Perhaps the harshest penalty in the tax law is sometimes called the "100 percent penalty." If you are a "responsible person" in a company and you fail to remit employment taxes withheld from employees' paychecks to the federal government, you can be held personally liable for 100 percent of the unpaid amount.
The tax law definition of a "responsible" party is any person responsible for collecting, accounting for or paying over taxes who willfully fails to perform the duty.
What constitutes willful behavior? "If a person knows that these required actions are not taking place for whatever reason, the person is acting willfully," according to the IRS. "Paying other expenses of the business instead of paying the taxes is willful behavior."
The IRS can be aggressive about seeking the 100 percent penalty (also known as the Trust Fund Recovery Penalty) and the courts frequently take its side in the argument, as illustrated by two court cases:
In one case, Steven Lindsey was a 50 percent shareholder of TFS, a company that leased truck drivers solely to Clearwater Trucking Company, another company owned by the same parties. When Clearwater fell into financial difficulty, it stopped paying TFS for the leased drivers. As a result, TFS failed to pay employment taxes withheld from its drivers' wages. The IRS assessed the 100 percent penalty against Mr. Lindsey, but he contended he was not a "responsible person" since he didn't have check-writing authority for TFS. Therefore, he argued, he did not willfully fail to pay the employment taxes.However, the Tenth Circuit Court noted that check writing is only one facet considered in the equation. Lindsey effectively had the power to pay the taxes, so he is personally liable for the unpaid amount. (U.S. v. Lindsey, 90 AFTR2d 2002-5468)
In another case, two taxpayers were involved in a partnership that owned a hotel. After the hotel was sold, the IRS determined that payroll taxes were not paid. The partners argued that they were not responsible for withheld taxes since they hired a couple to manage the hotel.
The court found the partners had legal control over the business at the time the tax deposits should have been made - even though the couple managing the hotel had an option to purchase it and ultimately did buy the property. As evidence, the court noted that the partners had signatory control over the bank accounts. (Harry Hunison and Bud Vigue, 2002-1 USTC 50,179; U.S. District Court)
Moral of the story: If you can be held personally liable for withheld employment taxes -- whether or not you're an owner or officer of the company -- protect your company by making sure that Uncle Sam is paid in a timely fashion. In many cases, the IRS can go after any number of people. Outsourcing payroll is one popular method small businesses are using to ensure their payroll tax obligations are met.
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