Trust fund recovery penalty: why unpaid payroll tax becomes personal

What are trust fund taxes?

Federal income tax withheld from employees' pay, and the employees' share of Social Security and Medicare tax. The business holds this money in trust for the government. The employer's own matching share of Social Security and Medicare is not part of the trust fund, though the business still owes it. See payroll taxes explained.

Withheld amounts are recorded as liabilities in the books until deposited, which makes any shortfall easy to see.

Who can be held liable?

Anyone who is responsible for collecting, accounting for and paying the taxes and who acted willfully. Responsibility depends on actual authority over finances: signing checks, deciding which bills to pay, controlling payroll. Owners, officers and directors are commonly assessed, and employees such as bookkeepers can be if they had real control. Willfully means knowing the taxes were unpaid and choosing to pay other creditors instead; no intent to defraud is needed.

Delegating payroll to a bookkeeper or payroll provider does not remove an owner's responsibility. Owners who sign checks and decide which creditors to pay are usually responsible persons, even if someone else processes the payroll.

Telling the bookkeeper to pay suppliers first, while payroll taxes go unpaid, is the classic example of willfulness.

How does the IRS process work?

1. Investigation

   A revenue officer reviews records and interviews potentially responsible people, often using a standard interview form.

2. Proposed assessment

   The IRS sends a letter proposing the penalty to each person it considers responsible.

3. Appeal

   Each person has 60 days to file a written appeal before assessment.

4. Assessment and collection

   If not resolved, the penalty is assessed and collected from personal assets.

Several people can be held liable for the same amount, although the IRS collects the total only once.

Each person can raise different facts, such as lack of authority or not knowing about the unpaid taxes.

What does it cost?

A business with ten employees withholds $6,000 of income tax and $3,060 of employee Social Security and Medicare each month, and stops paying for four months. The trust fund portion is $36,240, which can be assessed personally against each responsible person. The employer share of $12,240, plus penalties and interest, remains a debt of the business.

Can the penalty be discharged in bankruptcy?

Generally no. The trust fund recovery penalty is treated as a tax debt that usually survives personal bankruptcy, and closing the business does not end it either. It can be resolved through payment, a payment plan, or in some cases an offer in compromise.

Do states have similar rules?

Yes. Many states hold responsible persons personally liable for unpaid state withholding tax, and for sales tax collected but not paid over. The same habits that protect against the federal penalty protect against these. See collected sales tax but did not remit.

How do you avoid it?

• Deposit payroll taxes on time, ahead of other bills. See the deposit schedule.
• Use a payroll provider that deposits automatically.
• If cash is short, contact the IRS before falling behind, and file all returns on time.
• When paying a balance voluntarily, designate the payment to the trust fund portion first, which reduces personal exposure.

What if you are already behind?

File every missing Form 941, stop the debt growing by making current deposits, and propose a payment plan. Get representation before any interview with a revenue officer. See IRS payment plans and Form 2848.

Act early: the longer arrears build, the larger the personal exposure becomes.

This guide is general information. It is not tax or legal advice for your situation.