Rethinking the ‘Responsible Person’ Penalty

By Don G. Smillie

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JUNE 2005 - One benefit of the corporate form of business is limited personal liability. A corporation may file for bankruptcy and have debts canceled by the court. A discharge in bankruptcy precludes a creditor from pursuing collection from corporate managers or owners. One such debt that regularly arises in a corporation is payroll taxes. Because a company pays only a net check to the employee and the balance to the IRS, some managers of companies succumb to the temptation to not remit payroll tax liabilities and instead use the money to satisfy obligations they consider more pressing. As all accountants know, however, business prospects often worsen and debts cannot be paid. The company then files for bankruptcy and is reorganized or liquidated. Most debts are discharged, and the company obtains a fresh start.

In 1954, Congress made a major revision to the Internal Revenue Code that enacted IRC section 6672, the 100% penalty for individuals that do not remit payroll taxes. Congress enacted section 6672 to reduce the occurrence of the IRS being a discharged creditor by encouraging prompt payment of these payroll taxes.

Application of IRC section 6672 requires careful identification of the components of payroll liabilities. The taxes subject to section 6672—federal withholding and the employee FICA and Medicare taxes withheld—are referred to as “trust fund taxes.” Trust fund taxes do not include the employer portion of FICA and Medicare or federal unemployment taxes, which are considered a liability of the corporation not subject to section 6672.

Section 6672 provides that any “responsible person” required to collect and remit trust fund taxes shall be liable for a penalty equal to the amount of the tax that was to be withheld and paid to the IRS (the 100% penalty). The new name for the penalty is “the trust fund recovery penalty.” A responsible person can be any officer or employee of a corporation who is responsible for accounting for and paying the taxes to the IRS.

Responsible and Willful

Two primary tests must be met in order for IRC section 6672 to apply: the responsible person test and the willfulness test. These two tests determine whether a person can be held liable for the taxes due. A responsible person has the primary duty in the corporation to collect and remit taxes on wages. If more than one person fits this definition, all may be held liable under section 6672. The IRS has broad powers for selecting responsible persons. As a practical matter, it often pursues those with the deepest pockets. In some cases, it pursues those standing nearest the fallen corporation. A responsible person could be someone who computes the payroll, writes payroll checks, signs checks, supervises the payroll function, or has managerial control over the affairs of the corporation. Directors and shareholders can be responsible persons.

The critical factor that makes someone a responsible person is the power to make a decision to pay or not to pay. The courts look broadly over the company to find who had the actual authority to pay the funds and who controlled the process of determining the preference of payment. In many court cases, accountants in management have claimed that they were merely acting on orders from superiors and would have been punished or fired if they had paid the tax to the IRS. The courts have sided with the IRS in most cases, because these accountants held additional managerial positions over and above their accounting role, making them already in fact responsible persons.

The willfulness test determines if a person knew the taxes were not paid and willfully and intentionally did not remit the funds to the IRS after knowing that such funds were due. The courts consider the state of mind of the person at the time of the willful act as a material fact, but each court uses different criteria. A finding of reasonable cause is not sufficient to overturn a finding of willfulness. Willfulness includes a “reckless disregard” of a known or obvious risk that trust fund taxes would not be paid to the IRS. Responsible persons act willfully if they know taxes are due and use funds to pay other debts. Responsible persons do not act willfully if they do not know of a tax liability but, upon learning of the liability, use funds to pay current taxes.

Once the IRS determines a tax is due, an agent completes forms 4180 and 4183, which identify the responsible persons in the company. The agent also recommends who should be considered the responsible persons based on an assessment of the criteria discussed above. In 1993, the IRS revised its position and determined that secretaries, bookkeepers (nonaccountants), and charitable volunteers are not subject to IRC section 6672. Most courts, however, have followed the IRS in holding accountants in management liable. One exception is the 10th Circuit Court, which recently ruled against the IRS. It charged lower courts with determining if the accountant had a sufficient degree of control over the affairs of a company to make him a responsible party under section 6672. One court even stated that if the accountant had disobeyed and paid the taxes due, he would have violated an ethical duty to his employer and could have been charged with the illegal conversion of corporate funds.

Bankruptcy Does Not Discharge a 6672 Penalty

According to the Federal Bankruptcy Code, the IRC section 6672 penalty is not dischargeable if a corporation declares bankruptcy. Before bankruptcy, a responsible party may direct payments to the trust fund portion of employment taxes before other taxes are paid. After a company files for bankruptcy, any payments to the IRS are considered out of the control of the company. The IRS may apply subsequent payments to any liabilities due, but typically applies payments to non–trust fund liabilities first. It can always pursue collection of the tax against the responsible party after the bankrupt company is stripped of available assets.

The Supreme Court has ruled that the bankruptcy court may require the IRS to apply payments a different way in order to facilitate a reorganization plan. This is rarely invoked, because the payments are not usually crucial to a plan of reorganization. The IRS must assess and collect the IRC section 6672 penalty the same way as any other tax. The statute of limitations is the same, which means the IRS must assess the penalty within three years from the time the return is filed and has 10 years in which to collect. During that time, the IRS has the power to file a lien on all of the responsible person’s property, seize assets, including bank accounts and homes, and garnish future wages and income. The credit record of the individual party is usually ruined, and no credit can be obtained as long as a lien exists.

Recommendations for Change

Two areas within the current system should be overhauled: 1) who is liable and who pays, and 2) the initial process by which a new business is formed.

Liability. IRC section 6672 added the accountant in management as another layer of liability for the trust fund portion of payroll taxes. But shouldn’t employees also assume some measure of risk and responsibility pertaining to the payment of their employment taxes? They are on the job every day and have a closer relationship with the employer than does the IRS. They could determine, on some reasonable basis, that the taxes have or have not been paid.

For example, the employer could indicate an Electronic Federal Tax Payment System (EFTPS) number on a pay stub so each employee would have evidence that related taxes were remitted to the Treasury Department. Employees could then notify the IRS if they have concerns that the taxes were not deposited. Employees that did not alert the IRS would ultimately be held liable for their own taxes. This would spread the liability over a greater number of people rather than a few responsible persons designated by the IRS. Notification from an employee would also alert the IRS of a payment problem sooner than does the current system.

Formation of a new business. The IRS should be required to estimate the extent of liabilities expected to emanate from a new business and establish some type of bond to guarantee the payment of taxes up to some agreed-upon amount. Prospective entrepreneurs might give additional thought to starting a business if the entry price were higher and the potential costs were well documented. The current system allows anyone to obtain a federal identification number and open up a business.

If the IRS trust fund payment were limited to a predetermined amount from a party who had previously agreed to such a liability, bankruptcy would then revert to the purpose for which it was originally intended. Business owners and other responsible persons could discharge their agreed-upon liability to the best of their current ability and through payments over the next 10 years. Any liability over the agreed-upon amount would be discharged in bankruptcy. This system would result in the appropriate responsible persons being held liable and would avoid ruining the finances of an innocent person.

Awareness of payroll taxes should also be conveyed to a new owner before an identification number is issued. An application to obtain the number by phone could be expanded into a counseling session regarding key aspects of business operations, such as payroll taxes. The IRS could then document that the owner has been informed regarding pertinent aspects of business and related taxes. Alternatively, a new business-owner’s CPA could administer the counseling session.

By discussing liability up front, the parties involved would have the option to accept or reject responsibility before it is invoked by the IRS. The interviews and counseling sessions at the beginning of the business would inform all parties about the reality and the amount of any potential liability. Agreements could be modified on a regular basis, and parties could be given opportunities to rescind or revise their position with the business. The existence of the liability and the amount of the liability should be established in some fair and rational manner at the outset, rather than after the business is in trouble. Responsible persons under IRC section 6672 could clearly assess their personal exposure and determine whether they are willing to assume the risk. This would be much more equitable and fair than the current system.

Don G. Smillie, CPA, CSA, established his own firm in 1975 and is a lecturer at Southwest Missouri State University, Springfield, Mo.




















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