If you’ve incorporated your business or formed a limited liability company, you may have the belief that you can’t be personally liable for your business’ debts. Think again. If you have employees and you fail to deposit the taxes you’ve withheld from their paychecks, you may be 100% personally liable for these taxes. Here’s what you need to know.
What are trust fund taxes?
When an employer withholds income tax and the employees’ share of FICA to cover their Social Security and Medicare taxes, the employer is acting in a fiduciary capacity. The taxes don’t belong to the employer; they represent payments by employees that the employer is handling for them. So, trust fund taxes include:
- Income tax withholding
- Withholding for FICA
- Withholding for additional Medicare tax for an employee with wages in excess of $200,000
An employer is required to deposit these taxes with the U.S. Treasury within a set time frame, which depends on the amount of deposits. Most small businesses are on a monthly schedule, which means they must deposit taxes for the month by the 15th day of the following month. Larger firms have a semi-weekly schedule. And a very small employer with annual deposits of $1,000 or less can pay the withholding along with an annual tax return, Form 944. You can find more about federal tax deposits in IRS Publication 3151.
Note: There may be state and local taxes responsibilities, which are not discussed here. Check with the rules in your location.
What are the penalties for late filing?
An employer that fails to deposit trust fund taxes on time, in the right amount, and in the right way is subject to a failure-to-deposit penalty. The penalty is a percentage of the taxes not deposited on time, in the right amount, or in the right way. The IRS sends a bill—a notice or letter—stating the amount of the penalty that’s owed.
The amount of the penalty is a percentage of the unpaid deposit. The later the deposit, the greater the percentage. For example, if the deposit is no more than 5 calendar days late, the penalty is 2% of the undeposited amount. If it’s more than 15 calendar days, the penalty is 10% of the unpaid deposit. If it’s more than 10 calendar days after (1) the date of a first notice or letter from the IRS (e.g., CP220 Notice) or (2) the day of receiving a notice or letter from the IRS for immediate payment (e.g., CP504J Notice), the penalty is 15% of the unpaid deposit. What’s more, interest is charged on the penalties.
You can get penalties lifted by showing you acted in good faith and with reasonable cause for being unable to make deposits on time. But interest can’t be removed.
What are the penalties for non-filing?
If trust fund taxes are not deposited, there’s a trust fund recovery penalty. This is 100% of the unpaid tax which can be assessed against a “responsible person” for “willfully failing “ to collect or pay them. In other words, it’s a personal penalty and not a business penalty.
Responsible person. Whether a person is viewed as a responsible person depends on his/her duties or powers to collect, account, and pay trust fund taxes. And there can be more than one person who is a responsible person. The IRS lists the following as potentially responsible people:
- An officer or an employee of a corporation,
- A member or employee of a partnership,
- A corporate director or shareholder,
- A member of a board of trustees of a nonprofit organization,
- Another person with authority and control over funds to direct their disbursement,
- Another corporation or third party payer,
- Payroll Service Providers (PSP) or responsible parties within a PSP
- Professional Employer Organizations (PEO) or responsible parties within a PEO, or
- Responsible parties within the common law employer (client of PSP/PEO).
A couple of recent court cases highlight when a person is or is not a responsible person.
- Is a responsible person. Having weak math skills was not a defense to the penalty; the owner of a management consulting firm was still liable. The Tax Court said that hiring a bookkeeper didn’t relieve the owner of his responsibility to see that trust fund taxes were being paid. In this case, the sole shareholder/officer used funds recovered from an embezzler to pay personal expenses rather than employment taxes, his bad math skills not withstanding.
- Is not a responsible person. Not everyone who has the authority to write a check on behalf of a business is a responsible person. In a recent district court case, the general manager of an auto repair shop was not a responsible person—and wasn’t liable for the trust fund recovery penalty—because he wasn’t the decision-maker; the company owner was. While the manager was an authorized signatory on one of the company’s bank accounts, he only signed checks at the direction of the owner. The manager never authorized or calculated payroll or determined financial policies for the company.
Willful failure. Only a willful failure can result in the trust fund recovery penalty. Willfulness means being aware, or should have been aware, of the outstanding trust fund taxes and intentionally disregarding the law or being plainly indifferent. No evil intent or bad motive is required. For example, using funds to pay the rent, internet access, or other business creditors rather than depositing trust fund taxes is an indication of willfulness.
Where there are multiple parties fitting the definition of a responsible person who acted willfully in failing to pay the taxes, the IRS may go after any one of them. For example, if a 50-50 general partnership fails to pay the taxes for its employees, the IRS may assess the full trust fund recovery penalty from either partner (assuming each is a responsible person). Of course, if this happens, the partner that paid the penalty can try to recover funds from the other partner. This may or may not be possible given the terms of the partnership agreement, whether the partner has the financial ability to pay, or other factors.
Conclusion
It’s essential that small business owners make the handling of trust fund taxes a priority. Don’t assume that a company bookkeeper or outside professional (e.g., a payroll service; a CPA) is doing it. Verify that deposits are being made. When in a cash crunch, don’t pay creditors before paying these taxes. When any issues arise regarding payments and penalties for trust fund taxes, consult with a CPA or other tax professional.
For more information about trust fund taxes see earlier blogs here.
