Avoid the Employment Tax Delinquency Trap
The IRS can assert personal liability for some withholding taxes.
by Scott A. Dondershine and Ginger McGuffie
In today’s economy, more and more companies find themselves trying to get by on reduced revenues and slim operating margins. When poor business conditions cause revenues to dwindle, banks may revoke essential lines of credit. Companies looking for a quick cash fix are easily lured into the trap of using withheld employment taxes-which should be remitted to the Internal Revenue Service (and to appropriate state agencies)-to fund critical operating expenses. The consequences of not paying withheld payroll taxes can be considerable. This article focuses on repayment strategies CPAs can recommend to help companies resolve delinquent federal employment tax problems.
THE DELINQUENCY TRAP
There are four types of employment taxes-two are “trust fund” taxes and two are “non-trust fund” taxes. The former two consist of employee federal income taxes and the 50% share of FICA taxes an employer must withhold from employee wages. Non-trust fund taxes are those owed by the employer-unemployment taxes and the employer’s 50% share of FICA taxes.
The employment tax delinquency trap is a double-edged sword. In addition to imposing stiff penalties and interest on delinquent employment taxes, under Internal Revenue Code section 6672 the IRS can assert personal liability (generally known as the 100% trust fund recovery penalty) for the trust fund portion of the delinquency on any and all responsible persons. A responsible person is anyone who has the power to ensure the trust fund taxes are paid on time.
Responsible persons can include employees other that corporate officers and directors such as the controller, payroll manager or a bookkeeper. The IRS can assert and enforce personal liability for the trust fund portion against any number of responsible persons simultaneously and usually seeks to hold as many persons as possible liable. As discussed below, even bankruptcy does not provide an escape from this liability. Because the IRS is very aggressive is asserting the 100% recovery penalty, it is critical for CPAs to ensure that companies facing this problem retain attorneys well versed in the special legal issues involved who can advise them of the ramifications of the penalty assessment.
DESIGNATE THE PAYMENTS
Since individuals generally cannot be held personally liable for the non-trust fund portion of a company’s delinquent employment taxes (or related interest and penalties), it is crucial to responsible persons that the trust fund portion (for which individuals can be held liable) be repaid as quickly as possible-before the non-trust fund portion. CPAs should advise companies they could pay off the trust fund portion first by designating specifically how payments against the delinquency should be applied. A word of caution, however. Since the IRS often does not favor designating payments, exercising judgment as to when to designate can be important to retain IRS cooperation in devising repayment strategies.
Companies should use the following language – “Direct and apply to the remaining trust fund balance owed for the form 941 period(s) ending XX.”—
- In a cover letter accompanying the payment.
- On the back of the check as a restrictive endorsement.
- On the memo line of the check.
Form 941, Employer’s Quarterly Federal Tax Return, is the form most employers use to report employment tax obligations other than unemployment taxes. If a company is uncertain which form 941 periods are delinquent, or of the outstanding trust fund balance for that period, the designation should instead be to the trust fund balance “for the most recent form 941 period(s) for which taxes are owed.”
Designation to the most recent periods can achieve additional benefits if a company owes employment taxes for multiple periods. Depending on the length of the delinquency, it may be preferable to repay the most recent periods first; under IRC section 6651, penalties for a failure to pay the outstanding balance generally accrue at a rate of 1% per month for a maximum of 50 months delinquent and an older period has a small balance remaining, it may be advantageous to pay the small balance so fewer periods are delinquent.
HOW IT WORKS
Assume that on January 1, 1996, ZZ Company had $100,000 of unpaid trust fund payroll taxes outstanding for each of the quarters ending June 30, 1993, and December 31, 1995, taxes by applying the payment to the more recent period. If the company failed to designate that period, the IRS would apply all or part of the payment to the earlier period. Penalties would continue to accrue on the recent one since there would still be tax due and the 50 months would not yet have expired.
Many taxpayers are unaware of their legal right to designate how payments are applied, and the IRS takes advantage of every opportunity to apply undesignated payments against the non-trust fund portion first, including interest and penalties. The only way a company can be deprived of its right to designate is if the IRS has taken enforcement action (such as seizing a company’s bank account) to obtain payment. All other payments generally are considered “voluntary” and thus subject to designation. If the designation is not clear and concise, however, the IRS often will deny it and apply the payment to the non-trust fund portion. The right to designate also can be jeopardized under formal installment agreements negotiated with the IRS.
ADDITIONAL STRATEGIC CONSIDERATIONS
In most delinquent employment tax situations, other strategic considerations also need to be addressed. These include potential appeal of penalties imposed in addition to the 100% trust fund penalty, lien subordination, and submission of an offer in compromise and bankruptcy.
Appeal and abatement. IRC sections 6651 and 6656 impose steep penalties on taxpayers for failing to timely file payroll tax returns and for not paying employment taxes. These penalties are, however, subject to abatement if a taxpayer can demonstrate the failure was due to “reasonable cause and not due to willful neglect.” Although court decisions, the regulations under section 6651 and the Internal Revenue Manual narrowly construe the term reasonable cause, revenue officers are given considerable discretion in determining whether it exists. Accordingly, it often is wise to submit a thoroughly detailed petition seeking abatement of penalties.
Subordination.The IRS may be willing to subordinate its tax lien to that of a delinquent taxpayer’s lender if it can be convinced such an action will make it easier to collect the delinquent taxes. By doing so, the IRS reduces the lender’s risk, enabling a taxpayer to borrow for critical operations despite filed tax lien. The IRS frequently agrees to subordinate when it is unlikely the taxpayer can repay the delinquent taxes without financing.
Offer in compromise. In the context of unpaid payroll taxes, this involves an agreement to accelerate repayment in exchange for a deduction in the amount of tax owed. For the IRS to accept an offer, however, a taxpayer must, at a minimum, offer accelerated payments equal to the amount that can be collected based on the taxpayer’s assets, the taxpayer’s present and future income (generally projected average monthly income less expenses for the next five years) and what might be collectible from other persons liable for the 100% recovery penalty.
Assume XXX Company owes $300,000 in unpaid payroll taxes, including penalties and interest. The company has no assets other than a building worth $100,000 that is subject to a $75,000 mortgage that was recorded before the IRS tax lien. If the IRS could collect $10,000 from all other persons liable for the trust fund penalty and XXX Company has monthly net income of $2,000, the offer should be for accelerated payments of at least $155,000, calculated as follows:
|Taxpayer’s collectible assets
($100,000 less $75,000)
|Amount form present and future income
(60 months times $2,000)
|Collectible assets of other responsible persons||10,000|
|Minimum amount of offer||$155,000|
The required minimum offer based on this formula usually limits an offers effectiveness to situations in which the money for the offer is coming from an outside source, such as a loan or an investment in the taxpayer by an outside party.
Bankruptcy. The final strategic option is bankruptcy. Although unpaid employment taxes cannot be discharged in bankruptcy, a bankruptcy taxpayer can be granted more time to repay. For instance, bankruptcy can, generally, extend the time over which the delinquent taxes can be repaid to six years from the date the payroll taxes were assessed.
Devising a strategy for successfully negotiating repayment of delinquent employment taxes with the IRS requires careful consideration and competent professional guidance and representation. While CPAs can offer advice about the tax implications, it is prudent also to consult a tax attorney who understands the legal implications of repayment strategies. Experience indicates there usually is a viable strategy for every situation, no matter how bleak the circumstances may appear initially. Obtaining competent guidance before committing irreversible errors often means the difference between eventual success in overcoming an economic setback and a company’s ultimate failure.
- CASH SHORTAGES MAY FORCE SOME companies to use withheld employment taxes to find critical operating expenses instead of remitting them to the Internal Revenue Service.
- IN ADDITION TO STIFF PENALTIES AND interest on delinquent employment taxes, under Internal Revenue Code section 6672, the IRS can assert personal liability for the trust fund portion of the delinquency on all responsible persons-any individual with the power to ensure the taxes are paid on time.
- SINCE INDIVIDUALS CANNOT BE HELD personally responsible for the non-trust fund portion of the delinquent taxes, it is important that the trust fund portion be repaid quickly. Early payoff can be accomplished by specifically designating how payments made against the delinquency should be applied.
- UNDER IRC SECTION 6651, PENALTIES for failure to pay the outstanding balance accrue at 1% per month for a maximum of 50 months. This means it may be advantageous to pay newer delinquencies first since the maximum penalties may already have accrued on older balances.
The above article reprinted with permission from the Journal of Accountancy, Copyright (c) 1996 by the American Institute of Certified Public Accountants, Inc. Opinions of the authors are their own and do not necessarily reflect policies of the AICPA.