Magazine article The CPA Journal

The Trust Fund Recovery Penalty and Encumbered Funds No Easy Way Out

Magazine article The CPA Journal

The Trust Fund Recovery Penalty and Encumbered Funds No Easy Way Out

Article excerpt

The "trust fund recovery penalty" can impose sizeable liabilities on officers and other employees of financially struggling or failed companies that fail to pay withholding or employment taxes. Individuals facing this penalty will often claim that they had no choice, that there were no funds not already spoken for or controlled by others. To their chagrin, these employees learn that the trust fund recovery penalty imposes a strict obligation on any person with knowledge of unpaid employment taxes, with only a narrow exception for encumbered funds.

The Trust Fund Recovery Penalty

Under Internal Revenue Code (IRC) section 6672, "any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax ... shall... be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over." Section 6672 is referred to as the "trust fund recovery penalty," because the person collecting tax owed by a third party is meant to hold the funds in trust for the 1RS. Liability for the trust fund recovery penalty rests on two elements: it applies to a "responsible person" who "willfully" fails to collect or pay over the tax.

A "responsible person" is anyone with a duty to collect or pay over the tax. The term may include officers and employees as well as other persons under the duty, but it does not automatically apply to all persons with a given position with an employer. Whether a person is a "responsible person" depends on whether he has some control over the finances of the employer, including the disbursement of funds and the priority of payments to creditors. Many people can fit this definition, and if the tax is not collected and paid, the 1RS will try to assess the penalty on all of them.

A responsible person is only liable if he or she "willfully" failed to collect or pay over the tax. Willfulness is broadly defined as "deliberate, voluntary, conscious choice to prefer another creditor over the United States government." Willfulness does not require specific intent to deprive the government of the taxes, only knowledge that taxes are owed and a payment to another creditor instead of the government. Once a person learns that taxes have gone unpaid in past quarters during which she was a responsible person, she has a duty to use all current and future unencumbered funds available to the corporation to pay those taxes. Any other use of funds will be considered willful.

Encumbered Funds

Responsible persons who are assessed a trust fund recovery penalty will frequently assert that the company's funds were and are encumbered, so that no penalty is owed. Unfortunately, most if not all court decisions on this question run against the responsible person. Under the rule laid down by the courts, almost no funds are encumbered funds.

The Court of Appeals for the Eighth Circuit, in Honey v. United States [963 F.2d 1083 (8th Cir. 1992)], stated the rule as follows: "Funds are encumbered only where the taxpayer is legally obligated to use the funds for a purpose other than satisfying the preexisting employment tax liability and if that legal obligation is superior to the interest of the 1RS in the funds." This rule follows from the definition of willfulness. If a taxpayer is legally obligated to use funds for another purpose, and the obligation is superior to the IRS's interest in the funds, then the responsible person cannot be said to have made a voluntary choice to prefer the other creditor over the U. …

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