Are You Personally Liable?

 
 
liabilityMost employers operate as a corporation or limited liability company (“LLC”).  Using such an entity generally limits owners’ personal liability for the company’s obligations.

Except in special circumstances, creditors of a company can look only to the assets of the company to satisfy the company’s obligations and not to the owners’ personal assets.
 
 

Many owners do not realize …

Many owners do not realize, however, that the limited liability provided by a corporation or LLC will not keep owners from being personally liable for certain withheld taxes that are to be held in withholding trust accounts.

In fact, liability for employee withholdings may be imposed not only on the employer, but on a broad range of people involved in the employer’s business.   Personal liability can also arise in other circumstances, including 401(k) or other employee benefit withholding and, in certain states, unpaid payroll.  This article addresses the more common problem of withheld or collected taxes.
 
 

A bankruptcy case filed in Seattle, WA last year …

There is a bankruptcy case filed in Seattle, WA last year in which one of the creditors was the State of Washington.   The State made a claim against the company for sales and excise taxes exceeding $800,000.   According to the filing, the CEO resigned as of the day of filing the bankruptcy.

What that CEO may not be aware of is that the state can not only hold him personally liable for those taxes due, but can hold liable the owner of the company, the Chief Financial Officer, and anyone who would be considered a “control person” as related to the finances of the company. In fact, since the company in question had a financial advisor, if it can be shown that the financial advisor “knew or influenced” the company to not pay the taxes due, they can also be held personally liable.
 
 

Officers, directors, and responsible parties are almost uniformly held personally liable …

Officers, directors, and responsible parties are almost uniformly held personally liable if funds have been withheld or received from one source; the funds collected are earmarked to pay a particular tax liability, and the responsible person fails to pay the taxes. Taxing authorities view such funds as being held in trust for their benefit.   This applies to certain taxes at the federal level as well. Often corporate officers and especially directors are not aware of the risk they take when accepting positions. It is important to understand the nature of the risk being taken, especially with a privately held company.

[contentbox width=”475″ borderwidth=”3″ borderstyle=”none” bordercolor=”000000″ dropshadow=”5″ backgroundcolor=”F5F5F5″ radius=”10″]Section 6672(a) of the Internal Revenue Code imposes penalties on those who are required to collect and pay taxes and “willfully” fail to do so.  [/contentbox]

This is commonly referred to as the “trust fund recovery penalty,” so named because the one who is responsible for collecting and paying such taxes is deemed to hold those funds in trust for the government.
 
 

The essence of these different IRS tests is:

In determining whether the penalty applies to an individual, the Internal Revenue Service must first determine who is a “responsible person,” and then whether that individual was “willful” in failing to pay the taxes to the IRS.    While courts consider several factors in determining whether one is a “responsible person,” the essence of these different tests is: did the person have knowledge of the underpayment and did he have the ability to control the decision of whether the taxes were paid.

Certain corporate titles put individuals squarely in the government’s cross-hairs, such as “president,” “CEO,” “CFO” or any other title that connotes control over, or responsibility for, the financial affairs of the company.   While generally one who is only a stockholder or only a director would not meet the legal definition of a “responsible person,” there have been cases where a zealous revenue agent will cast a wide net and seek to impose liability on a director or majority owner.
 
 

Suppose investors provide capital …

For example, suppose investors provide capital to a business and those investors are elected to serve on its board of directors.  The board delegates day-to-day management to a CEO, who further delegates specific duties to other members of a management team.

During the course of its growth, the corporation experiences a cash crunch and the CEO directs the controller to hold back funds that should be paid to the IRS and instead use those funds to satisfy other obligations.   The CEO initially intends to “borrow” the funds and pay them back quickly, but when the company’s cash flow crisis deepens the CEO decides to hold back funds again in order to keep the company going.
 
 

Board members might find themselves with tax penalties in a significant amount …

Although the board members have access to the company’s banking records and financials, the board has not instituted appropriate internal controls or audit procedures to ensure that the company is satisfying its tax obligations.  When the IRS discovers the company’s failure to remit payroll taxes, it seeks to impose liability, not only on the CEO but also on certain members of the board who the agent believes either knew that the company was not paying taxes or recklessly disregarded the facts.  In such a scenario, an otherwise unwitting board member might find themselves with tax penalties in a significant amount.  Worse, in cases of fraud or other misconduct, certain tax violations also carry the risk of misdemeanor or felony convictions.
 
 

At the state level …

At the state level, a “responsible person” may be held personally liable for failure to pay sales and use taxes if the state has such taxes.  In states that have no sales tax, but where the employer collects employee state income tax, there is personal liability for those taxes, In some states, such as California where both are collected, personal liability extends to all trust fund taxes.

The responsible person, however, must have the requisite measure of control over collected taxes and the ability to direct payment (or nonpayment) of those taxes.  The responsible person is not liable if the taxes can ultimately be collected from the primary taxpayer.

Consequently the taxpayer company generally must be liquidated, dissolved, or abandoned with little or no chance of recovery from the company’s liquidated assets.  Even then, if failure to pay the taxes was caused by circumstances out of the responsible person’s power to control, liability will generally not attach.   Nevertheless, responsible persons of cash-strapped organizations should insure that employee income, sales and use taxes which are collected, are properly accounted for and promptly paid.
 
 

Other negative consequences may arise …

In addition to the personal liability, other negative consequences may arise when trust fund taxes are not timely paid.

  • Sales and employment tax liability is not discharged by bankruptcy.
  • Even if the funds withheld are eventually paid, the IRS may charge interest and a penalty of up to 20 %  for late deposits and individual states have their own interest policies.
  • Liability can be imposed on successors of the business under certain circumstances.

 
 

Trust fund liability is a serious issue …

Trust fund liability is a serious issue.  While the withholding trust accounts may appear to be an accessible source of cash for hurting businesses, there are significant consequences for not paying the trust fund taxes (or making late payments).

If the employer’s business must close, most debt may be discharged on dissolution of the entity that operates the business.

However, dissolving the entity will not protect the owners (and responsible persons) from personal liability for trust fund taxes.

Instead of taking “loans” from trust funds to meet current debts, a responsible business should seek out other alternatives.