Beware of the 100 Percent Penalty Tax
| Publication year | 1981 |
| Pages | 466 |
| Citation | Vol. 10 No. 3 Pg. 466 |
1981, March, Pg. 466. Beware of the 100 Percent Penalty Tax
Everyone knows that corporations as well as individuals must pay their federal income taxes when due or face possible civil and criminal penalties for failing to do so. A somewhat more obscure, and less understood area of tax law is the system of income tax withholding. Where an "employer-employee" relationship exists, the Internal Revenue Code ("IRC") imposes a duty on the employer to collect, account for and pay over certain taxes as "agent" for the IRS. When a corporate employer, large or small, finds itself in financial difficulty, its officers, directors, employees or other persons with payroll responsibilities, may resort to these "trust funds" as a means of meeting current non-tax liabilities. When this occurs, virtually everyone connected with the affairs of the corporation may find themselves a target of the so-called "100 percent penalty tax."
Many non-tax law practitioners may have little or no knowledge of this penalty tax or how it can be utilized by the IRS. Its effect can be devastating to the taxpayer/client who has incorporated, or who may have become involved with a corporation, without being counseled in the dangers of trust fund abuse. At the present time, a surge in 100 percent penalty cases is occurring, due largely to economic problems caused by the recession and rapidly rising interest rates.
The purpose of this article is to inform the practitioner of the nature of the 100 percent penalty tax and its potential effect upon persons who are employed by or otherwise associated with the corporation and to offer some brief guidelines as to available avenues of relief when a client inadvertantly, or negligently, falls into the penalty tax trap.
Those familiar with the area of federal tax administration know that the most jealously guarded tax collection mechanism within the U.S. Treasury Department arsenal is income tax withholding at the source. If the necessary "employer-employee" relationship exists, then pursuant to IRC § 3402, there also exists a duty to withhold income and FICA taxes from employee wages.
Considerable literature and litigation continue to emanate from the employee versus independent contractor controversy. While a detailed treatment of this complex issue is beyond the scope of this article, it should be noted that there are many factors cited in the regulations and case law that should be considered in determining status as an "employee."(fn1) The degree of supervision and extent of control over the place and hours of work seem to weigh most heavily in the
analysis. If the employer has the power to supervise employees' work and can specify when and where they shall perform their services, chances are excellent that the IRS will prevail in construing an employer-employee relationship.
As a practical matter, incorporated businesses will almost always have one or more "employees," with the result that the corporation or its designated agent will be an "employer" required to withhold taxes. Where there is an employer required to withhold, that employer must then account for and pay over these withheld taxes to the IRS, or deposit them either quarterly, monthly or weekly with an authorized commercial bank or a Federal Reserve Bank, depending upon the amount of taxes withheld.(fn2)
These so-called "trust funds"(fn3) are the primary source to which the IRS will look for payment of the employee's personal taxes. Should anything happen to these funds before they are "paid over," the IRS will be very disappointed since it must ultimately give the employee full credit against his or her personal tax liability for the amount of taxes actually withheld by the employer.(fn4) It is for this reason that the IRS will move swiftly and forcefully to correct employment tax abuses and to collect delinquent or misappropriated taxes.
The problems of employment tax abuse seem to stem from the tendency of individual taxpayers to assume that, if they incorporate their business, they will somehow be able to avoid civil and criminal liability for "corporate" misdeeds, including the nonpayment of federal and state taxes. When times are hard, corporate cash flows are lean and business creditors are demanding their money, the trust funds become an irresistible source of emergency cash. Unfortunately for many misinformed entrepreneurs, the IRS does not consider itself to be in the business of lending money or extending credit to anyone.
On the contrary, with the first occurrence of a significant delinquency, or if a pattern of delinquency has emerged, the Collection Division of the IRS will respond immediately, usually with a stern warning and a demand that all taxes be brought current. In many cases, the corporation will also be placed on a mandatory monthly deposit program.(fn5) Where such warnings are not heeded or where substantial delinquencies have already occurred, the Collection Division will implement stronger collection measures, particularly in situations where the solvency or survival of the corporate entity is in doubt.
Where employment taxes are not timely paid, and/or necessary returns (Forms 940 and 941) are not filed when due, the IRS, as a matter of course, will assess the delinquent taxes against the corporation, along with the failure to pay and/or failure to file penalties provided by IRC § 6651. In rare cases, the IRS may impose the civil fraud penalty provided by IRC § 6653(b).
In more than a few instances, however, these assessments are to no avail since the corporation is either insolvent or bankrupt. If this is the case, the IRS has another and generally more effective card to play, namely the so-called "100 percent penalty tax" provided by IRC § 6672. Simply stated, § 6672 permits the IRS to assess 100 percent of any delinquent "third party"(fn7) employment taxes against "any person required to collect, truthfully account for, and pay over any tax ..." and who "willfully fails to collect such tax, or truthfully account for and pay over such tax...."
The statute is broad enough so that the penalty tax may be imposed upon any person who is required by the IRC to withhold taxes, whether or not a corporation is involved. Thus, the penalty can be invoked against a partner,(fn8) a personal representative(fn9) or a sole proprietor. However, as noted in IRS Policy Statement P-5-60,(fn10) the provisions of § 6672 are primarily for the purpose of collecting trust fund taxes from "responsible employees" and officers of
corporations. The Policy Statement makes it clear that § 6672 is to be used only as a secondary collection tool after all appropriate attempts are made to collect the taxes from the corporation.
Be that as it may, in a situation involving an insolvent or defunct corporation with assets which are either nonexistent or unavailable for levy and seizure, the Collection Division will waste no time in recommending § 6672 assessments against...
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