Payroll taxes troubles is the largest portion of the tax resolution cases we handle in our office.
The issue is why?
That is what I will be addressing in this post today.
Given that most businesses fail due to cash-flow issues, it should not be surprising that taxes collected and withheld by the business also get spent when the business starts to struggle. Add to that most businesses start their life cycle under-capitalized, and it is easy to see why payroll tax debt can become a problem.
Payroll taxes are the easiest loan available to the small business owner and the hardest to pay back. Easy because there are no loan documents to fill out, no dealing with the bank and their loan covenants or permission to ask. Just keep and spend the money. It is the hardest loan to pay back because with all the penalties and interest, the struggling business soon finds itself in a financial hole it has no hope of getting out from.
The worst part about payroll tax debts is the personal liability to the owners and, even, certain employees. Yes, certain employees and even some third parties may be held responsible to the unpaid payroll taxes. Owing payroll taxes is no joke and must be taken seriously. Because of the potential personal liability, not making payroll tax deposits has the potential to destroy the owner’s personal finances.
The Impact of Payroll Taxes to the US Government Money Stream
Payroll taxes are a significant stream of money for the United States Government. In 2018 alone more than $1.13 trillion were collected in federal employment taxes and more than $1.34 trillion collected in income taxes withheld by employers. The total taxes paid over by employers on behalf of employees totaled more than $2.48 trillion, representing more than 71% of all the taxes collected by the United States Government. (source: IRS Databook for 2018: https://www.irs.gov/statistics/soi-tax-stats-irs-data-book)
The amounts withheld by an employer from the employees for the employee’s share of the FICA taxes and federal income tax are referred to as “Trust Funds” because the employer is holding these funds in trust for the United States Government.
IRS Weapons to Collect Unpaid Payroll Taxes
- Code Section 6672 – In an effort to protect this cashflow source for the US Government, Congress created Internal Revenue Code (“IRC”) § 6672 to allow the Commissioner of the Internal Revenue Service, when payroll taxes are not paid over to the government, to assess a penalty against individuals and/or businesses whom it deems to be responsible for accounting for and paying over the payroll taxes and who willfully failed to do so. The penalty is equal to 100% of those trust funds taxes not properly accounted for and paid over to the United States Government by the employer.
- Code Section 3505 – Allows the IRS to collect unpaid Trust Fund taxes from third party lenders who knowingly loaned funds to cover a company’s net payroll knowing that the company either could not or would not deposit the payroll taxes.
- Code Section 7202 – This tax code makes it a crime punishable by both fine and/or incarceration for those parties that willfully try to evade or defeat the accounting and payment of the trust funds to the United States Government.
- Code Section 7215 – In light of the difficulty of proving intent, Congress later created IRC § 7215 making it a misdemeanor when individuals and/or businesses fail to account and pay over the Trust Fund taxes. IRC § 7215 reduced the fines and potential time for incarceration from those allowed under IRC § 7202 but, because it is a misdemeanor, there is no requirement for the Government to prove intent to obtain a conviction.
Though the Government has historically found it difficult to prove criminal intent where the payroll taxes were spent to sustain business operations, recently the IRS and United States Department of Justice have increased their enforcement in the payroll tax arena, both civilly and criminally. Now, the Department of Justice more frequently seeks injunctions against employers who fail to deposit properly and the prosecution of employers who violate IRC § 7202 and/or IRC § 7215.
Payroll Tax Penalties
There are a number of penalties that generally apply when an employer fails to properly account and pay over the payroll taxes. These penalties are significant, and include the following:
- Failure to File: The failure to file a Form 941 or Form 940 is 5% per month, limited to 25%;
- Failure to Pay: The penalty for failing to pay over payroll taxes is .5% per month, limited to 25%;
- Failure to Deposit Penalties: the penalty for failing to make federal payroll tax deposits depends upon the number of days late that the deposit is ultimately made:
- 2% Deposits made 1 to 5 days late.
- 5% Deposits made 6 to 15 days late.
- 10% Deposits made 16 or more days late, but before 10 days from the date of the first notice the IRS sent asking for the tax due.
- 10% Amounts that should have been deposited, but instead were paid directly to the IRS, or paid with your tax return.
- 15% Amounts still unpaid more than 10 days after the date of the first notice the IRS sent asking for the tax due or the day on which you received notice and demand for immediate payment, whichever is earlier.
- Dishonored payment penalty: a penalty of 2 percent of the amount of the check or other commercial payment instrument generally applies if the check does not clear the bank. However, if the amount of the check or other commercial payment instrument is less than $1,250, the penalty is $25 or the amount of the check or other commercial payment instrument, whichever is less.
The reason why payroll tax issues become so difficult to overcome is because the failure to withhold and pay-over the moneys properly adds up, but then the application of the penalties and interest piles up. Often business owners believe they can make up the shortfall “soon”. However, they do not appreciate how severe the penalties are.
Who Could Be Held Responsible For Unpaid Trust Funds?
IRC § 6672 allows the Internal Revenue Service to recover “trust funds” withheld from employee’s pay from “any person required to collect, truthfully account for, and pay over any tax imposed” and “who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof”
There are two key elements required for an individual or business to be held responsible for the Trust Fund Recovery Penalty under IRC § 6672:
- The person had to be required to collect, account and pay-over the payroll taxes, and
- The person’s failure to do so must have been willful.
The IRS’ stated position is that willfulness exists where “money withheld from employees as taxes, in lieu of being paid over to the Government, was knowingly and intentionally used to pay the operating expenses of the business, or for other purposes.” (Revenue Ruling 54-158)
The fact that there are insufficient funds to pay both employees and taxes is not a defense. In such a case, employers are expected to prorate the payments so that the employees get a portion of their pay and the IRS obtains the proper amount of withholding for the pay distributed.
Individuals with sufficient control over the payroll process will be deemed responsible when the company fails to pay-over the payroll taxes, even if they are not the ultimate decision maker. Thus bookkeepers, finance personnel, and even third-parties such as accountants and bankers, could be held liable. (See Hochstein v. United States – 900 F.2d 543 (2nd Circuit, 1990))