The Draconian Trust Fund Penalty – When Is An Employer Deemed To Have Willfully Failed To Withhold and Remit Employees’ Income Taxes

Putting the burden on employers to collect income tax on its behalf is a very effective, efficient and cost-saving tool – for the government. To encourage employers to pay the government first, Internal Revenue Code Sec. 6672, imposes a “Trust Fund Recovery” penalty. The term “trust fund” taxes refer to taxes that are withheld from employees’ pay towards their federal income tax obligations, plus the employee’s one half share of the Federal Insurance Contributions Act (FICA) that fund Social Security and Medicare programs. The idea is that these amounts are held by the employer “in trust” for the government. Willful failure to remit the amounts so collected can subject the employer to a civil penalty equal to 100% of the unpaid amounts not paid with the quarterly employment tax returns (Form 941). Another important part of this penalty is that it attaches not only to the employer but to the “responsible person” individually. In this sense the government has the ability to hold the entity and its members, officers and shareholders jointly and severally liable both for the taxes due and for payment of the penalty.

Generally, a Section 6672 assessment will be assessed when:

The individual was a responsible person (anyone who has the status, duty, and authority over financial decisions) within the liable entity; and
That individual or those individuals willfully failed to collect, truthfully account for, and pay over trust fund taxes (by knowingly paying other creditors while the trust fund taxes were due to the IRS). This is not uncommon where businesses are distressed financially and opt to cover payroll over paying the IRS.

What constitutes “willfulness” is a question of fact, that is, dependent on the particular circumstances of your situation. Courts have found “willfulness” in the following circumstances:

1. A company vice president and office manager (B) who had authority to sign company checks and use corporate funds to paid debts to creditors other than the IRS after discovering that the company was delinquent in its 941 filings. B kept the company books and payroll records and knew that the unpaid taxes continued to accrue. Yet, he remained a company vice president for a year thereafter without paying the withheld amounts to IRS.

2. Payment to other creditors in preference to the U.S. by the president of a manufacturing corporation who was signatory on the corporation’s bank account, in charge of day-to-day operations, and aware of delinquent taxes as they accrued.

3. Use of corporate funds by president to pay other company creditors after he discovered that FICA and withheld income taxes had not been paid to the government. The court ruled that once the responsible person discovers that these taxes have not been paid, it is his duty to pay the government what is owed before he pays other creditors, regardless of his reason for not doing so.

4. Payment of employee wages by volunteer corporate officers of a not-for-profit corporation while previously incurred withholding and FICA taxes for the last two quarters of Year 1 and first three quarters of Year 2 hadn’t been paid over. This constituted payments to creditors other than the U.S. The officers’ admissions that payments were known to be somewhat “late,” together with the conclusion that the corporation continued to pay its routine debts, supported a finding of willful conduct. Despite the officers’ claim that they took “corrective action” by hiring outside accountants and certifying paid administrators of the corporation, the extended period of nonpayment beyond May 3, Year 1, the time they became aware of late payments and tax problems, plainly indicated that they didn’t take “all reasonable efforts” to see that the taxes would in fact be paid. Assertions by two of the officers to the effect that the money was embezzled by corrupt employees weren’t adequate to controvert their earlier admissions that they were aware that the corporation wasn’t meeting, in a timely fashion, its withholding tax obligations to IRS.

5. Failure by corporate president/chief operating officer to pay over the corporation’s withheld income tax and FICA after he knew the corporation failed to pay these amounts for the first three quarters. He was an authorized signatory on the corporation’s bank account and was responsible for disbursing corporate funds.

6. Failure by corporate president/90% shareholder to remit withholding taxes that he was aware were delinquent and his preference of other corporate creditors over IRS.

7. The responsible person had knowledge of payments to other creditors after he was aware of the failure to pay withholding taxes.

8. The chairman of the board of directors/vice president’s use of corporate funds to pay other creditors after learning that withheld taxes hadn’t been paid over to IRS.

9. Endorsement of checks to creditors by a part-time bookkeeper who knew that withheld payroll taxes were due.

10. Taxpayer knew that the corporation’s taxes weren’t paid and allowed the corporation to pay other creditors, or signed corporate checks paying other creditors, before the government.

11. Taxpayer’s instructions to another corporate officer who was the majority shareholder to pay the taxes due did not excuse the taxpayer from willfulness where he was the person issuing most company checks, was aware the taxes were unpaid, and used available funds to pay other creditors.

12. Taxpayer knew of and authorized payments to other creditors—including the payment to himself for the then due installments on a loan that he had made to the corporation and the continued payments of interest to his wife and son on loans that they had made to the corporation—after he was aware of the failure of the corporation to pay the withheld taxes.

13. A chairman of the board, who was also a 97% shareholder and aware of unpaid withholding taxes, invested additional funds into the corporation and directed payments to other creditors over IRS.

14. A president/50% shareholder (PS) had actual knowledge that his brother, the other 50% shareholder, hadn’t paid withholding taxes when payments were made to creditors and to PS as wages. The district court didn’t believe PS’s claim that his brother deliberately and effectively misled him with regard to tax payment. PS knew that a tax payment had been returned for insufficient funds. PS clearly ought to have known that there was a grave risk that withholding taxes weren’t being paid and was in a position to find out for certain very easily.

15. Husband/manager of wife’s store knew of unpaid payroll taxes via correspondence directed to him from IRS and continued to perform management duties, including the issuance of checks.

16. One of the corporation’s owners (A), who was also an officer, director and daily manager of the corporation, failed to correct mismanagement of the corporation’s tax responsibilities after having notice of the withholding tax delinquencies. A (1) had notice of the tax delinquencies when she signed some of the corporation’s quarterly tax returns which set forth unpaid payroll taxes owed by the corporation and when she fired the operations manager for failure to pay the corporation’s tax liabilities and (2) paid or allowed to be paid creditors of the corporation instead of IRS.

17. A corporate president/chief stockholder allowed the payment of other creditors when he knew that withholding taxes hadn’t been paid. He acted willfully as a matter of law for purposes of a summary judgment against him, since he knew that withholding taxes hadn’t been paid and, during that time, corporate funds were used to pay wages to employees.

18. A corporate president knew of the corporation’s unpaid employment tax liability and participated in decisions to pay creditors other than IRS. The corporate president attended board of directors meetings at which the corporation’s failure to pay employment taxes was discussed and stated that creditors should be paid based on whether they demanded payment and whether the company needed the creditors’ services. Thus, he placed payment to IRS on a low priority.

19. President and partial owner of a corporation sold her interest and claimed that she was unaware of the unpaid taxes at the time when she ceased active involvement in the corporation. Her allegations were contradicted in pleadings relating to her counterclaim for contribution in which she stated that she had contacted IRS and was advised that there was a trust fund tax liability of $40,000. This knowledge, as well as her admission in the counterclaim pleadings that she participated in the decision not to pay the entire tax obligation, resulted in a finding of willfulness.

20. Shareholders, officers and directors of a corporation signed checks making payments to creditors while they knew that the corporation’s withholding tax liability remained unpaid. The checks were presented to these shareholders, officers and directors by a shareholder/officer/director who was in charge of the corporation’s day-to-day affairs.

21. General manager, who had authority to sign company checks and who directed the payment of the company’s bills, tendered a check for the payment of past due taxes to IRS, but the check was returned because of insufficient funds. After the check was dishonored, the taxpayer didn’t try to pay the past due taxes again, and acknowledged that he authorized or allowed other creditors to be paid during the period the taxes were accruing.

22. Manager of company was aware of the payroll tax problems yet paid other creditors ahead of the government. To the extent that he may have relied on others to pay the taxes, this reliance was unreasonable, given the company’s poor track record in this area.

23. Vice president/chief financial officer preferred another creditor and himself, in his capacity as a creditor, over IRS, despite knowledge that his company owed withholding taxes. Although he had no check-signing authority, he decided how funds were spent and which creditors were paid.

24. Corporate officers who had been notified that the corporation had received a notice from IRS indicating that the corporation was delinquent in its payments of withholding taxes continued to pay other creditors instead of IRS based on their subjective belief that the notice was incorrect.

25. Taxpayer was one of two partners of a partnership that bought a manufacturing company, which failed to pay over withheld taxes while it was owned by the partnership. The partner was a vice-president of the company and said that he chose to pay the company’s other creditors rather than IRS because he had to leave the company in viable operating condition in order to rescind the purchase agreement.

Contributing source: RIA / Checkpoint

One can see that the threshold for “willfulness” is fairly low. It appears that mere knowledge of an outstanding FICA tax / withholding obligation, coupled with payment to other creditors could constitute willfulness and support the government imposing the Trust Fund Recovery Penalty. This is a very hot area for the federal and state governments at this time. Employers would be very wise to make sure that the government is paid first.

Ari Good, Esq.