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ROBERT E. MCKENZIE, ESQ.
ARNSTEIN & LEHR LLP
120 SOUTH RIVERSIDE PLAZA, SUITE 1200
CHICAGO, IL 60606
312-876-6927
312-876-7318 fax

1.10 Congress enacted the Trust Fund Recovery Penalty Statute to encourage prompt payment of withheld and other collected taxes by allowing the Internal Revenue Service to assert a liability against responsible third parties [IRC 6672]. The amount of the penalty imposed by the statute for failure to comply with its provisions is measured by the tax required to be collected or collected and not paid over. That is why the liability is referred to as a " 100% Penalty." The penalty is civil in nature, not criminal.

Trust Fund 120 Congress clearly restricted the provisions of IRC 6672 to "Trust Fund" taxes as defined in IRC 7501. In other words, the penalty only applies to collected or withheld taxes that are imposed on persons other than the party who collects, accounts for, and pays over such taxes.

2.10 There are two major tests to determine if someone is subject to the provisions of IRC 6672. They are primarily questions of fact and may be stated as follows: (1) Whether the party against whom the penalty is proposed had the duty to account for, collect, and a over trust fund taxes; and (2) Whether he or she willful failed to perform this duty.

2.20 In general, the Internal Revenue Service has the right to pursue any person who, meets the tests, even if he was not an officer or employee of the corporation which originally collected the taxes.

Assessment Against Several Persons 2.30 The penalty can be assessed against more than one person. It is not unusual for the Internal Revenue Service to assess the penalty against several responsible persons. In the event that the IRS assesses several persons, it may collect the entire liability from any of those persons.

3.10 When a corporation fails to pay taxes, the IRS may proceed against the persons responsible for the nonpayment. IRC 6672 provides statutory authority for imposing a Trust Fund Recovery Penalty on "any person required to collect, truthfully account for, and pay over collected taxes" who willfully fails to collect such tax or willfully attempts in any manner to evade or defeat such tax or payment thereof.Generally, two conditions must be met in order to assess and collect the Trust Fund Recovery Penalty tax: (1) The taxpayer must be a responsible person, an (2) The taxpayer's conduct must be willful. )]

No Need To Be a Corporate Officer 3.20 The cases have established that this definition encompasses anyone who has all or any part of the decision as to which liabilities will be paid and which will not or as to when such liabilities will be paid.

4.10 The key to liability under Section 6672 is control of finances within the employer corporation: the power to control the decision-making process by which the employer corporation allocates funds to other creditors in preference to its withholding tax obligations. 3

4.20 Liability attaches to those with power and responsibility within the corporate structure for seeing that the taxes withheld from various sources are remitted to the Government. This duty is generally found in high corporate officials charged with general control over corporate business affairs who participate in decisions concerning payment of creditors and disbursal of funds.4

Ultimate Control 4.30 The Trust Fund Recovery Penalty should only apply to the person or person who have ultimate control over the company finances. Who decides which bills get paid by the company?

Person's Authority 4.40 Several factors may indicate that a party is a responsible person, but the key element is whether that person has the statutorily imposed duty to make tax payments. The substance of the circumstances must be such that the officer exercises and uses his authority over financial affairs or general management or is under a duty to do so, before that officer can be deemed to be a responsible person.6.60

Responsibility Supposed by Corporate Office 4.50 It is seldom that there would be a clear case of ultimate authority. Most companies have more than one person in control and when there is a business failure, each officer will find it economically to his advantage to point at the others. The mere fact that someone signs checks or tax returns within the company, does not in fact indicate with certainty that person should be held liable. The fact that someone has a grandiose corporate title may also not be indicative of her true authority within the company.

6.10 The Internal Revenue Service must prove and establish a second element for liability under the Trust Fund Recover Penalty. That element is "willfulness." A responsible person need not have failed to pay the taxes with a fraudulent or evil purpose. That person must merely be shown to have knowingly and intentionally disregarded the duty to pay trust fund taxes to the Internal Revenue Service. "Willfulness" can be defined as "'An act is willful if it is voluntary, conscious, and intentional.'A responsible person acted willfully if he 'knowingly' used available funds to prefer other creditors over the Internal Revenue Service.20

No Liability Without Personal Fault 6.20 The Trust Fund Recovery Penalty cannot be asserted without a showing of personal fault.21 This is a penalty and the penalty is invoked only upon willful failure to pay a tax.

Personal Fault 6.30 The Court of Claims has refined the definition of willfulness by stating: "Personal fault being a necessary element of willfulness, relevant evidence bearing on the element ofpersonal fault may not be ignored.22

Reckless Disregard of Known Risks 6.40 If a person lacks knowledge that withheld taxes were not being paid over, that person can defend against willfulness unless he or she recklessly disregarded obvious or known risks.23

Lack of Knowledge 6.50 Obviously the best defense of willfulness is to establish that your client lacked knowledge that the taxes were not being paid.23.25 If one can show that the purported responsible person was misled by subordinates, liability could be avoided unless he or she recklessly disregarded known risks.

Subsequent Knowledge 6.55 If a responsible person gains knowledge that her company has previously failed to pay trust fund taxes, she might also be held liable by the Internal Revenue Service. In Honey v. United States,23.30 the corporate president disappeared. Subsequent to the corporate president's disappearance, other corporate officers took over the management of the business for a short time before it filed for bankruptcy. During that time the officers became aware of the prior tax liabilities due to the Internal Revenue Service. The officers were held liable for the prior accrued liabilities even though the Court found that they were unaware of those liabilities during the time of accrual. The Court reasoned that once the officers gained knowledge, any funds received from an source by the company were imposed with the trust of the United States.

Liabilities Caused by Embezzlement6.60 The author has successfully defended a corporate president by establishing that the liabilities resulted from an embezzlement by the corporate controller. In that case the controller had used corporate withholding taxes to pay "phantom employees." The embezzlement was not discovered until an audit was performed by an outside CPA firm.

Lack of Funds 6.100 A corporation's poor financial condition and inability to meet debts is not a justifiable excuse for willfulness. 25.60

8.10 Under the Code, a Trust Fund Recovery Penalty must be assessed within three years of the April 15th following the year during which the quarterly liabilities arose IRC 6501 (a), (b)(2)]. For example, the penalty with respect to liabilities arising during 1985 must be assessed on or before April 15, 1989. If the return is filed later than the April 15th following the year during which the liability arose, the statutory period for assessment is three years from the date of filing.

9.10 1RC 7501 states that withheld taxes "shall be held to be a special trust fund in trust for the United States" [IRC 7501]. The purpose of the Trust Fund Recovery Penalty provision is to collect from individuals only unpaid funds held in trust by The employer. .

Amount of Penalty 9.20 The amount of the penalty is the amount of the trust fund.25.80 The trust fund is comprised of only the withheld taxes, i.e., withheld income tax and the employee's share of Social Security tax. The trust fund does not include the employer's matching share of the Social Security tax because those funds are not withheld from the employee's wages [IRM 56(18)3].

10.10 One method of reducing the potential trust fund liability is to assure that the employer designates each payment made on account by placing a restrictive endorsement on the back of each check worded as follows: "Direct to Trust Fund Portion of taxes only for the period ended for Corporation" [IRM 5181.3(l 0), I RM 5527(4)].

11. COMPUTATION OF THE TRUST FUND RECOVERY PENALTY 11.10 In proposing a Trust Fund Recovery Penalty an IRS Revenue Officer will secure transcripts of all the unpaid tax periods of a corporation. The Officer will then complete a computation sheet [App A; IRM 5638.71 ]. Revenue Officers are instructed to compute the proposed penalty in a manner most advantageous to the government.32 As tax practitioners, our goal, obviously, is to compute the proposed penalty in a manner most advantageous to the client. In every case, recompute the proposed penalty. By reviewing the computation and IRS transcripts one can verify the proper computation o the penalty. Many times the Revenue Officer has failed to follow even the guidelines set out in the Internal Revenue Manual.

Application of Payments 11.20 Appendix B sets forth a series of questions concerning the application of payments provided by the Internal Revenue Manual to Revenue Officers. Be aware that the answers to these questions reflect the IRS position, not necessarily the position taken by the courts. The IRS has published rules for its employees setting forth how payments should be applied when computing the Trust Fund Recovery Penalty. In United States v. Webster32.50 the Court held that the IRS could not apply payments on account to unassessed penalties. The IRS could apply payments to assessed nontrust fund tax liability and accrued interest, but not to unassessed penalties. The Court believed that because there is always a potential contest with respect t penalties, the IRS did not have the right to apply payments to unassessed penalties.

Payments Applied to Accrued Interest and Penalties 11.30 Of particular interest is the position of the IRS that it may apply payments to accrued interest and accrued penalty prior to paying assessed trust fund taxes. The IRS computer does not apply payments in this manner on the corporate account. It only applies payments to accrued penalty and interest when all assessed tax, penalty and interest has been paid. The computer does apply payments in the manner set forth in the IRS manual when it is computing the Trust Fund Recovery Penalty. It is certainly arguable that the IRS should compute a proposed Trust Fund Recovery Penalty using the same application of payments that it normally used for application to the employer account. The author has been unable to find any court cases which specifically give the IRS the right to apply payments contrary to its computer system. On the other hand, there are no cases forbidden such action.

Application of FTD's 11.40 One important area of note on the IRS Application Rules is that the taxpayer is entitled to have the Federal Tax Deposits (FTD) applied only to tax. Such payment may not be applied to penalties and interest. Many times Revenue Officers improper apply such payments to penalties and interest. The taxpayer should request timely FTD's applied to trust fund and nontrust fund taxes on a pro rata basis. Many times Revenue Officers attempt to prospectively apply FTD's to subsequently accrued nontrust fund taxes. Courts have found that the IRS may not prospectively apply FTD's or payments.33 At least one court has found that the IRS must apply FTD's pro rata between trust fund and nontrust fund taxes.33.10 The IRS is not entitled to apply a corporation's excess tax deposits for one-quarter to the penalties for that quarter. The IRS is required to apply the tax deposits to subsequently accrued taxes in the following quarters. The IRS was not entitled to apply the surplus tax deposits to a penalty that had not yet matured at the time a company made its tax deposits.33.20 The internal Revenue Manual provides as follows: "Where the Taxpayer establishes that an FTD credit was in the amount required by Treas. Reg 31.6302 (C)-l) (with allowance for Safe Haven Rule), the credit will be considered to be a designated payment that will be applied to the employees portion of FICA, the withheld FICA, and the withheld Income Tax covered by the FTD.

12.10 At any time after an employer fails to pay trust fund taxes, the IRS may begin investigating a proposed Trust Fund Recovery Penalty. It is standard practice for the Service to begin investigating any time a Revenue Officer discovers that a company owes taxes. Many times the Revenue Officer will begin the process when the company is still operating and has entered into a payment agreement with the Service [IRM 5638(10).5). If the payment agreement will be for more than 18 months, the potentially responsible officers must sign a statutory waiver to avoid assessment [IRM 5638(10)(3)]. The Service views the Trust Fund Recovery Penalty as a collection tool and rightly believes that the threat of personal liability will cause the management of an operating company to maximize a payments to the IRS. Such a policy can create severe management disruptions in a company as corporate officers must try to juggle corporate financial problems, conflicting loyalties to each other, and the potential for personal financial devastation if they are assessed a Trust Fund Recovery Penalty. In many districts, the Service will assess responsible persons and begin collection from the officers even though the corporation is still operating and making payments on its overdue taxes IRM 5638.2.

13.10 Once a Revenue Officer has determined the basic financial and organizational information about a company, he or she will begin gathering supporting documents. It is standard practice to summon the company's banks for signature cards, corporate resolutions, bank statements, canceled checks, and loan agreements. Revenue Officers will also seek copies of leases, contracts, and the corporate minute books.

14.20 Having completed a preliminary investigation, the Revenue Officer next prepares proposed Trust Fund Recovery Penalties against the persons whom he or she believes to be responsible persons. For this purpose the Revenue Officer prepares a report titled "Recommendation re 100-Percent Penalty Assessment". The report calls for the Revenue Officer to determine whether to assert against each potentially responsible person. The Officer can decide not to assert against a responsible person if it is determined that the penalty would not be collectible from that party. (Since the IRS views the Trust Fund Recovery Penalty as a collection device, the author has found that the greater his client's net worth, the less likely the IRS is to determine the client not to be a responsible person.)