The IRS’s Trust Fund Recovery Penalty: A Perilous Trap for the Unwary
Under the Internal Revenue Code (the “IRC”), employers must withhold certain taxes from employee pay. These monies are referred to as “trust fund taxes” because they are held in trust on behalf of the government, and employers must turn these withheld amounts over to the government on a regular basis.
For various reasons, employers sometimes fail to remit these trust fund taxes to the government when they are supposed to. For example, struggling businesses facing challenging financial decisions as to which creditors will be paid to keep the business afloat, may fail to pay withheld taxes and instead “borrow” from the government to pay other creditors first. This may be a perilous path not only for the employer but also for individuals within the organization who have decision-making authority. While other creditors may have to rely on veil-piercing concepts to collect the company’s liability from anyone other than the company, the federal government does not.
To allow the IRS to collect, Congress authorized § 6672 of the IRC which allows IRS to collect directly from the personal assets of certain control individuals. As was stated in Wright v. United States, “[t]he statute is harsh, but the danger against which it is directed—that of failing to pay over money withheld from employees until it is too late, because the company has gone broke—is an acute one against which, perhaps, only harsh remedies are availing.” 809 F.2d 425, 428 (7th Cir. 1987).
In a nutshell, § 6672 provides that any person required to collect, account for, and pay any tax imposed under the IRC who willfully fails to do is liable for a penalty equal to the total amount of the unpaid tax. Thus, liability under § 6672 attaches if an individual both (i) qualifies as a “responsible person”; and (ii) “willfully” fails to pay over the amount due.
Section 6672 has been interpreted by the courts quite broadly to encourage individuals to stay abreast of their companies’ withholding and employment taxes. As such, the penalty has ensnared many an unsuspecting charitable board member, officer, bookkeeper, accountant, investor, or other person associated with a taxpaying organization. Thus, it is important for anyone in such a position to bear in mind that their title carries significant risk. Even where such a person is completely non-complicit in the discouraged activity, they may still bear the burden of mounting a legal defense against IRS claims.
It is also important to understand that each such responsible person is liable for 100% of the trust fund recovery penalty. Perhaps the only significant limitation on the IRS’s latitude is that, while it may assess any and all responsible persons until the amount due has been paid, it can collect the tax due only once. Also, IRS claims preempt state law, rendering for example, creditor protections for homestead real property inapplicable.
While the government bears the burden of proving that the taxpayer is a responsible person, taxpayers bear the burden of proving a failure was not willful. Willfulness has been defined as the “voluntary, conscious, and intentional decision to prefer other creditors over the United States.” Ruscitto v. United States, 629 Fed. Appx. 429, 430 (3d Cir. 2015).
The willfulness requirement is satisfied when the responsible person makes the deliberate choice to pay the withheld taxes to other creditors, instead of paying the government. Where the responsible person does not segregate the trust fund taxes but uses them to cover operating expenses (such as employees’ wages and claims of other creditors), each payment may be a voluntary, conscious, and intentional decision to prefer other creditors over the government. This requirement is satisfied with something as simple as making payroll. Thus, in most business scenarios, negating willfulness can present a significant challenge. Importantly, § 6672 is a civil, and not a criminal, statute. Its criminal analogue, § 7202, requires the additional concept of “known legal duty” to comply with due process of law requirements under the Constitution. However, no such requirement is associated with § 6672, so it is much easier for the government to meet its burden of proof.
To sum up, it is absolutely critical for all control persons within any taxpaying organization (including nonprofits and government entities, which are nonetheless subject to withholding requirements and employment taxes) make themselves aware of applicable deadlines and other procedural requirements. Failure to do so can result in life-altering penalties being assessed against personal assets including homesteads and other property which is generally considered exempt from creditor claims. Could you write a personal check for 100% of your organization’s employment taxes?
If you have questions regarding the Trust Fund Recovery Penalty or are facing other IRS issues, please reach out to FGHW for a consultation.
Christian S. Kelso, Esq. is a partner at Farrow-Gillespie Heath Witter LLP. He draws on both personal and professional experience when counseling clients on issues related to estate planning, wealth preservation and transfer, probate, tax, and transactional corporate law. He earned a J.D. and LL.M. in taxation from SMU Dedman School of Law.