Trust Fund Recovery Penalty – A Business Owner’s Worst Nightmare

October 18, 2018

“Nothing is certain except for death and taxes,” is a phrase that was written by Benjamin Franklin in 1789 and still holds true today, and for all foreseeable future. Since that time, the payroll tax system has advanced considerably. One of the major changes has taken place is a shift in responsibility from the employee to the employer regarding the remittance of payroll tax payments. With an increase in responsibility, employers face greater risk, which includes the possibility of a penalty imposed on the business owners as well as individuals involved in the payroll function personally in the event withholding taxes are not turned over to the government. These circumstances became all too real for Jon R. Hartman of Spectrum Tool & Design, Inc., when he was found liable under Code Sec. 6672 for failing to remit payroll taxes to the IRS.

Under this section of the Internal Revenue Code (IRC) a “responsible person” is defined as  someone who is “responsible for collecting, accounting for, and paying over payroll taxes.” However, for penalties to be imposed, that individual would have to “willfully fail to perform this responsibility.” Willful has been further conflated with “reckless disregard,” which means that a responsible party need not act intentionally, but only with gross negligence. The epitome of this may be found with the previously mentioned Jon Hartman.

Hartman and Dan Ott each owned 50% of Spectrum Tool & Design, Inc. While both owners had the power to handle all monetary affairs of the company, Ott solely undertook the duty to actually make the tax payments. The court nonetheless found that Hartman was a responsible party as defined by the IRC.

Spectrum began having financial issues which Hartman was aware of, and in December 2003 their payroll service provider, ADP, terminated the contract due to Spectrum’s lack of funds necessary to remit the tax payments in full. This was the first red flag, which should have alerted Hartman that withholding payments were not being remitted. However, he chose to ignore this while continuing to make payments for other ordinary business expenses ahead of the IRS.

In July 2004, Hartman found payroll tax payment checks on Ott’s desk and contacted the IRS to arrange a meeting to deal with the nonpayment. During that meeting, Hartman maintained that this was the first time he became aware of the delinquency. Typically during the course of such a meeting, the agent will formally demand that the company stay current with all new payroll tax obligations. However, Spectrum was unable to do so, and Hartman continued to keep Ott in charge of remitting tax payments. In October 2004, Hartman met with the IRS and again Hartman was faced with the fact that Spectrum was behind on tax payments for the new payroll periods.

Hartman did not make any substantive changes to get current. The lack of action taken by Hartman, constituted reckless and therefore willful behavior, as determined by the Court of Appeals of the Sixth Circuit. As a result, the court found that the IRS may collect the trust fund recovery penalty equal to 100% of the total tax payment delinquency from Hartman personally.

These issues could have been mitigated early on had Hartman reacted to the first red flag. There are a number of actions Hartman could have taken, including:

  • Upon first suspecting an issue, contact the IRS to determine if any balance exists, and then get personally involved.
  • Contact an accounting firm to get an independent review of payroll tax compliance.
  • Relieve Ott from the payroll function and personally oversee the activities of his replacement.
  • Open the bank statement each month and look at the disbursements to identify the payroll tax payments made.
  • Review the bank reconciliations each month to determine if payroll tax payments have cleared or if they are still showing as outstanding, and that the reconciliation is consistent with the bank statement.

Hartman closed his eyes and hoped the problem would go away on its own. This just does not happen in the world of business.

Issues such as these often lead to difficult questions and judgements for business owners. The corporate or LLC entity form may protect the business owners from personal liability for most business transaction matters, but it provides no protection when it comes to paying over withheld payroll taxes to the government. This is not just the IRS; almost all states have similar provisions to hold individuals personally liable for nonpayment of payroll taxes withheld from employees’ paychecks.

Please contact Larry Rubin or one of our tax advisors at 301.231.6200 with any questions you may have.