Trust Fund Recovery Penalty

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What is a Trust Fund?

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When employers hire new employees, they have them fill out a W-4 form. It is a form that determines the number of dependents you have. The number of dependents in turn determines how much your employer should withhold from your wages for income tax. The employer then will additionally withhold an amount from social security and another for Medicare.

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The employer then matches both social security that he took from the employee and the Medicare. Then he should deposit the total amount of your social security and Medicare withheld and the matching on those two along with income tax withheld in a bank account for the benefit of the IRS.

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Social security, Medicare plus income tax withheld is what is called the trust fund. Notice that the matching or the employer portion is not included in the definition of the trust fund.

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Trust fund money is supposed to be deposited on certain dates after it is collected from the employees. The frequency of the deposits will mirror the frequency of the payroll periods and the amount of money to be deposited. Generally speaking, the larger the deposit the more frequent that the employer should deposit what is in their custody.

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What is Recovery Penalty?

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If the money is not deposited in the prescribed times then the IRS may assess recovery penalty. The IRS assesses late payment penalty on the entities that do not pay in time. The penalty is called late payment penalty. But that is not what we are talking about. Trust fund is concerned with punishing those who owned the decision to make the payments to the IRS and they did not. So, it may be assessed against an employee and not necessarily the owners.

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The penalty is leveled against those who willfully use the money for other purposes other than paying the IRS. They may pay the suppliers instead of the IRS as an example. The recovery penalty is 100% of the taxes owed. It must be stressed that the penalty is leveled on the persons who are directly liable.

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For instance if a corporation (the person which is considered directly liable) owes back taxes for payroll, it will pay late penalty (different from the recovery penalty). The employee, the accountant or the controller who is vested with the ability to choose who to pay when money is tight and pays others to the exclusion of the IRS, that employee may be liable for the recovery penalty (not the corporation).

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The Devil is in the Details

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Self employed persons or proprietors are not liable for this tax because they wear two hats, one of them is the owner. They are directly liable persons and hence they are not assessed this penalty. An interesting question arises about limited liability companies (LLC).

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These companies can be structured as single member LLC and thus treated as a proprietorship (self employed) for tax purpose, or it can operate as a corporation and treated as such for tax purposes.

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Accordingly recovery penalty will not be leveled against the owner of a single member LLC because he is just like a proprietor. He is directly liable (remember that this penalty for payroll back taxes are leveled on indirect persons.)

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Similarly, because the members of a corporate LLC are not directly liable (considered to be different persons from the corporation and therefore not directly responsible) they will be subject to this penalty.

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So, to show the seriousness of this awesome burden created by such tax problem, let us suppose that the back taxes owed to the IRS for the trust fund is $100,000. The corporation may initially assess say $5,000 as late penalty. The employee may be assessed $100,000 recovery penalty.  That is how serious this IRS tax debt is. Your CPA, tax attorney nor enrolled agent may be able to provide tax help to navigate this problem.

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Uncle Sam Has a Long Arm

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How does the IRS determine indirectly liable persons? They go to the bank and get copy of the signature card. If you are authorized to sign the checks you are doomed if you let payroll tax debt accumulate. Of course, they use other methods to determine liable persons. The bottom line they want to determine persons of authority and signing the checks is to them a good clue.

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To assess the penalty against persons they must willfully fail to pay the taxes to IRS.  What does the term “willfully” mean? Most persons who don’t pay the trust fund taxes have all the best in intention in the world to pay the taxes some day. Most people owing this tax face some type of cash flow problem. They decide to pay other people who are breathing down their throat but not the IRS.

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The IRS at this point may not be aware yet that there is a tax debt to be paid. So under the pressure they channel the money to the most squeaking wheel. Does the fact that they have a faithful intention to pay the taxes when the cash flow improves exempt them from the (willfully) characterization? The answer is no. Intention is determined by the check that was disbursed and to whom it was written.

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Payroll tax problems are very serious. The IRS can even press criminal charges against people who are persistently ignoring meeting their payroll tax obligations. They can be subject to imprisonment for up to five years. It is therefore very important to negotiate as early as possible an IRS settlement such as installment agreement or an offer in compromise to avoid serious consequences.

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Installment agreements may not be automatic in payroll tax problems. If the IRS detects that you keep adding to the tax debt with every additional pay period, they may deny you the option of the installment agreement and keep attacking you with collection actions such as bank levies.