Employment tax penalties: Let's keep it civil.

• Author: Salzman, Martha L.

Many practitioners who counsel business clients, both small and large, are familiar with the difficult challenges that quickly arise when taxes are withheld from employee wages but not turned over to the federal government. On occasion, these taxes are not paid over due to the misdeeds of an in-house bookkeeper or a third-parry payroll service responsible for ensuring that a business meets its tax obligations. More often than not, however, employers, acting without bad intentions, use the withheld money to satisfy pressing trade obligations or to meet payroll, debts the nonpayment of which is likely to lead to the shutdown of the business and loss of employee jobs. Unfortunately, this strategy can prove extremely costly to both the business and its principals, generating exposure to substantial penalties for late payment or failure to pay at all.

Making the stakes even higher, the federal government has taken steps in recent years to increase the likelihood that employment tax cases will be handled criminally. All of this means that tax advisers working with business clients cannot focus solely on strategies to minimize and pay the business's income tax obligations but also must be extremely vigilant regarding employment tax duties.

This article focuses on the potential criminal consequences that can arise when a business fails to collect or pay over withheld tax. Included is an analysis of the key tax crimes that can be charged in these cases. The article provides suggestions to help practitioners recognize when a business's failure to pay employment tax may be treated criminally. It also provides guidance about how best to proceed to minimize a client's potential jeopardy. The article includes a discussion of the difficult issues practitioners face as they seek to resolve civil cases through cooperation, while remaining cognizant of the potential for criminal referral and prosecution. Ultimately, however, the article notes that advisers best serve clients by detecting nonpayment early and promptly crafting payment plans to bring delinquent obligations current and ensure new periods do not become delinquent.

Policy change: Increased emphasis on federal criminal prosecution

The Tax Division of the U.S. Department of Justice (DOJ) pursues both civil litigation and criminal investigations and prosecutions for failure to comply with employment tax obligations. (1) Recently, the DOJ has increasingly emphasized criminal prosecution of those who fail to comply with their obligations to withhold, account for, and pay over federal employment taxes. In an April 2016 press release, the DOJ stressed that the failure to comply with federal employment tax obligations is "not simply a civil matter." (2) Instead, employers that fail to pay employment tax, and treat amounts withheld from employees' wages as the employers' own property "are engaging in criminal conduct and face prosecution, imprisonment, monetary fines and restitution." (3)

The DOJ's emphasis on the criminal prosecution of employment tax evasion was further demonstrated by an amendment to the federal sentencing guidelines. (4) The "Background" commentary provided with the guideline for sentences imposed for "Failing to Collect or Truthfully Account for and Pay Over Tax" formerly read as follows:

The offense is a felony that is infrequently prosecuted. The failure to collect or truthfully account for the tax must be willful, as must the failure to pay. Where no effort is made to defraud the employee, the offense is a form of tax evasion, and is treated as such in the guidelines. (5) The Guidelines Manual was amended in November 2016 to remove the first sentence of that background comment, eliminating the premise that employment tax criminal prosecutions are rare or infrequent. When it proposed this amendment, the U.S. Sentencing Commission provided the following reason for the change:

The Department of Justice in its annual letter to the Commission has proposed that the "infrequently prosecuted" statement should be deleted. The Department points out that while that statement may have been accurate when the relevant commentary was originally written (in 1987), the number of prosecutions under section 7202 have since increased substantially. The use of [section]2T1.6 increased from three cases in 2002 to 46 cases in 2014. (7) Employment tax criminal statistics

In light of the Sentencing Commission's reliance on statistics in support of its revisions to the manual's commentary, it is interesting to look at some numbers. The IRS's data regarding employment tax evasion (8) show that the numbers of investigations, recommended prosecutions, sentences imposed, incarceration rates, and average sentence length vary from year to year. In 2014, (9) the IRS initiated 120 criminal investigations and recommended 92 prosecutions. In that same year, the government sentenced 88 persons with an incarceration rate of 73.9% and an average sentence of 17 months. In 2015, the IRS initiated 102 criminal investigations and recommended 80 prosecutions. (10) Sixty-two persons were sentenced in 2015, with an incarceration rate of 77.4% and an average sentence of 24 months. In 2016, the IRS initiated 137 criminal investigations and recommended 77 prosecutions. Eighty-seven persons were sentenced in 2016, with an incarceration rate of 70.1% and an average sentence of 14 months.

The statistical trends are not entirely clear, at least in part because a case may cross fiscal years--so that an investigation that the IRS begins in one year may not result in a recommended prosecution or sentencing until a later year. (11) However, two significant facts should concern anyone representing a client in an employment tax audit. First, the number of employment tax criminal investigations initiated in 2016 increased significantly--over 14% more than the number of investigations begun in 2014 and 34% more than the number initiated in fiscal year 2015. Second, although the incarceration rate and average sentence length vary from 2014 to 2016, the average incarceration rate has remained above 70%. In other words, if a client is convicted for criminal employment tax evasion, there is a greater than two-thirds likelihood of incarceration when sentenced. (12)

Statutory provisions

The government has great latitude in deciding whether to handle an employment tax case civilly or criminally. Three Code sections potentially apply. Sec. 6672(a) imposes a 100% civil penalty on responsible officers in cases of failure to withhold and/or pay over employment taxes. Sec. 7202 makes failing to meet employment tax obligations a felony, punishable by a fine of not more than $10,000, prison for up to five years, or both. Sec. 7201 is the statute criminalizing tax evasion, a crime also punishable by a much larger fine than that imposed under Sec. 7202, and may also impose imprisonment, or imprisonment and a fine.

The portions of these sections that define the activity that is subject to a penalty (i.e., the willful failure to collect and/or pay over employment tax or the willful attempt to evade or defeat tax) are virtually indistinguishable. Sec. 6672, tided "Failure to Collect and Pay Over Tax, or Attempt to Evade or Defeat Tax," provides:

(a) General rule. Any person required to collect, truthfully account for, and pay over any tax imposed by this tide who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over. No penalty shall be imposed under section 6653 [regarding the failure to pay stamp tax] or part II of subchapter A of chapter 68 [regarding the accuracy-related and fraud penalties] for any offense to which this section is applicable. Sec. 7202, which by its title applies to willful failures to collect or pay over the tax, provides, in its entirety, as follows:

Any person required under this tide to collect, account for, and pay over any tax imposed by this tide who willfully fails to collect or truthfully account for and pay over such tax shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $10,000, or imprisoned not more than 5 years, or both, together with the costs of prosecution. Sec. 7201 is tided "Attempt to Evade or.Defeat Tax." It provides that "[a]ny person who willfully attempts in any manner to evade or defeat any tax imposed by this tide or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony." Persons convicted of violating Sec. 7201 may be fined "not more than $100,000 ($500,000 in the case of a corporation)" or, like Sec. 7202, "imprisoned not more than 5 years, or both, together with the costs of prosecution."

The government uses this provision to prosecute many kinds of tax evasion--not just cases involving employment tax obligations. Also, it clearly applies to what may be unsuccessful attempts to evade tax, which the language of Sec. 7202 does not specifically cover. In the context of employers who fail to meet their employment tax responsibilities, however, the key difference among all three of these provisions relates to consequences: 100% of the unpaid tax as a civil penalty against a responsible individual under Sec. 6672 as compared to a criminal fine and/or imprisonment.

Given the similarity between Sec. 6672 and Sees. 7202 and 7201, one would expect some administrative guidance regarding the circumstances in which the IRS will pursue a criminal prosecution. In fact, however, the only guidance that might help a tax adviser counsel a client in determining whether the IRS will seek a criminal prosecution in a particular case is in the Internal Revenue...