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Tax Penalty for Trust Funds: How the IRS Can Personally Collect Taxes on Your Business

Tax Penalty for Trust Funds: How the IRS Can Personally Collect Taxes on Your Business

Taxes on trust funds can cause big problems for small businesses. When an employer withholds part of his employee's salary to pay income tax, social security, and Medicare taxes, that money is kept "in trust." It must be paid into the treasury each month or every two weeks. Problems arise when the business uses these funds for other purposes, such as rent, utilities, or suppliers. Usually, the employer intends to replace the "borrowed" trust funds, but sometimes cash flow becomes low and unpaid taxes begin to rise faster than the business can cope with. Many of these business owners failed to realize that when they prioritized other creditors over the federal government, the IRS can collect back taxes from you. The reach of the IRS exceeds what many people believe.


What are trust fund taxes?

When a company pays its employees, it does not issue them a check for all the money the employee earned. The employer is liable for withholding income tax and the employee's share of Social Security and Health Insurance (FICA) taxes from the employee's pay.

Your employees are confident that you will send this withholding tax to the Treasury on their behalf. This is why they are called trust fund taxes.


What happens when an employer does not pay the trust fund taxes?

When the Internal Revenue Service does not receive a federal tax deposit (or receives a deposit significantly lower than the employer's normal deposit), an IRS representative will attempt to contact the business owner. In the past, this first contact may not take place until employer fines and unpaid tax obligations start to spiral out of control. But, in 2015, the IRS launched the Early Interaction Initiative to combat payroll tax compliance proactively.

The Early Interaction Initiative (EII) identifies employers who appear to be late in paying taxes or have a history of late payments. An IRS representative contacts the employer through a personal visit, recorded call, or letter to provide helpful information and advice. This approach can occur even before the completion of quarterly payroll tax returns.

If the early outreach does not address the delinquency, a revenue manager will initiate an investigation. This investigation will focus on those who are empowered to make decisions about the finances of the company. This is known as a trust fund recovery investigation and allows the IRS to receive unpaid taxes from the company's trust fund and the assets of those responsible for non-payment of withholding taxes.


What are the sanctions?

The penalty for collecting the trust fund is equal to the unpaid payroll tax balance and is based on the amount of unpaid tax withholding and the employee's share of FICA tax withholding. The IRS also imposes interest on the TFRP (trust fund recovery penalty), so the responsible person may end up paying more than the amount of unpaid payroll tax.


Who can be held responsible?

Suppose the IRS is unable to levy taxes on the company's default payroll. In that case, the penalty for collecting the trust fund may be imposed on anyone responsible for collecting or paying the company's withheld taxes but willfully fails to collect or pay them. While the responsible person is usually the owner of the business, it could include anyone who has the authority to decide how to use the business's available money. This can include directors of a corporation, shareholders, members of the board of directors of a nonprofit organization, and employees authorized to sign over bank accounts.

Responsibility rests with the person exercising independent judgment in deciding which creditors to pay. For example, an employee who pays bills only on a supervisor's instructions should not be held responsible. The employee who determines which invoices will be paid or cannot be paid can be held responsible, irrespective of if they have a stake in the company.

"Willful" means that the responsible individual was or should have been aware of the need to pay taxes to the trust fund and either intentionally ignored the law or was indifferent to its demands. Using the funds available to pay other creditors instead of the IRS is an indication of stubbornness.


What happens next?

Once the revenue officer has determined who is responsible, he will send a letter outlining his plan to assess the trust fund recovery penalty. The recipient of the letter has 60 days to appeal. Once the IRS establishes the penalty, it can start trying to tax the responsible party or the parties' personal property. This can include filing for a federal tax lien or forfeiture of assets. Sanctions for the recovery of trust funds are generally exempt from bankruptcy discharge. In some extreme situations, failure to pay trust fund taxes can even lead to criminal prosecution. Intentional failure to collect and remit taxes on the trust funds is punishable by a fine of up to $10,000, five years in prison, or both. However, the IRS generally reserves criminal charges for more extreme cases where trust fund taxes have been misappropriated for personal use.


What can you do?

The IRS is aggressive in assessing penalties for collecting trust funds, so if you are falling behind with your tax obligations, it is essential to resolve the situation as soon as possible. There are options for resolving penalties, including an offer in compromise, installment agreements, appeals, and even disputes. These options can be expensive and complex, so the best way to avoid clawing back penalty funds is to do your best to pay your taxes, even if that means putting the government first over other creditors. When this is impossible, you will need the help of an experienced tax exemption professional who can guide you through the steps necessary to avoid a civil sanction against you.


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