cage match begins with a thorough investigation, as the IRS looks to identify anyone with check signing authority, as outlined above. Then, the Service joins any defendant who has assets that can be seized. These targets then basically receive thirty-day letters, like the ones the government uses in gift and estate tax matters. If the person does not appeal, or the IRS Appeals Office sides with the auditor (and we can fairly guess how often that happens), the Service assesses the taxes and penalties.

The Service can use almost anything in its toolbox in TFRP collections matters, including:

• IRS summons,
• Bank account levy, or
• Lien.

Sometimes, there are statute of limitations issues involved.

Possible Defenses

Once the IRS assesses the amount due and files a lien, Collection Due Process kicks in. Given the lack of judicial remedies in the delinquency/collections process, adversely affected taxpayers may be able to invoke the CDP, get their day in court, and challenge the merits of the assessment.

The bad news is that there is no jury and the judge is likely to be a generalist, and litigants only get limited discovery opportunities in tax court. The good news is that the government cannot run up legal fees by pulling more defendants into the litigation and the IRS cannot pursue any collections activities until the CDP completely runs its course.

Most TFRP cases involve employers who put their hands into the proverbial cookie jars to cover a cash flow shortage. If that’s the case, and the client’s business has picked back up, it may be best to work out a deal with the IRS for an installment payment plan. Additionally, if the client has assets, pay down the taxes before paying other delinquent third-party creditors; be sure that these payments are dedicated to the principal, because the IRS normally applies money to the penalties and interest first.

Clients are always scared when a friendly neighborhood G-man shows up at the door and begins asking questions, and their fear is justified. However, if the client is forthcoming and dedicated to resolving the issues, TFRP matters are eminently manageable. Good night, and good luck.