Businesses, individuals and trust fund liabilities

What you need to know

by Mark Pridgeon, CPA, JD, Pridgeon & Zoss | February/March 2018 Footnote

Editor's note: Updated Jan. 30, 2018

ABC Corporation has just gone out of business and it owes the IRS and the Minnesota Department of Revenue (DOR) hundreds of thousands of dollars in trust fund taxes.

The corporation has no funds to pay these taxes and no prospect of receiving funds in the future to pay them. Therefore, the tax authorities will look at individuals involved in the business to see if the trust fund liabilities can be imposed on them.

Talk about a conundrum.

What are trust fund taxes?

Trust fund taxes are taxes due to the federal or state government that are withheld from employees (payroll taxes) or collected from customers by businesses (sales tax, for example). At the federal level, these are primarily federal income tax and FICA (Federal Insurance Contributions Act) taxes withheld from employees. At the state level, trust fund taxes are usually state income taxes withheld from employees and sales taxes paid to retailers by customers.

To protect the state, federal and state law authorize the IRS and the DOR to assess trust fund taxes against persons responsible for the corporation's failure to pay those taxes. Internal Revenue Code Section 6672 authorizes the IRS to assess these taxes against individuals involved with the business who were responsible for collecting, accounting for and paying trust fund taxes who willfully failed to do so. As interpreted by the courts, this means liability may be imposed on persons with authority over corporate finances who willfully (knowingly) failed to pay the trust fund taxes.
Minnesota Statutes Section 270C.56, subd. 1, has similar language about imposing liability on persons with responsibility to see to the payment of trust fund taxes, but does not contain a willfulness or knowledge requirement.

Criteria considered

In the case of ABC Corporation, we will consider three different individuals with three different levels of participation in the business's decision-making.

Up first is Mr. Absentee Investor. He has invested millions of dollars into ABC Corporation, but he has never taken any management role in the corporation. Specifically, he has never served as an officer, never been authorized to sign checks, played no role in hiring or firing employees, processing payroll, filing payroll tax returns, or making payment or deposits of trust fund taxes. He did not know about the unpaid taxes until after the business failed.

The second person is Mr. Wheeler Dealer, the CEO of ABC Corporation. He has set the company's fiscal policy, owns 50 percent of the stock of the corporation, makes all of the company's hiring and firing decisions, decides which creditors are paid when money runs short, and signs all of the company's tax returns. He was very aware of the tax liabilities and specifically directed that they not be paid.  

Third, we meet Mr. Clerk. Like Mr. Wheeler Dealer, he has authority to sign checks. He signs most of the company's checks to vendors and to the tax authorities. However, he does so only at the direction of Mr. Wheeler Dealer. He prepares and signs the payroll tax returns and when funds were available, made the payroll tax deposits at Mr. Wheeler Dealer's direction.

Who's liable?

So, which of these three individuals would be held liable for the unpaid trust fund taxes?

Mr. Absentee Investor should not be held liable on these facts: Under the federal law, he had no responsibility to pay the taxes and no knowledge that they were not paid. Under the state law, he had no formal or functional role in financial decision-making and, therefore, should not be held liable. The Minnesota Tax Court has ruled that an "entrepreneurial stake" in a failed business, taken alone, is not sufficient to justify imposing personal liability.

If you change Mr. Absentee Investor's facts, then the answer changes. For example, he would be at risk if he held corporate office, had check signing authority, signed tax returns or became part of the group at the company making financial decisions. Another risk indicator occurs when an investor learns that a manager or management has failed to pay trust fund taxes in the past. That puts the investor on notice about the manager, and some cases have held investors liable for future unpaid trust fund taxes ruling that their failure to prevent later defaults was due to recklessness or gross negligence.

Mr. Wheeler Dealer, on these facts, will certainly be held liable. He has made all the financial decisions, set company financial policies and specifically ordered that the trust fund taxes not be paid. Under federal law, he is responsible and willful. He meets the requirements for liability under state law as well; he has operational and financial control of the business.

What if Mr. Wheeler Dealer had operational control over the business, but no financial control? One Minnesota Tax Court case found that such an individual should not be held liable because control over finances is the key requirement for personal liability.

Finally, Mr. Clerk should not be held liable. He has insufficient power to be responsible for paying the taxes. His check signing is performed solely at the direction of his boss -- he is not an actual or potential financial decision-maker.

However, he would be at risk of personal liability if he gained more power in the company. For example, if he received a corporate title, such as treasurer or chief financial officer, then he is moving beyond clerk status. If the decisions about financial policy, and especially which creditors will be paid and not paid when funds are short, are made as a group decision and he is part of the group, then he is at risk.

Help those who need help

CPAs advising troubled businesses with federal and state trust fund tax liabilities need to be aware of the tax authorities' ability to make personal assessments against the business's financial decision-makers. You'll also want to be ready to warn business owners of the risks and hazards they face in deciding whether or not to pay these obligations.

Mark Pridgeon, CPA, JD practices with Pridgeon & Zoss. The focus of his 35-year career has been exclusively in the area of IRS and state tax law. You may reach him at 952-835-8320.