By Jason B. Freeman, CPA, J.D., Dallas
Editor: Valrie Chambers, CPA, Ph.D.
Employment tax enforcement is a critical element of the IRS's overall tax enforcement effort. It is an area in which the IRS has unique tools at its disposal—tools that some practitioners may find surprising. Recent government reports indicate a growth in "egregious employment tax noncompliance" and focus on the need to combat this trend through increased use of civil and criminal enforcement mechanisms (see, e.g., Treasury Inspector General for Tax Administration (TIGTA), "A More Focused Strategy Is Needed to Effectively Address Egregious Employment Tax Crimes," Rep't No. 2017-IE-R004). The need for increased employment tax enforcement is driven in part by the essential role that such taxes play in funding vital government programs and services, as well as the fact that the government views employers who willfully fail to account for and deposit employment taxes as effectively stealing from their employees and the U.S. Treasury. In light of these trends and reports, practitioners should have a basic awareness of some of the unique tools the government uses to enforce employment tax laws.
Employment taxes, defined to include withheld income, Social Security, and Medicare taxes, account for nearly 70% of federal taxes collected by the IRS. They are collected primarily through withholding and are, as the numbers suggest, vital to the integrity of the tax system. But while they make up a substantial portion of federal revenue, recent government reports indicate that they should be even greater. For instance, the IRS estimates that unpaid employment taxes accounted for $91 billion of the 2008-2010 average annual gross tax gap of taxes owed but not paid voluntarily and timely (IRS Publication 1415, Federal Tax Compliance Research: Tax Gap Estimates for Tax Years 2008-2010, p. 2 (May 2016)).
The IRS and the Department of Justice have made special efforts to publicly warn taxpayers that employment tax enforcement is currently among the nation's top tax enforcement priorities. The TIGTA report cited above indicates that even greater efforts are needed, hinting that the IRS should more aggressively assert trust fund recovery penalty assessments and recommending that the IRS expand its criteria for criminal referrals in the employment tax context. The report, while generally critical of inadequate employment tax enforcement, comes on the heels of the IRS's release of its 2016 Data Book, which indicates a greater than 40% increase in all employment tax civil penalties assessed in fiscal 2016 from those in 2015. These factors and trends signal that a greater focus on employment tax enforcement is underway and likely to continue.
A potent tool: The trust fund recovery penalty
The trust fund recovery penalty under Sec. 6672 is a basic procedural weapon that allows the IRS to assess a civil penalty against any "responsible person" who willfully fails to pay over a business's withheld employment taxes. In addition, Sec. 7202 makes it a crime to willfully fail to collect or pay over these taxes. There is significant overlap between the two provisions, and civil trust fund recovery penalty investigations are often a ripe source for criminal referrals. Practitioners advising or representing taxpayers with civil trust fund penalty exposure should, therefore, always remain cognizant of potential criminal implications.
Sec. 6672 provides for the imposition of a civil trust fund recovery penalty, also known as the 100% penalty because it equals the total amount of the unpaid withheld tax, against any responsible person who willfully fails to collect, truthfully account for, and pay over any federal tax. The statute, in other words, holds a responsible person personally liable for the penalty, effectively piercing the business's veil where the elements of responsible-person status and willfulness are present. Any given business may have multiple responsible persons, and the IRS often asserts the full amount of the penalty against more than one person associated with the business, pursuing each person until one or more of them pay the balance in full, without regard to each person's share of culpability for the underpayment.
The IRS has generally taken a broad view of who qualifies as a responsible person. It has found business owners, board members, officers, employees, and even outside accountants, among others, to have such status in various contexts. Whether a person will be deemed a responsible person is ultimately a question of his or her "status, duty, and authority" with respect to the business (Mazo, 591 F.2d 1151, 1156 (5th Cir. 1979)). The IRS inquiry focuses on factors such as ownership of, or formal roles in, the business; managerial-type authority; authority over disbursements and payments to creditors; preparation of tax returns or assisting in making employment tax deposits; and check-signing authority, among others. In the final analysis, responsible-person status is a fact-intensive question.
When it comes to the willfulness element, the IRS takes the position that a person acts willfully when he or she chooses to pay other creditors rather than the IRS even though he or she is aware, or should be aware, of the tax liability. This generally includes paying any other creditor in preference to the IRS, even employees. Importantly, willfulness in this context does not require bad faith or an intent to defraud the government, and courts have found that reckless disregard of a duty to collect and pay over taxes can be sufficient to satisfy the element of willfulness.
Criminal penalties also a distinct hazard
In addition to this unique civil enforcement tool, severe criminal penalties can apply in the employment tax context. The line between a civil and criminal violation is often quite thin. The elements necessary to establish a trust fund recovery penalty under Sec. 6672 are virtually identical to those necessary to establish criminal liability under Sec. 7202. Almost by definition, then, taxpayers facing a trust fund recovery penalty assessment often exhibit many characteristics that could support a criminal referral. That, of course, can increase the stakes when employment tax violations are at issue. And with TIGTA's recent report recommending an expansion of the criteria for referring potential criminal employment tax cases, practitioners may see a renewed focus on developing such cases.
Practitioners counsel compliance amid heightened enforcement
Moving forward, employment tax enforcement is likely to continue to increase, despite drops in overall tax enforcement in recent years due to budget and personnel constraints. Both the IRS and Department of Justice have openly signaled that addressing employment tax noncompliance is a high priority. Recent statistics underscore those signals, and recent government reports have recommended that the IRS do even more to enforce the employment tax laws. In this environment, practitioners should pay particular attention to their clients' employment tax compliance issues and advise them accordingly.