Posted by James Financial Services Inc

Avoid the Employment Tax Delinquency Trap

Avoid the Employment Tax Delinquency Trap

In this present economy, more and more companies are trying to survive on low incomes and low operating margins. When bad economic conditions lead to lower incomes, banks can withdraw critical lines of credit. Businesses looking for a quick cash settlement are easily drawn to the use of withheld employment taxes, which must be given to the IRS (and appropriate state agencies) to fund critical operating expenses. The consequences of non-payment of withheld employment taxes can be considerable. This article focuses on repayment strategies that can be recommended to help businesses resolve the tax issues of federal tax offenders.

The Tax Delinquency Trap

There are four types of payroll taxes: two are "trust fund" taxes, and two are "non-trust" taxes. The first two consist of federal income tax and 50% of FICA taxes that an employer must withhold from employee salaries. Taxes on non-trust funds are those owed by the employer's unemployment taxes and 50% share of FICA taxes.

The trap of tax employment delinquency is a double-edged sword. In addition to imposing severe penalties and interest on unpaid employment taxes under Section 6672 of the IRC (Internal Revenue Code), the IRS may impose personal liability (known as the 100% TFRP (trust fund recovery penalty)) for the trust fund portion of the delinquency on any or all of the responsible people. A responsible person is one who has the power to ensure that trust fund fees are paid on time.

Managers can include non-executive employees and corporate directors, such as the controller, payroll manager, or accountant. The IRS can claim and assert personal liability of the trust fund against any number of responsible people at the same time and will normally seek to hold as many people accountable as possible. As we will see below, even bankruptcy offers no escape from this liability. Since the IRS is very aggressive in imposing a 100% recovery fine, accountants must ensure that companies facing this problem hire lawyers who are experienced in particular legal matters and who can advise them. 


Allocate Payments

Since, in general, individuals cannot be held personally liable for the non-fiduciary portion of a company's payroll taxes (or related interest and penalties), it is essential to the responsible person that the portion of the trust fund (for which individuals may be held liable) be reimbursed as soon as possible before the non-fiduciary commission. Companies are advised that they can settle the trust fund portion first, including specifying how payments against delinquency are to be applied—however, one caveat. Since the IRS often does not favor the designation of payments, judgment about when to designate can be important in maintaining the IRS's cooperation in designing payment strategies.

Companies should use the following language: "Direct and apply to the remaining trust fund balance owed for the Form 941 period(s) ending XX."

  • In a letter accompanying the payment

  • On the back of the check as a restrictive approval

  • On the memo line of the check

Form 941 is the form used by most employers to report employment-related tax obligations other than unemployment rates. If a business does not know which period of Form 941 is overdue or which trust fund balance is pending for that period, the designation should be trust fund balance "for the most recent Form 941 period for which taxes are due."

Designation for more recent periods can provide additional benefits if a business owes payroll taxes for more than one period. Depending on the default duration, it may be better to pay the most recent periods first; According to IRC section 6651, penalties for non-payment of the unpaid balance usually accumulate at a rate of 1% per month up to 50 months implicitly and a previous period has a small outstanding balance, it may be beneficial to pay the small balance so that there are fewer periods of non-payment.


How It Works

Assume that on January 1, 1997, XX has overdue trust fund salary taxes of $100,000 for each quarter ended June 30, 1994, and December 31, 1996, imposed by the application of the last payment. If the business has not designated this period, the IRS will apply the full or partial payment to the previous period. The fines would continue to pile up on the recent one, as more taxes would be payable, and the 50 months would not have expired yet.

Many taxpayers are not aware of their legal right to determine how payments are applied. The IRS takes every opportunity to apply unallocated payments to the non-trust portion of the fund first, including penalties and interest. The only way a business can be deprived of its right of appointment is if the IRS has taken enforcement action (such as forfeiture of a business bank account) to obtain payment. All other payments are generally considered "voluntary" and are therefore subject to designation. However, if the designation is not clear and concise, the IRS will often deny it and demand payment of the non-trust portion of the fund. The right to designate may also be compromised by formal payment agreements negotiated with the IRS.


Additional Strategic Considerations

In most overdue tax situations, other strategic considerations must be taken into account. This includes possible recourse to penalties imposed in addition to the 100% trust fund penalty, subordination of collateral, and submission of an offer in compromise and bankruptcy.


  • Appeal and Abatement: IRC Articles 6651 and 6656 impose heavy penalties on taxpayers for non-compliance with updated tax returns and non-payment of payroll taxes. However, these penalties can be reduced if the taxpayer can prove that the non-compliance is due to "reasonable and unintentional cause." Although court rulings, Section 6651 regulations, and the Internal Revenue Manual strictly interpret the term reasonable cause, tax officials have considerable discretion in determining whether they exist. Therefore, it is often advisable to file a thoroughly detailed petition to obtain reduced penalties.

  • Bankruptcy: Another option is Bankruptcy. This is usually the last strategic option is bankruptcy. While unpaid payroll taxes cannot be reversed in bankruptcy, a bankrupt taxpayer may have more time to pay. For example, bankruptcy can usually extend the deadline for paying the delinquent taxes by six years from the date the payroll taxes were assessed.

  • Offer in Compromise (OIC): In the context of unpaid social charges, this is an agreement to speed up repayment in exchange for a deduction from the amount of tax due. However, for the IRS to accept an offer, the taxpayer must at least provide expedited payments equal to the amount collected based on the taxpayer's assets, the taxpayer's present and future income (usually the projected average monthly income fewer expenses for the next five years) and what might be collectible from other persons responsible for the 100% recovery penalty. 

Suppose Company XYZ owes $300,000 in unpaid payroll taxes, including interest and penalties. The business has no assets other than a building of $100,000, subject to a mortgage of $75,000 registered before IRS tax. If the IRS collects $10,000 from everyone liable for the trust fund penalty and XYZ has a net monthly income of $2,000, the offer must be for accelerated payments of at least $155,000.

  • Subordination: The Internal Revenue Service may be willing to subordinate its tax burden to that of a defaulting taxpayer's creditor if it can be confident that such action will facilitate the collection of unpaid taxes. In doing so, the IRS reduces the risk of the creditor by allowing the taxpayer to borrow for critical transactions despite the necessary tax collateral. In general, the IRS agrees to be subordinate when it is unlikely that the taxpayer will pay the unpaid taxes without funding.

Bottom Line

Devising a strategy to successfully negotiate an IRS delinquent employment taxes requires careful analysis and professional advice and representation. While CPAs can provide advice on tax implications, it is also a good idea to consult with a lawyer who understands the legal implications of repayment strategies. Experience shows that there is usually a viable strategy for every situation, no matter how bleak the circumstances may seem at first. Getting well-informed advice before making catastrophic mistakes often makes the difference between successfully overcoming economic failure and causing a business to fail.



James Financial Services Inc
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