Employers, under federal law, must pay something called “employment taxes” as it relates to its employees. It is one of the basic taxes that employers are responsible for. However, in our experience, when a business gets in trouble for one reason or another which affects cash flow, employment taxes are one of the first things employers look to avoid paying. This is usually done in the hopes that the business will turn around and cash flow will become positive, allowing for the payment of all taxes. The idea of not paying employees or necessary vendors seems like an unthinkable solution. However, failing to pay employment taxes is one of the worst things a business employer can do. The government has severe penalties for anyone who fails to collect employment taxes.
The Internal Revenue Service (IRS) has at its disposal something called the “Trust Fund Recovery Penalty or TFRP.” Enacted by Congress, the Penalty is meant to encourage employers to promptly pay employment taxes to the government. The money is initially held in “trust” (e.g. “trust fund”) until the employer deposits the money with the government. Generally, for the TFRP to apply to an individual two requirements must be satisfied. First, the individual must be a person who is “responsible” for collecting the employment taxes. Second, that person must “willfully fail” to collect or pay the taxes.
As you can guess, there are shades of gray in the law as it pertains to who is “responsible” and what is “willful.” Generally, a “responsible” person is someone who had a duty to perform and the power to direct the collecting, accounting, and paying the trust fund taxes. This person may be an owner of the company, the company’s accountant or controller, an officer or employee of a corporation; a member or employee of a partnership; or a corporate director or shareholder; or a member of a board of trustees of a nonprofit organization.
Further, it is important to understand that one’s “title” may or may not be relevant. For example a bookkeeper that has no authority to actually determine which creditors to pay may not be considered a “responsible” person, but rather that person’s supervisor or even the company’s owner may be responsible if they don’t actually pay any bills. The key is determining who actually exercises independent judgment with respect to the financial affairs of the company. Check writing authority and other considerations also come into play. An individual generally cannot hide behind the fact that they delegated authority to another to complete these tasks.
If the IRS determines that a person is “responsible”, the next step is to determine if the person acted “willfully”. There are two key requirements regarding “willful”. First, the responsible person must have been, or should have been, aware of the outstanding taxes, and second either intentionally disregarded the law or was plainly indifferent to its requirement. Further, using business assets to pay other creditors after one knows the company owes the IRS employment taxes can also be considered “willful”.
As an owner of the company, you are typically considered “willful” even if you truly did not know the taxes weren’t being paid if you were aware of financial issues and ignored them. Therefore “putting your head in the sand” will generally not protect you when a simple inquiry into the bank statements or other documents would have shown you that employment taxes were not being paid.
One other extremely important aspect to understand regarding the TFRP is that it is a person liability to the individual that does not get discharged in bankruptcy. That is, again, why this is the last thing you want to not pay in the event the company is in financial trouble. Most corporate debts do not create personal liability, which is the primary purpose of forming corporate entities. The TFRP will remain regardless if the company closes and regardless if you file personal bankruptcy.
How do you avoid the TFRP? That’s pretty simple. Make sure that all employment taxes are collected and paid to the IRS, and make sure all tax deposits, payments, and required tax returns (Form 940 and Form 941) are filed on time.
If you’re being investigated for the TFRP and have any questions or need legal counsel, please give us a call.