Business tax debt: Payroll taxes and personal liability

David's restaurant had twenty-two employees, a lease he could not get out of, and a stretch of five bad quarters after a highway project cut off the main road to his parking lot. During those quarters he made payroll every two weeks. What he did not make were the federal tax deposits that went with it.

It did not feel like theft. It felt like triage. The money was in the account on Friday, the employees needed to be paid, the food supplier needed to be paid, and the IRS deposit was the one obligation with no immediate consequence for skipping. He told himself he would catch up when the road reopened. The road reopened. He was $140,000 behind.

I have put David's chapter in Part IV rather than Part III because employment taxes are not a different flavor of the same problem. They are a different problem. The money David did not send was not the restaurant's money. It had been withheld from his employees' paychecks and belonged to the government from the moment it was withheld. The Code treats it as held in trust. The IRS treats failure to remit it as the most serious category of civil tax debt it handles. And the law provides something that exists almost nowhere else in civil tax collection: a mechanism to collect the business's debt from the owner personally, no matter how the business is organized.

If your tax problem involves payroll, every timeline in this book runs faster, and this chapter is the one to read first.

What employment taxes are

When you pay an employee, four things happen in the background. You withhold federal income tax from their pay. You withhold their share of Social Security and Medicare, 7.65 percent. You owe your own matching share of Social Security and Medicare, another 7.65 percent. And you owe federal unemployment tax, a small amount per employee, separately.

The first two, the income tax withheld and the employee's share of Social Security and Medicare, are the trust fund taxes. They came out of the employee's paycheck. The employee will get credit for them on their own return whether or not you ever send them in. The government has, in effect, already paid the employee's tax on their behalf and is relying on you to deliver the money. The employer's matching share and the unemployment tax are the non-trust-fund portion: real debts, but the business's own.

You report all of this quarterly on Form 941, and you deposit the money on a schedule that depends on how much you withhold, either monthly or twice a week, through the Electronic Federal Tax Payment System. The deposits are due long before the quarterly return. A business that files its 941 on time but has not made the deposits has already been late for months.

How fast it gets expensive

The failure-to-deposit penalty is tiered by lateness: 2 percent if the deposit is one to five days late, 5 percent at six to fifteen days, 10 percent beyond that or within ten days of a first notice, and 15 percent if the tax is still unpaid ten days after the IRS sends a notice and demand. Add the failure-to-pay penalty, interest, and in some cases the failure-to-file penalty if the 941 itself is late, and a quarter's unpaid payroll tax can grow by a third in a year.

But the penalties are not the real danger. The real danger is that the IRS assigns employment tax cases to revenue officers quickly, that revenue officers have authority to act fast on them, and that the IRS has a specific mandate to stop what it calls pyramiding, the pattern of a business falling further behind each quarter while continuing to operate. A business that is pyramiding can find itself facing levies on its receivables, a lien, demands for immediate current compliance, and in persistent cases a federal court injunction, all within months rather than years.

The Trust Fund Recovery Penalty

This is the part that makes employment tax different from everything else in this book.

Section 6672 of the Code allows the IRS to assess a penalty equal to 100 percent of the unpaid trust fund taxes against any person who was responsible for collecting and paying them and who willfully failed to do so. The penalty is assessed against the individual, not the business. It becomes a personal tax debt of that individual, collectible from their personal bank accounts, wages, and property, with its own ten-year collection period. It survives the closing of the business. It survives the bankruptcy of the business. It survives the personal bankruptcy of the individual, because trust fund taxes are never dischargeable. The corporate or LLC shield that protects owners from the business's other debts does not apply, because the penalty is assessed against the person, not the entity.

Two words carry the provision.

Responsible. A responsible person is anyone with the status, duty, and authority to decide which creditors get paid. Owners, officers, and managing members almost always qualify. So can a bookkeeper or office manager with signature authority who actually decides what gets paid, a controller, or in some cases an outside accountant who took over the company's finances. The question is control, not title. David's bookkeeper, who processed payroll but had no authority over which bills were paid and who had told David in writing three times that the deposits were behind, was not responsible. David was.

Willful. Willfulness does not require bad intent. It means that you knew the trust fund taxes were unpaid and chose to pay other creditors instead, or that you recklessly disregarded a known risk that they were unpaid. Paying your employees, your landlord, and your supplier with money that should have gone to the deposit is willful under this standard. Every business owner who has ever made payroll on Friday knowing the deposit was not made has met it. That is not a moral judgment. It is the legal test, and it is deliberately easy to meet.

How the penalty gets assessed

A revenue officer investigating an employment tax case will identify the people who might be responsible and interview each one using Form 4180, a detailed questionnaire about who had authority over hiring, firing, signing checks, deciding which bills to pay, and dealing with the IRS. The interview is usually in person or by phone. You can have a representative present and you should, because the answers are the evidence.

If the officer concludes you are responsible and willful, you receive Letter 1153, a proposed assessment of the Trust Fund Recovery Penalty. You have sixty days to protest it to the Independent Office of Appeals. If you do not, or if Appeals sustains it, the penalty is assessed against you personally and the ordinary collection process begins: notices, final notice, levy.

The IRS can assess the penalty against every responsible person, and it will often assess it against several people at once, each for the full amount. It collects the trust fund amount only once, from whichever combination of the business and the individuals it can reach, but until it has collected it, every assessed person is fully exposed.

What the business can do

The first and non-negotiable step, before any negotiation, is to get current. From today forward, every deposit on time, in full. Revenue officers will not discuss an agreement on past liabilities with a business that is still falling behind on current ones, and the IRS's manual tells them not to. David enrolled in EFTPS, set the deposit to pull automatically from the operating account the day after each payroll, and showed the officer the first two on-time deposits before the second meeting. That changed the tone of the case more than anything else he did.

For past liabilities, the business's options parallel the individual's, with adjustments.

The in-business trust fund express agreement. If the business owes $25,000 or less in employment taxes, including penalties and interest, it can get an installment agreement of up to 24 months without a financial statement, with direct debit required above $10,000. This is the equivalent of the streamlined plan and it is fast.

A regular installment agreement. Above that, Form 433-B for the business, usually 433-A for the owner as well, and a payment plan set by the business's disposable income. Revenue officers have more discretion here than the automated system does, and a well-documented proposal from a business that is demonstrably current often gets approved. David's was $3,400 a month on the $140,000, after penalty relief on the first quarter under First Time Abate, which applies to the failure-to-deposit penalty.

An Offer in Compromise for the business. Possible but rare for an operating business, because the IRS values the business as a going concern and because it is reluctant to compromise trust fund taxes while the business continues. It is more common when the business has closed.

Currently Not Collectible. Rarely available to an operating business with payroll tax debt, for the same pyramiding reason.

What the owner can do

Separately from the business, the owner has to think about personal exposure, and there are three levers.

Designate payments to the trust fund portion. When the business makes a voluntary payment, it has the right to specify that the payment be applied to the trust fund portion of the liability. The IRS, left to itself, applies payments to the non-trust-fund portion first, which keeps the owner's personal exposure as large as possible for as long as possible. A letter with every voluntary payment, or a notation on the EFTPS payment, stating that the payment is to be applied to the trust fund portion of a specific quarter, reduces the amount that can be assessed against the owner personally. Levy proceeds and other involuntary payments cannot be designated. For David, whose $140,000 was about $95,000 trust fund and $45,000 non-trust-fund, designation meant that every dollar the business paid under its agreement shrank his personal exposure rather than the business's.

Contest the assessment where there is a real argument. If you were not actually responsible, because someone else controlled the finances and you had a title without authority, or if you were not willful, because you did not know and had no reason to know the deposits were not being made, the sixty-day protest is where that argument belongs, with documents. Owners who were genuinely locked out of the finances by a partner, or who discovered an embezzling bookkeeper, have won these. Owners who knew and paid other bills do not, and the better course is to concede the assessment and concentrate on the business paying the liability so that the personal assessment never has to be collected.

Keep the business agreement current. When the business is in a current installment agreement, the IRS's practice is generally to hold collection on the owner's personal Trust Fund Recovery Penalty assessment while the business pays. The assessment sits there, with its own notices, but no levy follows as long as the business performs. If the business defaults, the IRS pursues the owner. That is the structure David ended up in: a $95,000 personal assessment that he never paid a dollar on directly, because the restaurant's $3,400 a month, designated to trust fund, paid it down over about three years, after which the remaining non-trust-fund balance was the restaurant's alone.

If the business is going to close

Some businesses with payroll tax debt should close, and the owner knows it. The question is how.

Closing does not make the trust fund liability go away. It converts it, immediately, into a personal problem via the penalty. Before closing, understand what the trust fund portion is, designate every remaining payment to it, and consider whether an offer on the business's liability, which is easier once the business is not a going concern, could reduce it before the penalty is assessed. Then, once the penalty is assessed against you personally, you are an individual with a tax debt, and Parts II and III of this book apply to you: a payment plan, an offer based on your personal finances, hardship status. The one door that is closed is bankruptcy; trust fund taxes do not discharge.

Do not start a new business entity and move the employees and customers into it while leaving the debt behind in the old one. The IRS treats this as a successor or alter ego situation, can assess the liability against the new entity, and treats the maneuver as evidence of willfulness in any penalty case. It is also the fact pattern most likely to draw a criminal referral under section 7202, which makes willful failure to collect or pay over employment taxes a felony. Prosecutions are rare and are reserved for egregious cases, but egregious cases tend to involve exactly this: a long pattern, a closing, a new entity, and the same owner.

Three rules for anyone who runs payroll

First, the deposit is not your money. Treat it like the sales tax you collect for the state or the tips you hold for your staff. If the operating account cannot carry it, the business has a problem that skipping the deposit does not solve, it defers and multiplies.

Second, verify your deposits yourself, even if you use a payroll service. Enroll in EFTPS under the business's own account and look at the deposit history every quarter. Payroll service fraud, where the provider collects the money and does not remit it, happens every year, and the employer remains liable for every dollar. The IRS has started sending employers notifications when their payroll provider's deposits change; read them.

Third, if you are behind, call before the revenue officer does. A business that comes forward, gets current, and proposes a plan is handled very differently from one that is found. The officer's job is to stop the bleeding and collect what is owed. If you have already stopped the bleeding, you have done half of the officer's job, and officers notice.

David's restaurant is still open. He describes the five quarters as the most expensive loan he ever took, and he is right, because the effective interest rate on borrowing your employees' withholding, once penalties and the personal exposure are counted, is higher than any lender in the country would charge.

For people like David, and for Michael, and for anyone whose case has a revenue officer, a business, a six-figure balance, or an argument worth making, the question of whether to hire help is real. It is also the question most abused by the industry that answers it. The next chapter is about how to answer it for yourself.