Understanding the IRS Trust Fund Recovery Penalty

One of the most common points of confusion among business owners that I discuss tax problems with has to do with the Trust Fund Recovery Penalty. I’d like to explain what “trust fund” taxes are, where they come, how the IRS holds somebody personally responsible for them, and, most importantly, what you can do about them. This is probably going to be a long article, so you might want to get comfortable.

What Are “Trust Fund” Taxes?

“Trust fund” taxes are any tax that is collected by you, on behalf of somebody else. There are many different trust fund taxes, but the two most common are sales taxes and income withholding taxes.

Most states are very aggressive about collecting sales taxes (North Carolina will physically arrest you for not paying them). Technically speaking, sales taxes are owed by the person making the purchase. However, because they are collected at the point of sale, they are a trust fund tax. This is because the person paying them (e.g., your customer) is “trusting” you to hold that tax money and pay it on their behalf. When you receive sales tax money from your customers, you are supposed to hold it in a separate “trust” account, and then hand it over to the tax man when you it is due (usually monthly, in most states/counties).

Income withholding taxes are also “entrusted” to you by your employees. Specifically, these are income taxes you withhold from paychecks, and the employee’s half of Social Security and Medicare that you take out of their paycheck.

Even though the employee never sees the money that’s taken out of their paycheck, they expect it to exist, somewhere. That somewhere is a trust account (generally your payroll account) where you save that money up and then pay it to the government every two weeks or monthly.

Payroll taxes are the single biggest enforcement concern to the IRS. Part of running a business and having employees is “exercising ordinary business care and prudence”. This is fancy lingo enshrined within the tax code that basically means the IRS expects you to exercise common sense in regards to running your business. Part of this common sense is to understand that your employees cost you more than just the paycheck you actually write them, and if your business doesn’t have the revenue to support those extra costs of having employees, then you shouldn’t have the employee.

So, to recap, trust fund taxes are taxes that are owed by other people, such as your customers (sales tax) and employees (income tax, Social Security, and Medicare withholding), but are held by you for actual payment.

Trust Fund Recovery Penalty Personal Assessment

As mentioned above, the collection of payroll taxes is the single biggest enforcement priority for the IRS. Why? Because those taxes are the actual money that funds the Federal government on a day to day basis. Payroll taxes are the Federal government’s biweekly and monthly paychecks from all of us that are working.

Because this is such an important part of funding government operations, trust fund taxes are the only taxes subject to an extremely powerful collections tool. This tool is special to the IRS, because for them, it does not require going to court. This tool is commonly referred to as “piercing the corporate veil”, and means that the government can come after not just your corporation, LLC, or partnership to collect the tax, but can come after individual corporate officers and try to collect these taxes from them personally.

The IRS is required to follow a procedure before sticking you personally with this tax bill. The process is all administrative, meaning that it is done by your Revenue Officer, and does not go to court, never seen by a judge, and no lawyers are involved.

In order to assess the trust fund against you as an individual, the IRS must determine two things:

  1. That you were the person within the company responsible for paying over the trust fund taxes.
  2. That you were willful in not paying them.

The responsible person is generally considered to be the person in the business that manages the finances, calculates payroll, and signs the paychecks. Even if another employee, such as an office manager or bookkeeper, actually does the physical work of crunching payroll and printing the checks, the responsible person is generally the corporate officer, LLC member, or manager that delegated that task to the employee. For most small businesses, the responsible person tends to be the owner. Also, keep in mind that multiple people can be held responsible.

The IRS must also demonstrate that the responsible person willfully failed to pay the trust fund taxes. What this means is that the person made a conscious decision to use that money for another purpose OR failed to make sure the money existed in the first place. In general, the IRS will look at what other bills got paid instead of the payroll taxes, and use that as sufficient evidence that “willful failure to pay” occurred.

The IRS uses a 4-page interview form to ask all the questions to determine who is “willfull” and “responsible”. This is called a Form 4180, and must be filled out by the IRS employee by telephone or in person. Your representative may use industry lingo and refer to this as a “4180 interview” for short — this is what he is talking about.

After a 4180 interview is conducted, the Revenue Officer will make a determination, and issue an IRS form called a Letter 1153, which is usually accompanied by a Form 2751. The Letter 1153 is the document proposing the assessment of the trust fund against you personally, and the Form 2751 is the form you would sign to skip the appeals process and simply accept the assessment.

In some cases, part of the resolution plan worked out by your representative will include simply accepting the assessment, in exchange for something else, such as a payment plan. However, unless your representative explains that it’s part of the plan, NEVER SIGN A FORM 2751!!!

If you did not file an Appeal, the Letter 1153 goes into force, and the trust fund is assessed against you after 60 days. Appeals will be discussed below.

If the Trust Fund Recovery Penalty (the term for the individual assessment) is tacked onto your personal taxes, then you owe it just like you would personal income taxes. At this point, the IRS can come after your personal paychecks, personal assets, personal bank accounts, etc.

Resolving Trust Fund Recovery Penalty Cases

Resolving Trust Fund Recovery Penalty cases can be complicated. The first route usually taken by a tax professional that you hire to help you with this is to fight the “responsible” and “willful” determination. In a larger company, there is often one person responsible, and another willful, but neither is both.

An example of this is a company with a CFO or comptroller that makes financial decisions for the company, and might make the decision to pay rent, utility bills, paychecks, etc., instead of the taxes. However, this person is not the individual that is actually responsible for calculating payroll, signing paychecks, and performing other payroll related functions. In this case, there might be nobody that fits both the “responsible” and “willful” criteria.

Unfortunately, in most small companies, the person that is responsible and willful is generally the same person, usually the business owner. In the case of a small business owned by a married couple, it is fairly common for both spouses to be involved in the financial decision making for the business, which usually makes both of them responsible and willful.

Basically, the smaller the business, the more likely it is that one person, and only person (the owner), is going to get whacked with the Trust Fund Recovery Penalty.

In some cases, the IRS may be willing to delay the assessment of the trust fund against a person. In order to do this, you’re going to need to agree to an extension of the maximum legal length of time that the IRS has for making the personal assessment, which is done by signing a Form 2750 (do not confuse this with Form 2751!). In exchange, the IRS will often accelerate the granting of a payment plan to the business itself, based on the theory that the business will pay off the trust fund over time, and therefore make it pointless to hold you personally responsible.

If the assessment can’t be avoided, then it becomes a personal tax matter. At this point, the other resolution options normally available for personal tax matters come into play, such as payment plans, reduced settlements (Offer in Compromise), and uncollectible status. One thing to keep in mind is that trust fund taxes CAN NOT be eliminated in bankruptcy.

Conclusion

This has been a long article, and probably a lot to digest. However, it explains the entire process of trust fund recovery penalty assessment, where it comes from, and what you can do about it. Hopefully, if you are facing this particular IRS demon, you now have a better understanding of how you can fight it.

While most tax problems really can be resolved on your own, Trust Fund Recovery Penalty cases are one of the few situations where I highly encourage people to obtain professional representation. If you are in this situation, please get in touch with me to to discuss your case.