January 15, 2023 | Tax Penalties
The Trust Fund Recovery Penalty is the penalty you incur as an employer responsible party, if you withhold income tax, Medicare, and Social Security taxes from your employees’ wages, but don’t send the money to New York State or the IRS.
The penalty is basically these unpaid monies imposed against you personally.
In general, the IRS and NYS imposes a Trust Fund Penalty against any person who has the obligation to either collect or pay over employment taxes that are withheld from an employee’s salary, when those monies are not paid to the IRS or NYS. Often this happens, when a business is having financial difficulties and uses the payroll withholding to pay other expenses, or a person is stealing the payroll money (inhouse or a payroll provider) or the payroll systems are not working correctly and the wrong payroll obligations are being paid in to the tax authorities.
The Trust Fund Penalty is not a true penalty (meaning not a true addition to the tax amount like a typical tax penalty is). It is the amount of monies that should have been paid to the IRS or NYS, that were taken from the employees’ wages (federal and state withholding taxes, and social security). Therefore, it is actually a portion of the wages which were not paid and is not a true “penalty”. Therefore, this penalty does not include interest and penalties charged against the employer for the failure to pay in the taxes owed. However, once the assessment is made against the person individually as a responsible person, interest charges will begin to accrue, and you will need relief if you can’t pay it, or want to fight the assessment.
As stated above, the Internal Revenue Service and the New York State Department of Taxation and Finance requires that employers withhold taxes from the wages of employees, and employers are required to contribute similar taxes. This is commonly referred to as “payroll taxes,” and can include income taxes, Social Security taxes, and Medicare Taxes. The IRS and NYS requires that employers file documents with the agency to report the funds being withheld. Employers must file Form 940 and Form 941, and NYS-45. The Form 941, the Employer’s Quarterly Federal Tax Return, is where employers report Social Security and Medicare taxes withheld. The Form 940, the Employer’s Federal Unemployment Tax Return (FUTA Tax Return) provides funds for paying unemployment compensation to employees who lose their jobs. This tax is solely paid by employers, and most pay this unemployment tax at both a federal and state level.
Trust Fund Recovery Penalty
If you are a business owner with employees, you must file these payroll tax forms. The IRS views the failure to pay payroll taxes as a serious violation. If a business owner does not pay the required payroll tax for their business, the IRS and NYS will take action. The tax authorities will be able to collect on the payroll tax owed, as well as penalties and interest on the tax debt owed. The tax authorities often tries to impose a Trust Fund Recovery Penalty (TFRP) on a responsible person when taxes are not paid.
The TFRP is a way to encourage that employers file Form 940 and Form 941 promptly, and pay the amount owed. This penalty can be assessed because the employer holds the employee’s money in trust until there is a federal and state tax deposit, and the penalty can be applied if these taxes are not immediately available to be collected. The TFRP can apply to a person who is responsible for collecting and paying withheld income and employment taxes, who willfully fails to pay. The penalty amount will be the amount of unpaid taxes withheld, as well as the employee’s portion of withheld payroll taxes.
If you find yourself in this situation, you will be asked to complete an interview with the IRS and state to determine how responsible you are for not paying the proper taxes. If you are determined to be a responsible person in not paying the taxes, tax authorities will mail a letter that states that they plan to assess the TFRP against you. This initial IRS letter will explain your rights and notify you that there is a 60-day window in which you will be able to appeal. At this point, and preferably earlier, you should contact an experienced New York Tax Attorney to help you avoid the penalty. If you do not respond to the letter or act, they will assess the penalty against you and demand payment. Once the penalty amount has been assessed, the IRS is authorized to take collection action against any personal assets you own through federal tax liens, levies on property, or seizure of assets.
You can avoid the TFRP if you file and pay all employment taxes when required on a timely manner. If you know that you are behind in your payroll tax payments, you should take proactive steps to pay any back payroll taxes owed and settle your tax debt. If you are in need of assistance in preparing Form 940 and Form 941 or need help because the IRS has collection has commenced, contact an experienced tax attorney immediately.
In some cases, the employer keep incurring new unpaid payroll tax assessments. This is often a difficult case since sometimes the IRS begins a monitoring process to make sure the current payroll taxes are paid before they will enter into a new installment agreement. I have seen in few cases where the IRS obtained an injunction to forbid the employer from having employees, and then they are forced to use a separate company agent for payroll.
How much is the Trust Fund Recovery Penalty (TFRP)?
As an example, say an employee is paid $1,000 in wages for the week. Of that amount $150 is held back for federal and sdtate income taxes, and $77 dollars for Social Security and Medicare. If you do not send the $227 to the IRS, then the TFRP against you would be $227.
Who can be held liable for the TFRP?
The TFRP is assessed against the person or persons responsible for failure to pay over the trust fund taxes. The penalty can be assessed against individuals, employees, partners, officers of a corporation, and members of a limited liability company (LLC) who operate the business. Furthermore, the IRS can collect from an officer, member, partner or other owner of the business. It sometimes comes as a shock to a person that they are liable for the unpaid taxes since they may have been an owner of the business but not in charge of the financial affairs of the business. In addition, the penalty can be assessed against more than one person, but once they collect it from any other party your liability will also be reduced.
There are defenses to the penalty that can provide tax relief. For example, if the payroll tax monies were deposited into a bank account, and the account seized by the bank to pay a loan, then there should be no penalty (Rykoff v. US 93-1).
To impose the tax penalty and prove a person was a responsible party, the taxpayer must have authority to pay over the tax, and the lack of payment must be willful. The IRS terms the person liable, the “responsible person”. To establish responsibility for the TFRP, the IRS must be able to show that 1) the person responsible had control or possession of funds that were collected but not remitted, and had a duty, authority, or other status to pay the taxes, and 2) the lack of payment needs to be willful (i.e. the lack of payment means they failed to collect and pay the trust fund taxes. A mistake and not paying would typically not create the penalty). The willful component is that the person knew or should have known that the withheld taxes were not paid to the government. Therefore, when a company used monies to pay other creditors and not the IRS, that can be a sign of willfulness. The TFRP under 6672 is separate from the tax liability imposed against the employee responsible party. The IRS does not need to first go after the employer for these monies.
One might ask how an owner is liable personally for the unpaid taxes. The concept of piercing the corporate veil. Under IRC section 6672, officers and/or owners of a corporation may be personally liable for TFRP, if they failed to ensure that the withholding and payroll tax obligations were met. Sec. 6672. Failure to collect and pay over tax or attempt to evade or defeat tax. The General rule. Any person required to collect, truthfully account for, and pay over any tax imposed by this title 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, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.
How is the TFRP liability determined?
The factors that the IRS uses to determine if a person is liable, also includes such factors as the ability hire and fire employees, exercise authority to pay bills, signing tax returns or payroll disbursement forms, having check signing authority, and make payroll tax deposits. The IRS will also look to the ability to pay bills without prior approval, your status as a corporate officer, the ability to run day to day operations. In the cases where a person, such as CFO of a company, has technical authority to pay bills and sign tax returns, the IRS will not let that person delegate the authority to another person to avoid the liability. The IRS will not typically assign liability for persons who are acting in a volunteer basis with an entity (such as a not-for-profit board member). Usually, the IRS will conduct an interview of the affected person before they make a decision concerning liability.
In the case of the IRS, they gather documents related to the company and its bank accounts. Items such as check signature cards, incorporation documents, and employee interviews are all used to determine who is liable. For the owner and other company employees who are involved with the finances of the business, the IRS will conduct a Form 4180 interview. However, the TFRP and the interview can be contested. There are a few ways to challenge a TFRP assessment. If you feel that the TFRP is incorrect and should not apply, then you can challenge it with the IRS Appeals or Tax Court. Also, during the Form 4180 interview you can contest TFRP liability, or you can contest TFRP liability after the TFRP is assessed. A TFRP can also be removed via a Collection Due Process (CDP) hearing on your case. These approaches would be used if you are not responsible for the penalty, such as if you were merely the bookkeeper and not the person responsible for the financial affairs of the business.
At the Form 4180 interview, they go through a questionnaire type process, and ask questions such as: 1) What is your job at the company?, 2) What is your title (as employee or director)?, 3) Do you have signature authority on the company bank account?, 4) Who signs company checks?, 5) Are you the only person who deposits money into the company bank account?, 6) Do you make the payroll deposits?, 7) Do you sign the tax returns?, 8) Do you set the financial policies of the company?
If you can show that you were not in control of or did not possess the trust fund taxes, then the TFRP may be removed. It is important to have a good tax lawyer represent you during this process. The TFRP can be a daunting tax issue, but with the help of a tax professional they can help get it resolved. These cases are won and lost by the evidence presented at the 4180 interview. If you do not have a good fact pattern, then its rare that I would allow a client to be interviewed since it only helps the tax authorities. If you are clearly liable for the penalty, then not to waste resources you can admit your liability bey signing Form 2751 (Assessment of TFRP).
The statute of limitations to assess the Trust Fund Recovery Penalty is generally three years following the withholding tax quarter was filed. The TFRP time frame begins on the return due date which can be one of the quarters during the year until your filing is either accepted by the IRS or State, or rejected and you receive a notice about your tax liability. Therefore, if the TFRP assessment is close to when the time period for assessment expires, this all needs to be reviewed.
- Try to establish that your client did not have Status, Authority or Duty to pay the taxes. For instance, the payroll manager may have the ability to send in the payroll deposits, but they were delegated that power by a financial officer of the company.
- Try to establish your client was just following orders (shift the blame to others).
- Try to establish that they were not a responsible party when the tax was not paid. In some cases, it can be shown you were only in charge for a portion of time the taxes were paid.
- Try to show lack of knowledge of the unpaid taxes (for example embezzlement scenario). Remember to prove their case, willfulness is required.
- Try to show that the statute of limitations has expired to assess the penalty.
- Try to shield assets of a non-liable spouse.
How to Resolve the Trust Fund Recovery Penalty
If the trust fund penalty is assessed (meaning your defenses did not work), the IRS must give written notice to the affected person. You can appeal the decision. You can prepare a protest of the assessment and if it’s for an assessment larger than $25,000 it needs to be a formal written protest. Once the case has been sent to the Appeals Office, at the hearing the taxpayer has the burden of proof to demonstrate that the requirements of IRC Sec. 6672 were not met. It is helpful at this time to consider a settlement since often the actual are not clear, and a reduction of the debt is better than the chance of not having any reduction. Perhaps you would agree to being liable for some of the periods, or an overall dollar amount. There is judicial review rights of the penalty with the US District Court, but not the US Tax Court. A complaint in such court needs to be filed within two years of when the IRS mailed the notice of disallowance of your claim.
Once a TFRP has been assessed and appeal rights are expired without success, the normal IRS collection procedures follow. You can create a payment plan or negotiate an offer in compromise to try and resolve the tax debt. An offer in compromise is often not an easy way to resolve this debt since the IRS understands that the TFRP is not dischargeable in bankruptcy, so it’s a more difficult ‘sell” to them to see the need to accept a reduction. If you are unable to make a full payment, the IRS may allow you to file for an extension of time to pay. If you would like more information on the Trust Fund Recovery Penalty, or need help resolving a tax issue, please contact us today. Our team of experienced tax professionals would be happy to assist you at (917) 382-5142 or (518) 213-3445.