Tax Court Case Demonstrates IRS’ Vigorous Pursuit of Trust Fund Recovery Penalty

November 8, 2016

A recent U.S. Tax Court case illustrates how aggressive the Internal Revenue Service (IRS) has become in using the trust fund recovery penalty (TFRP) to collect trust fund taxes.  The taxpayer against whom the IRS assessed the TFRP was the wife of a passive investor of the employer corporation, but she was not an officer of the employer corporation, did not control its financial affairs, had no ownership interest, had no authority to hire and fire employees, and otherwise had little or no decision-making power beyond ministerial duties.  Notwithstanding IRS’s contentions to the contrary, the Tax Court held that the taxpayer was not liable for the TFRP because she was not a responsible person and did not willfully fail to pay over to the government trust fund taxes withheld from employees.

An employer is required to withhold from an employee’s wages income, social security, and Medicare taxes, and to hold these taxes in trust until they are paid over to the government.  These withheld taxes are referred to as “trust fund taxes,” and are a principal source of tax revenue to the government.  Employees are treated as having paid these taxes to the government when they are withheld by their employer.  Once they are withheld, the IRS cannot collect these taxes from the employees if the employer fails to pay them to the government.

To encourage prompt payment of the trust fund taxes, the Internal Revenue Code contains the TFRP, which makes certain individuals personally liable for the trust fund taxes if the employer does not pay them over to the government.

The TFRP may be assessed against any person who (i) is responsible for collecting or paying withheld trust fund taxes, and (ii) willfully fails to collect or pay them.  Moreover, failure to collect and pay over trust fund taxes can land an individual in jail.  See Failure to Pay Over Payroll Taxes Could Land You in Jail – Part III.

A responsible person is a person or group of people who has the duty to perform and the power to direct the collecting, accounting, and paying of trust fund taxes. This person may be:

  • an officer or an employee of a corporation,
  • a member or employee of a partnership,
  • a corporate director or shareholder,
  • a member of a board of trustees of a nonprofit organization,
  • another person with authority and control over funds to direct their disbursement,
  • another corporation or third-party payor,
  • payroll service providers (PSP) or responsible parties within a PSP,
  • professional employer organizations (PEO) or responsible parties within a PEO, or
  • responsible parties within the common law employer (client of PSP/PEO).

A responsible person willfully fails to collect or pay trust fund taxes if he or she (i) must have been, or should have been, aware of the outstanding taxes; and (ii) either intentionally disregarded the law or was plainly indifferent to its requirements. (No evil intent or bad motive is required.)

In Fitzpatrick v. Commissioner, T.C. Memo. 2016-199, the taxpayer was the wife of a passive investor in the employer corporation.  At the request of her husband in early 2005, she performed certain ministerial duties in connection with the formation of the employer corporation, including opening a bank account and being a person authorized to sign checks on the account.  Once the employer was open for business, it was run primarily by its president, who was an active investor, and a general manager.  A professional payroll service company was engaged to handle employee payroll and the deposit of trust fund taxes and the employer’s share of payroll taxes.  As a convenience for the employer, the payroll service would prepare the paychecks and deliver them to the taxpayer’s house for her signature.  On a few occasions, the taxpayer signed non-payroll checks for the employer.

When the employer experienced financial difficulties and its bank account was frozen, the taxpayer was directed to open another bank account, which she did.  (The taxpayer wrote “sec” next to her name on the signature card, even though she was never the secretary of the employer corporation.)  When the employer did not have sufficient funds in its bank account to allow the payroll service to debit the account to pay the employment taxes due, the payroll service discontinued the tax deposit component of the services it provided the employer, without the taxpayer’s knowledge, but continued delivering checks to her house for her signature.  It was more than two years later that the taxpayer learned that the payroll service had discontinued its tax deposit component of its service.

When the trust fund taxes were not paid over to the government, the IRS assessed the TFRP against the taxpayer.  (It appears the president and general manager of the employer successfully contested their liability for the trust fund taxes through the IRS administrative process.)  The IRS contended that the taxpayer possessed all the recognized indicia of a responsible person.  It asserted the taxpayer exercised substantial financial control over the employer, was a de facto officer because she opened two bank accounts, had signatory authority over both accounts, and signed checks on behalf of the employer.

The Tax Court disagreed.  It found by a preponderance of the evidence that the taxpayer’s role was ministerial. She lacked authority to control the financial affairs of the employer or to exercise any significant authority over the disbursement of funds; she had no involvement in the day-to-day affairs of the employer (except for a few weeks during its pre-opening phase); she was not an officer, director, owner or employee of the employer at any time; she had no authority to hire and fire employees; she had no responsibility to oversee or ensure the payment of payroll taxes; she was not its bookkeeper or accountant; and she did not reconcile the bank statements.  Moreover, she had no duty to, and did not, oversee the employees, collect payroll information, compile payroll information, or remit payroll information to the payroll service company.  These were the duties of the general manager.

Once the Tax Court found the taxpayer was not a responsible person, it did not need to determine whether her acts were willful.  Nevertheless, the Tax Court examined the willfulness of the taxpayer’s action, and found persuasive her argument that during the relevant periods she lacked the requisite knowledge that the payroll taxes were unpaid, and therefore did not satisfy the willfulness requirement.

Reading the Tax Court opinion, one cannot help but sense that the court was surprised, if not annoyed, that the IRS would seek to collect the TFRP from the taxpayer with such weak facts supporting her status as a responsible person or her actions as willful.  While the facts in this case may not fairly represent the IRS’s general approach to assessing the TFRP, it is clear that the IRS will vigorously pursue the TFRP when trust fund taxes are collected and not paid over to the government.  Business owners, directors, officers and key employees need to understand how serious an offense it is to collect from employees’ wages, the money for income, social security and Medicare taxes, and not pay them over to the government.  Not only can this result in personal liability for the full amount of the trust fund taxes collected and not paid over to the government, but it also can be a crime punishable by incarceration.