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Pay the IRS Before Other Creditors

April 16, 2012

Article courtesy of SBAM approved partner AdvanceHR

How Courts Find “Willful Neglect”

It’s widely-known that employers are required to deposit employment taxes with the federal government in a timely fashion. However, the potential consequences of a failure aren’t as well-publicized. If you are treated as a “responsible person” for this purpose, you may be personally liable for an amount equal to 100 percent of the tax liability.

In other words, the shortfall might come right out of your own pocket!

Liability may be avoided only if you can show that the failure to pay taxes wasn’t willful. If you simply know about an employment tax deficiency-or should have known-and you ignore the problem, it is considered to be willful neglect.

Who is a “responsible person” for this purpose? Unfortunately, there’s no-clear cut definition in the tax law. Each case is decided on the its own merits. However, the courts have traditionally focused on three key factors:

1. Status – Are you an officer or high-ranking employee of the company or do you otherwise have an ownership interest in the company?

2. Duty – Is the duty to manage, oversee or otherwise administer the financial affairs of the company stated in writing? If so, does it specifically pertain to the payment and collection of employment taxes?

3. Authority – Do you have the authority to ensure that employment taxes are properly collected and paid? Do you have authority to sign checks, hire and fire employees and so on?

Note that the responsibility isn’t necessarily limited to just one person in the company. It can be extended to multiple parties who could be held jointly or severally liable, as one court case illustrated.

Facts of the case: Mr. Constantino, the founder of a Pennsylvania-based trucking firm, owned 80 percent of the company and served as its Chief Executive Officer (CEO), president and treasurer. He was paid an annual salary of $232,000. Mr. Horovitz, the Chief Financial Officer and vice-president owned the remaining 20 percent of the firm. He was paid $180,000 a year.

On several occasions, Horovitz advised Constantino that the company was failing to pay its employment taxes. Both officers were fully aware of that the firm was experiencing severe economic difficulties. Nevertheless, using funds collected for employment taxes, Horovitz authorized payments to other creditors totaling $1.8 million. The IRS eventually hit both with a tax bill of close to $1 million after interest and statutory penalties were tacked on.

Eventually, the District Court determined that both parties may be held responsible, Constantino knew about the deficiencies and that other creditors were being paid before the IRS. Also, his status as the CEO and highest-paid employee was a contributing factor. Similarly, Horovitz is also responsible because he authorized the checks to other creditors through use of the funds from employment tax collections. (Horovitz, DC-PA, 2:06-cv-279, 2/11/08)

In similar situations, the IRS can collect the full amount owed-liability, penalties and taxes-from either party or both. However, if one of the parties is not primarily responsible for the liability and pays a disproportionate amount, he or she may sue the other party in federal court for recovery of funds.

Is being sick enough to get you off the hook from the 100 percent employment tax penalty? Not according to another court case.

Due to a wide variety of health problems-including obesity, high cholesterol, diabetes and gout-the CEO of a company curtailed his time in the office. He formally resigned his position as president. The next year, he suffered a heart attack, followed by an angina attack a year later.

Nevertheless, in his remaining capacity as CEO, he still maintained control over management affairs. He had the ability to write and sign checks, prefer one creditor over another and supplement corporate accounts with personal funds. Result: The District Court determined the CEO was a “responsible person” for unpaid employment taxes. (Savage, DC-Cal., 2/22/06)

Practical approach: Don’t put yourself at risk. Take steps to ensure that payroll taxes are paid in full and on time. If other amounts are owed, make sure that the IRS is paid first. Using an outside payroll services firm can help ensure compliance.

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