Avoid Personal Liability for Unpaid Federal Payroll Taxes

Payroll Taxes

During the COVID-19 pandemic, some cash-strapped employers may fail to pay over federal income and employment taxes that were withheld from employee paychecks to the U.S. Treasury. In the eyes of the IRS, this is a major tax faux pas — punishable with a whopping 100% penalty against any responsible person.

In other words, the entire unpaid federal payroll tax amount can be assessed as a penalty against a responsible person or several responsible persons. The logic behind the 100% penalty is that the federal government should be able to collect withheld, but unpaid, federal payroll taxes from unscrupulous individuals who had control over an employer's finances.

Woman working at home using a computer and notepad

While that may seem fair in theory, it doesn't take much to be classified as a responsible person who's exposed to the 100% penalty. Proof of unscrupulousness may not necessarily be required. Here's the story.

Who's Considered a Responsible Person?

The 100% penalty can be assessed only against a so-called "responsible person." That could be:

The 100% penalty can also be assessed against an employee of a sole proprietorship or an employee of a single-member (one owner) LLC.

To be hit with the 100% penalty, an individual must meet the following two criteria:

  1. Be responsible for collecting, accounting for, and paying over withheld federal taxes, and
  2. Willfully fail to pay over those taxes.

The term "willful" means intentional, deliberate, voluntary and knowing — as opposed to accidental. The mere authority to sign checks when directed to do so by a higher-up doesn't establish responsible-person status. There must also be knowledge of and control over the finances of the business.

The IRS will look first at individuals who have check-signing authority. However, you can't deflect responsible-person status by simply assigning signature authority over bank accounts to someone else. To determine responsible-person status, the IRS also may consider whether the individual:

In certain circumstances, outside parties — such as lenders, attorneys and accountants — can also be responsible persons.

For example, a tax attorney who actively participated in managing the finances of several corporations in which he had invested was found to be a responsible person. He also had check-signing authority and previously exercised his authority as a corporate officer to correct the corporation's failure to pay over employment taxes.

When Do Insiders Qualify as Responsible Persons?

Situations involving outsiders are the exception, not the norm. In most cases, the 100% penalty is assessed against people inside the company.

For example, a corporation's newly hired CFO became aware that the company was several years behind on its payroll taxes and notified the company's CEO of the situation. The CFO and CEO then informed the company's board of directors.

Although the company apparently had sufficient funds to pay the taxes, no payments were made. After the CFO and CEO were both fired, the IRS assessed the 100% penalty against them both for withheld but unpaid taxes that accrued during their tenures.

In another case, the IRS ruled that a volunteer member of a charitable organization's board of trustees was a responsible person. Why? The volunteer had 1) knowledge of the organization's tax delinquency, and 2) the authority to decide whether to pay the taxes.

Likewise, the president of a daycare center's board of directors was found to be a responsible person — even though he wasn't paid for his work and wasn't involved in day-to-day operations. The factors that led to that determination: He secured loans for the center, directed its tax payments and reviewed its financial reports.

What Payroll Tax Relief Was Provided by the CARES Act?

Thankfully, the Coronavirus Aid, Relief and Economic Security (CARES) Act grants some meaningful federal payroll tax relief for this year. It allows employers to defer the 6.2% employer portion of the Social Security tax component of FICA tax owed on the first $137,700 of an employee's 2020 wages.

The deferral applies to wages paid during the deferral period, which began on March 27, 2020, and will end on December 31, 2020. The employer must then pay the deferred payroll tax amount in two installments:

  1. Half by December 31, 2021, and
  2. The remaining half by December 31, 2022.

This payroll tax deferral deal is available to all employers — small and large alike — with no requirement to show any specific COVID-19-related financial distress.

Does the 100% Penalty Apply to Self-Employed People?

If you're self-employed, you're not exposed to the 100% penalty issue unless you have employees. But you're effectively exposed to a 100% penalty for any unpaid federal self-employment (SE) tax. Plus, you'll be hit with an interest charge penalty if your quarterly estimated federal income tax payments don't cover your SE tax bill.

Under the CARES Act, self-employed people can defer half of the 12.4% Social Security tax component of the SE tax for the deferral period, which began on March 27, 2020, and will end on December 31, 2020. The 12.4% Social Security tax hits the first $137,700 of 2020 net SE income.

Self-employed individuals must pay the deferred SE tax amount in two installments:

  1. Half by December 31, 2021, and
  2. The remaining half by December 31, 2022.

For More Information

When you participate in running an organization that hasn't paid over federal payroll taxes that were withheld from employee paychecks, you run the risk of the IRS classifying you as a responsible person. If that happens, you could personally be assessed a 100% penalty.

Consult your tax advisor about what records you should be keeping and what actions you should be taking (or not taking) to avoid exposure to the 100% penalty.

IRS Issues Guidance on Trump's Payroll Tax Deferral

President Trump issued an executive memorandum on August 8 to temporarily defer federal payroll taxes for the period between September 1, 2020, and December 31, 2020. The deferral applies to the 6.2% Social Security tax component of the FICA tax that's ordinarily withheld from the first $137,700 of an employee's 2020 paychecks.

The deferral is available only for employees whose wages are less than $4,000 for a given biweekly payroll period during the deferral period (or an equivalent amount for other payroll periods).

Recently issued IRS guidance clarifies that employers (not potentially eligible employees) can decide whether they'll implement the deferral deal. Employers aren't required to implement the deferral, however.

Notice 2020-65 is brief, and private employers still have questions about whether, and how, to implement the deferral. The President's action only defers Social Security taxes; it doesn't forgive them, meaning employees will have to pay the taxes later unless Congress passes a law to eliminate the liability.

Issued on August 28, Notice 2020-65 postpones the withholding and remittance of the employee share of Social Security tax until the period beginning on January 1, 2021, and ending on April 30, 2021. Penalties, interest and additions to tax will begin to accrue on May 1, 2021, for any unpaid taxes.

The guidance states that if necessary, the employer "may make arrangements to collect the total applicable taxes" from an employee.

Contact your tax advisor if you have questions about how to proceed.

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