You can be held liable for the IRS Trust Fund Recovery Penalty—all the unpaid employment taxes—without being an owner of the business.
About a month ago we addressed how bankruptcy handles employment taxes—those withheld from employees’ paychecks for income taxes, Social Security, and Medicare taxes, but then not paid over to the IRS or state by the owner of the business.
In a sole proprietorship—an unincorporated business owned and operated by one person—that one person is personally responsible for all of the business’ debts. That includes the debt for any unpaid employment taxes. That’s who our previous blog post was primarily addressed to.
Personal Liability through the Trust Fund Recovery Penalty
But it’s not only the owners of sole proprietorships who can be liable for such taxes. Through the Trust Fund Recovery Penalty any “responsible” person who “willfully” fails to pay employment taxes can be made personally liable for paying them. (The focus in today’s blog post is on federal taxes, but most states with withholding taxes have similar enforcement mechanisms.)
A “responsible” person is one who “had the duty to account for, collect, and pay over the trust fund taxes to the government.” This could an officer of a corporation, a partner in a partnership, an employee, corporate directors and shareholders—anybody in a role to pay the taxes within the business.
“Willful” failure to pay the tax means that the person knew that the taxes were owed, and “either deliberately chose not to pay the taxes or recklessly disregarded an obvious risk that the taxes would not be paid.” The person has to have the ability to exercise independent judgment, not just be following orders without any discretion.
The Trust Fund Recovery Penalty is, as the Internal Revenue Code says, “equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.”
How Bankruptcy Can’t Help, and Can Help
Bankruptcy can’t discharge (legally write off) employment taxes, neither Chapter 7 “straight bankruptcy” nor Chapter 13 “adjustment of debts.”
But either a Chapter 7 or 13 filing will stop the collection of the Trust Fund Recovery Penalty. That may buy you more time to dispute the appropriateness of the Penalty assessed against you, and give the IRS more time to pursue others for payment of the underlying employment tax or for payment of the Penalty.
And if you are ultimately held to be liable to pay the Trust Fund Recovery Penalty, Chapter 13 particularly provides a flexible and protected way to pay this Penalty.
The Importance of Buying You Time
The IRS may collect employment taxes only once, whether from you, the business, or from some other responsible party. That means that to the extent that somebody else pays, that reduces the amount you may have to pay.
The filing of a bankruptcy imposes the “automatic stay” on all your creditors, including the IRS. The “automatic stay” stops virtually all collection activity against you by the IRS, including efforts to collect the Trust Fund Recovery Penalty.
The “automatic stay” protection generally lasts only 3 or 4 months in a Chapter 7 case, but can last the full 3-to-5-years of a Chapter 13 case.
So especially under Chapter 13, you may need to pay only a reduced amount of the Trust Fund Recovery Penalty if in the meantime others pay a portion of it. Or you may not need to pay anything if the IRS gets paid in full from other sources.
Also, you may succeed in challenging the Trust Fund Recovery Penalty against you. Just because the Penalty is assessed does not necessarily mean that it is legally appropriate. You may in fact have not been a “responsible” party who “willfully” did not pay the tax. The Penalty may well be worth disputing, and a bankruptcy filing—again, especially Chapter 13—would buy you more time to do so.
Paying the Penalty If You Are Indeed Liable
If you must pay the Trust Fund Recovery Penalty, Chapter 13 would give you up to 5 years to do so. Usually additional interest does not accrue during the repayment period. The payment terms can be extremely flexible, based on your actual budget, and often allowing other even more time-sensitive debts (such as child support arrearage or vehicle payments) to be paid ahead of these taxes. And because of the protection of the “automatic stay,” if your circumstances were to change you would usually be able to adjust your Chapter 13 payment plan based on the new realities, instead of being at the mercy of the IRS.
For all these reasons, bankruptcy in general and Chapter 13 in particular can be the most effective way to deal with a Trust Fund Recovery Penalty assessment against you.