Avoid the Payroll Tax Trap: Using Withheld Payroll Taxes for Other Purposes Can Be a Dangerous and Expensive Game

By Godfrey, Howard | Journal of Accountancy, November 2004 | Go to article overview

Avoid the Payroll Tax Trap: Using Withheld Payroll Taxes for Other Purposes Can Be a Dangerous and Expensive Game


Godfrey, Howard, Journal of Accountancy


EXECUTIVE SUMMARY

* AN EMPLOYER BECOMES A TRUSTEE FOR THE U.S. government when it distributes payroll checks to employees. Withheld payroll taxes are called "trust fund taxes" and, in the eyes of the IRS, belong to the government. Companies should not use these funds to pay salaries, business expenses or for any other purpose.

* WHEN AN EMPLOYER FAILS TO PAY ITS WITHHELD payroll taxes to the government, IRC section 6672(a) imposes a penalty equal to the entire amount of the trust fund taxes on every "responsible person" who "willfully" fails to see that the taxes are paid. The IRS may assess the penalty against a responsible person without first trying to collect the penalty from the employer.

* AFTER THE IRS INTRODUCES PROOF IN COURT that the penalty applies, the taxpayer has the burden of proving he or she is not a responsible person or that there was no willful payment of other creditors while payroll taxes remained delinquent. A responsible person can avoid a charge of willfulness by taking all reasonable efforts to see that the taxes are paid.

* IF A TRUST FUND RECOVERY PENALTY IS ASSESSED, the taxpayer can appeal, ask for a collection due process hearing, submit an offer in compromise, pay a representative penalty, file suit, seek reimbursement from other responsible persons or arrange to pay the assessment in installments.

The IRS assesses a trust fund recovery penalty (TFRP) against individuals it holds personally liable for their employer's unpaid payroll taxes. This is a civil penalty imposed on anyone required to collect, account for or pay over the taxes and who willfully fails to do so. This article describes how CPAs in public practice and private industry can keep clients and employers from reaching the point where the IRS holds them responsible for unpaid payroll taxes.

THE NATURE OF THE PENALTY

When an employer distributes payroll checks to employees, it becomes a trustee for the U.S. government. Withheld payroll taxes are called "trust fund taxes," and because they are held on behalf of the United States, they shouldn't be used to pay salaries, expenses or for any other purpose. Unfortunately, a business in financial trouble can be tempted to use trust fund taxes to pay immediate expenses such as payroll, rent and utilities. CPAs should urge employers to avoid dipping into withheld payroll taxes for operating expenses by considering alternative sources of capital, such as the sale of excess assets, borrowing and additional corporate or partnership equity investments.

If they do use the trust fund for other purposes, officers and other company employees may have to pay a civil penalty of 100% of the employer's delinquent trust fund taxes. The IRS imposes this TFRP on "responsible persons" under IRC section 6672, distinct from the employer's responsibility to pay over the taxes it withholds from employees. The IRS can assess the penalty against a responsible person or persons even though it has not attempted to collect the taxes from the employer. (See "Trust Fund Recovery Penalty Litigation," page 68, and exhibit 1, page 69, for how taxpayers who litigated imposition of the penalty fared in court.)

The IRS imposes the 100% penalty even where there was no bad motive and even if the individual was valiantly trying to save a company from bankruptcy so it could pay all creditors in full and protect employee jobs.

The concept "innocent until proven guilty" that applies in criminal cases does not apply here. Since the TFRP is civil, the IRS may treat individuals as "guilty until proven innocent." Criminal penalties also may apply for failing to deposit payroll taxes, and a person can be subject to both civil and criminal action. Exhibit 2, page 69, summarizes recent criminal cases.

CPAs need to remind employers and their employees that it's in their best interests to make accurate reporting and payment of payroll taxes a top priority. …

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