If you’re an owner, director or executive of a small business, you may not have all the legal protection you think you have.
Most employers operate as a corporation or limited liability company (LLC). Use of such frameworks 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.
Assessing personal liability. 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.
Personal liability can also arise in other circumstances, including 401(k) or other employee benefit withholding and, in certain states, unpaid payroll. In fact, liability for employee withholdings may be imposed not only on the employer but also on a broad range of people involved in the employer’s business.
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.
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.
Figuring out the responsible person. 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.
Certain corporate titles put individuals squarely in the government’s cross-hairs, such as a president, CEO, CFO or any other title that connotes control over or responsibility for company's financial affairs. While generally someone who is only a stockholder or a director would not meet the legal definition of a responsible person, there have been cases where a zealous revenue agent casts a wide net and seeks to impose liability on a director or majority owner.
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For example, consider this case of a corporation experiencing a cash crunch during its growth period and whose CEO directs the controller to hold back funds that should be paid to the IRS and use them instead to satisfy other obligations. 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 firm 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 board members whom the agent believes knew that the company was not paying taxes or recklessly disregarded the facts.
In addition a responsible person may be held personally liable for failure to pay sales and use taxes if the state where the businesss resides has such taxes. In states with 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.
In addition to personal liability, other negative consequences may arise when trust fund taxes are not paid in a timely manner.