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"Tax-Tips - Resist temptation to use payroll tax funds for creditor bills," by Carl J. Grassi published in Crain's Cleveland Business

TAX TIPS: Resist temptation to use payroll tax funds for creditor bills

CARL GRASSI

By CARL GRASSI

Published by Crain's Cleveland Business

June 13, 2011

 

When a business is struggling and decisions are made regarding cash flow, it may be tempting to cover more immediate costs by deferring payments of payroll taxes to the IRS —but that is a grave mistake.

 

Business owners hoping to save a business have been known to use payroll tax money to pay suppliers in a desperate gamble to keep the company afloat. That gamble exposes the owner and possibly others connected to the business to full personal liability for these taxes. Two recent federal court cases should serve as a reminder to business owners that these payments should get top priority.

 

The IRS will hold individuals personally responsible for a business' failure to pay what are known as “trust fund” taxes.

A trust fund tax is money withheld from an employee's wages (income tax, Social Security and Medicare taxes) by an employer. These amounts are supposed to be held in trust until paid to the U.S. Treasury. If this money is used to pay other creditors and the taxes are not paid, the IRS will assess the person or people deemed responsible for the failure to pay.

It does not matter whether the business is incorporated or is a limited liability entity.

In order to have personal liability, two elements must be present. First, the person must be a “responsible person.” A responsible person is a person who has the power to direct the collecting, accounting and paying of trust fund taxes. This person may be an officer, employee, director, shareholder, member or partner of a business.

Second, a responsible person must act “willfully” in not paying the taxes. This means the responsible person was, or should have been, aware of the outstanding taxes and either intentionally disregarded the law or was plainly indifferent to its requirements. No bad intent is required; simply allowing available funds to pay other creditors when the business is unable to pay the employment taxes is an indication of willfulness.

A recent federal court case held all of the shareholders of the company responsible, even though an officer of the company had been instructed by the shareholders to keep current with all payroll taxes and work out a payment program for delinquent payroll taxes.

The officer reported to the shareholders that an installment agreement had been entered into with the IRS, which apparently was not the case. While discussions were ongoing with the IRS about a possible agreement, the company continued to pay creditors other than the IRS.

Soon after, the company's creditors filed an involuntary bankruptcy petition, at which time the owners of the company learned that the officer had failed to resolve the payroll tax deficiencies.

The IRS assessed the full amount against each owner (as well as the officer) for the trust fund portion of unpaid payroll taxes, which amounted to more than $2 million. The court agreed with the IRS, finding that each of the five shareholders were personally liable for the full amount of the deficiency.

The owners argued that while they did meet the criteria of a responsible person, the failure to pay the taxes was not willful on their part. They had directed the officer to pay the taxes and had received assurance from the officer that the issue was being taken care of.

The court held that the delegation of responsibility did not constitute reasonable cause for the failure to pay. Furthermore, the reliance on the officer's assertions that the matter was being handled did not constitute reasonable cause.

In a separate case, a shareholder was held personally liable for unpaid trust fund taxes, even though the company's bank, and later a surety, had taken over the company's business and had failed to make the payments.

In this case, the court found that while the bank and the surety were responsible parties, this did not mean that the shareholder ceased to be a responsible party, and therefore had the duty to make sure that the payments were being made.

The lesson from both of these cases is that any person who could be deemed to be a responsible person must take any action necessary to make sure that trust fund taxes get paid. It is not enough that responsibility for payment is delegated to or legally assumed by someone else.

Business owners should therefore personally make sure that all payroll taxes are being timely paid and not used to fund payments to other creditors

Mr. Grassi is president of McDonald Hopkins LLC.

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