Congress passed a law a long time ago that was meant to “encourage” employers to pay the income and employment tax (social security and medicare) they collect from employees' paychecks. This law provides for a penalty to be assessed if the tax collected isn't paid. That penalty is called an IRS Trust Fund Recovery Penalty. It is often called the 100% penalty as well.
The tax that is collected from the employee's paycheck is considered “trust fund” tax because the employer holds the tax in trust until the deposit is made to the IRS. If you are an employer, you are 100% liable for the amount that is collected.
Internal Revenue Code 7501 makes clear that whenever any person is required to collect any internal revenue taxes from any other person and to pay over such tax to the United States, the amount of the tax shall be held in a special trust fund for the United States.
If the person responsible to do so doesn't forward the trust fund tax, the IRS can use the law passed by congress to penalize him or her for 100% of the Trust Amount. It won't matter that the business is still operating.
Internal Revenue Code 6672(a) provides:
“Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax on the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.”
The most common assessments of the trust fund recovery penalty come from the following taxes:
• 941, Employer's Quarterly Federal Tax Return – most common • 720, Quarterly Federal Excise Tax Return • 944, Employer's Annual Federal Tax Return • 945, Annual Return of Withheld Federal Income Tax
The penalty is not based on 940 Unemployment Taxes.
The 941 penalty amounts are made up of the employee's income tax and fica tax withheld form his or her paycheck. It doesn't include the employer's matching portion.
The Statute says…The 100% penalty can be assessed against you if:
1. you “willfully” fail to collect or pay the trust fund tax and if you are; 2. a person who is “responsible” for collecting and paying it.
Courts usually look at the following to determine whether you are a “Responsible Party”:
a. What were your duties b. Did you have the ability to sign checks c. What was the Identity of officers and shareholders d. Who was the person(s) responsible for hiring and firing e. Who was in charge of the financial affairs of the business
“Willfulness” is often shown by:
a. Paying other creditors after you know the withheld monies haven't been paid to the IRS. b. You recklessly disregard the risk that the taxes aren't being paid.
In essence, even if you didn't have actual knowledge that the taxes weren't being paid, you can be assessed the penalty just because you disregarded what was going on. Being negligent isn't enough but choosing not to investigate after finding out they weren't being paid?
Most of our clients are small business people and as a result it is difficult for them to defend the allegation that they were responsible and willful.
It is often wise when the assessment is being considered by the IRS to talk to an attorney about other options you may have to avoid it or to deal with it once assessed. The IRS offer in compromise can play a big role in both avoiding the assessment and in reducing the amount of the assessment after the fact. Look at newer blog entries for more about this penalty.