For the most part, the Internal Revenue Service views the nonpayment of a tax obligation as a civil matter. The IRS will take everything you own to satisfy the debt, and they typically cannot pursue the matter criminally. However not paying payroll taxes is a different story. If you willingly did not pay your payroll taxes, the IRS can pursue criminal action against you. This week we will discuss why payroll taxes are different than other taxes, recent case law, and what you can do to avoid criminal action.
My company Tax Crisis Center®, LLC deals with a lot of businesses that fail to pay their payroll taxes. Typically these taxes are not paid because of cash flow issues that small businesses have. My advice to my clients is always to pay your payroll taxes first before you pay anything else.
During these economically troubled times there exists great economic pressure on businesses of all types and sizes. Cash flow short falls are increasingly common. One of the temptations, and indeed common business practices for businesses, is to reduce and defer the payments to some creditors in a desperate attempt to keep the business operational. Officers, directors, and other employees of a corporation are generally not liable for the legal obligations, including tax obligations, of their corporation. This is known as the “corporate shield” defense for such individual. In a corporation or limited liability company, you are generally only liable up to your investment in the company. That is one of the benefits to incorporating. Nevertheless, there is an exception to this general rule where an employer fails to properly withhold and remit the employee’s share of income taxes and employment taxes to the IRS and the officer or director, as the case may be, was in a position to prevent this from occurring. The failure to remit such Payroll Taxes to the IRS most often occurs when the corporation decides to use the Payroll Taxes as, in effect, a short‐term loan to pay off other creditors before the IRS.
Payroll taxes withheld from employee paychecks are the property of the U.S. government, and are held in trust by employers until such time as they are deposited with the government. If a business fails to deposit payroll taxes, the IRS will seek to recoup them from any “responsible person” of the employer, including officers, directors, owners, or bookkeepers with signature authority over a bank account. The personal liability of such individuals can be substantial, and can include criminal liability under IRC § 7202 of the Internal Revenue Code for “willful” failures to “collect, account for, and pay over” payroll taxes. Not paying over the taxes to the IRS is embezzling money from the United States Treasury.
Employers are required by law to withhold from their employees’ paychecks the employee’s share of Payroll Taxes. When this occurs, the employer is deemed to hold the withheld Payroll Taxes “in trust” for the IRS until such Payroll Taxes are remitted to the IRS. IRC § 6672, also known as the “Trust Fund Recovery Penalty,” subjects those persons considered responsible for the collection and payment of Payroll Taxes to personal liability when their employer fails to pay over the Payroll Taxes to the IRS. Although technically a penalty provision, the Trust Fund Recovery Penalty is used solely as a device to collect the amount of unpaid Payroll Taxes, not as a means of imposing an additional penalty over and above the outstanding corporate tax liability.
The Trust Fund Penalty is typically imposed by the IRS to secure the government’s interest they will assess the Trust Fund Penalty against ANYONE that was responsible for the payroll taxes not being paid. Typically this would be corporate officers, but could also be the bookkeeper of the corporation.
The IRS frequently chooses to pursue collection of unpaid “trust fund” taxes from officers and directors of a business. These individuals are the most likely to meet the two‐part culpability test that is required by the Trust Fund Recovery Penalty, including “responsibility” and “willfulness.” Accordingly, liability for the Trust Fund Recovery Penalty can occur only when an individual is determined to be a “responsible person” and his or her actions as it relates to the Payroll Taxes are considered “willful.”
The term “responsible person” is very broadly defined and includes employees, board of directors, shareholders, and others outside the formal corporate organization. The responsible person is, in general, any person who can effectively control the finances of the corporation or determine which bills should or should not be paid and when. The responsible person usually has the ability to sign checks on behalf of the corporation. Factors such as knowledge, delegation of authority, and the relative responsibility of others have little or no bearing on the finding of “responsibility.” As such, the “least” responsible person is no less liable for the unpaid trust fund taxes than the “most” responsible person. Consequently, the IRS can attempt to collect from any deemed responsible person it chooses.
Recovery Penalty is civil rather than criminal. Accordingly, it is not necessary for the IRS to prove that the failure to remit the Payroll Taxes resulted from an individual’s bad purpose or evil motive. Generally, the willfulness requirement is met if a responsible person: (1) knowingly pays other creditors (or allows creditors to be paid) instead of the IRS; or (2) recklessly disregards the obligation to pay the trust fund Payroll Taxes to the IRS.
IRC § 7202 is the criminal counterpart to the Trust Fund Recovery Penalty. IRC § 7202, entitled, “Willful failure to collect or pay over tax,” provides that “[a]ny person required under this title [26 of IRC] to collect, account for, any pay over any tax imposed by this title who willfully fails to collect or truthfully account for and pay over such tax shall . . . be guilty of a felony”
In a significant recent case, United States v. Easterday, 564 F.3d 1004 (9th Cir. 2009), the defendant, Jack E. Easterday, operated a chain of nursing homes in Northern California through a corporation and subsidiaries. Although the corporation’s payroll tax returns filed with the IRS accurately stated its tax liabilities, the defendant, through the corporation, repeatedly failed to payover to the IRS the full amount of Payroll Taxes due. When the corporation did not pay the outstanding payroll tax liability to the IRS, the IRS filed liens against the corporate accounts and eventually filed criminal charges.
The defendant, Mr. Easterly, did not dispute that he failed to pay the Payroll Taxes when due. Instead, Mr. Easterly’s defense was simply that under long established Ninth Circuit law in United States v. Poll, 521 F.2d 329 (9th Cir. 1975), the criminal element of “willfulness” did not exist (and, therefore, could not be proven by the government) because the corporation lacked the financial ability to comply with the corporation’s Payroll Tax obligations as a result of the trust fund taxes being used to pay other corporate bills in order to keep the nursing homes operational.
The Ninth Circuit in Easterly held, however, that the government is not required to prove the taxpayer defendant had sufficient funds to pay the taxes due in order to establish the “willfulness” element of an offense of willfully failing to pay employee Payroll Taxes in violation of IRC § 7202. In so holding, the Ninth Circuit overruled its prior decision in Poll (and relied upon by the defendant), which held that willfulness requires a showing that, at the time payment was due, the taxpayer had sufficient funds to enable him to meet his obligations or that the lack of sufficient funds on the date was created by, or was the result of, a voluntary and intentional act without justification in view of all the taxpayer’s financial circumstances. As a result, the defendant in Easterly was convicted of a felony for failing to remit Payroll Taxes to the IRS.
Employers experiencing cash flow problems sometimes fail to pay over the withheld taxes, choosing instead to use the cash attributable to those taxes to fund operations. BIG MISTAKE. If an employer’s business ultimately fails and cannot pay the IRS the withheld taxes, the IRS will seek to collect them from any “responsible person” of the employer (e.g., an officer, director, shareholder (or other owner), or bookkeeper with signature authority over a bank account). This personal liability for the “responsible person” can be substantial. Moreover, in rare cases the IRS may seek criminal prosecution.
Mr. Easterday was the principal of a corporation that operated a number of nursing homes throughout Northern California. Between 1998 and 2005, the corporation and its subsidiaries accumulated a nearly $45,000 payroll tax liability, approximately $25,000 of which was paid. The corporations’ tax returns accurately stated their tax liability, but the corporations failed to pay over the actual taxes to the IRS. Mr. Easterday admitted that the companies in question had failed to pay over their payroll taxes, but claimed that he and his companies lacked the financial capacity to meet their tax obligations.
In response to the companies’ and Mr. Easterday’s failure to pay over their payroll taxes, the IRS charged Mr. Easterday with 109 counts of failure to pay over payroll taxes in violation of Section 7202 of the Internal Revenue Code. Each count represented a different quarter in which the payroll taxes went unpaid. At trial, Mr. Easterday’s witnesses testified that the companies’ did not pay their payroll taxes because those funds were needed to keep the nursing homes at issue operational. In light of this testimony, Mr. Easterday asked the court to instruct the jury that it had to find that his violation of Section 7202 had not been willful if the jury found that he lacked the ability to pay the payroll taxes due to the IRS. The trial court declined to give requested instruction, and the jury convicted Mr. Easterday.
On appeal, the Ninth Circuit affirmed the decision not to provide the jury instruction Mr. Easterday requested. The Court held that, although the statute requires a person to willfully violate the statute to be guilty of a Section 7202 offense, willfulness does not require the defendant to have the ability to pay the payroll taxes in question. Instead, the Court concluded that the willfulness required by Section 7202 merely constitutes a knowing and voluntary violation of one’s obligation to pay over payroll taxes to the IRS. In addition, the Court noted that Mr. Easterday’s position did not make sense when he could simply escape liability for paying over funds owed to the Government by claiming that they had been spent on something else. Thus, the Court recognized that the payroll taxes in question were the property of the United States and were simply being held in trust by Mr. Easterday until such time as they were to be disbursed to the IRS.
Pursuing payroll tax criminal penalties is becoming more and more common with the IRS. If you find yourself in a pickle and owe employment taxes, you will need a professional to take care of the issue with the IRS before it gets to a criminal status.
Craig Smalley is the managing partner of CWSEAPA®, LLP, which is an accounting and financial firm located in Delaware, Florida, and Nevada. Craig has been Admitted to Practice Before the Internal Revenue Service, is a Certified Estate Planner™, and is a Certified Tax Resolution Specialist™. Craig specializes in taxation and IRS representation all the way through the United States Tax Court. Form more information visit www.cwseapa.com, call 1-844-CWSEAPA, or email him at firstname.lastname@example.org
We Are Doing Something Amazing, and We Want You to Be Part of It™