When Payroll Tax Debt Becomes Personal: The Trust Fund Recovery Penalty

A corporation or LLC may owe the payroll taxes, but the liability does not always remain with the business.

When an employer withholds federal income tax, Social Security tax, and Medicare tax from employees' wages, those amounts are held in trust for the United States. If the business does not pay them over, Internal Revenue Code (I.R.C.) section 6672 allows the IRS to assess the unpaid trust fund taxes personally against any responsible person, most often an owner, officer, manager, or employee, who had a duty to collect, truthfully account for, or pay over those taxes and who willfully failed to perform that duty.

The result is the Trust Fund Recovery Penalty, commonly called the TFRP. Despite its name, the TFRP is not merely an additional penalty imposed on the employer. It is a collection mechanism that can make an owner, officer, manager, or other responsible person personally liable for 100 percent of the unpaid trust fund portion of the tax.

For business owners and executives facing payroll tax problems, that distinction matters. An entity-level tax problem can become a personal collection problem.

What taxes are subject to the TFRP?

The TFRP applies to taxes that an employer collects or withholds from someone else and is required to pay to the government.

For ordinary payroll taxes, that generally means:

federal income tax withheld from employees' wages;
the employee portion of Social Security tax; and
the employee portion of Medicare tax.

It does not ordinarily include the employer's share of Social Security and Medicare taxes or FUTA. Those are taxes imposed directly on the employer rather than amounts withheld from employees.

This is why the TFRP is frequently described as a "100 percent penalty." The assessment equals the unpaid trust fund tax itself.

Personal liability requires both responsibility and willfulness

Failure by the company to pay payroll taxes does not automatically make every officer, shareholder, or employee personally liable.

Section 6672 generally requires two things:

the individual must be a responsible person; and
the individual's failure to collect, account for, or pay over the tax must have been willful.

Both elements are intensely factual.

Who is a "responsible person"?

Responsibility does not depend principally on a person's title.

The question is whether the person had sufficient status, duty, and authority over the company's financial affairs to influence whether the taxes were paid. The Ninth Circuit has framed the inquiry as whether the individual had significant control over the enterprise's finances. Davis v. United States, 961 F.2d 867 (9th Cir. 1992).

Relevant facts can include whether the person:

controlled the company's finances;
had authority over bank accounts;
could sign checks;
determined which creditors would be paid;
controlled payroll;
participated in management decisions;
could hire or fire employees; or
owned a significant interest in the business.

No single factor necessarily controls.

A CEO or majority owner may be responsible, but the inquiry is broader than ownership or formal office. A CFO, controller, general manager, bookkeeper, accountant, payroll employee, LLC manager, or other individual may potentially qualify if that person actually possessed sufficient authority over the relevant financial decisions.

Conversely, an impressive title alone does not establish responsibility if the individual lacked meaningful financial authority.

The practical question is who could influence whether available money went to the IRS or somewhere else.

More than one person can be responsible

Responsibility is not exclusive.

The IRS can assess the same unpaid trust fund taxes against several responsible persons. For example, both a company's president and CFO might have sufficient authority to satisfy the responsibility test.

The government is not entitled to collect the underlying trust fund tax more than once, but it may pursue multiple responsible persons until that amount has been collected.

That makes a TFRP investigation different from many ordinary tax disputes. The IRS is not merely determining how much is owed. It is also determining who may be personally liable for paying it.

"Willful" does not mean fraudulent

The willfulness requirement is often misunderstood.

The IRS generally does not need to prove that someone intended to cheat the government or acted with a fraudulent motive. In the TFRP context, willfulness can exist when a responsible person knows payroll taxes are unpaid and nevertheless causes or permits available funds to be used for other purposes. The Ninth Circuit has held that a responsible person who pays other creditors with knowledge that trust fund taxes are due acts willfully. Purcell v. United States, 1 F.3d 932 (9th Cir. 1993).

A classic example is a struggling business that uses available cash to pay:

employees;
rent;
suppliers;
lenders; or
other operating expenses

while withholding taxes remain unpaid.

The decision may have been motivated by a genuine effort to save the business. That does not necessarily prevent a finding of willfulness.

Once a responsible person knows that trust fund taxes are delinquent, continuing to prefer other creditors over the United States can create personal liability.

Paying employees can itself create a problem

One particularly difficult situation arises when a distressed company continues to make net payroll.

From a business perspective, paying employees may seem unavoidable. But from the government's perspective, the company has paid employees their net wages while retaining the taxes withheld from those wages instead of depositing them with the Treasury.

As a result, continuing to pay net payroll while known trust fund taxes remain delinquent can support a finding of willfulness.

A business therefore cannot necessarily avoid TFRP exposure by arguing that it used the money only to keep employees paid and the company operating.

Reckless disregard can be enough

Actual knowledge is not the only route to willfulness.

Courts and the IRS also consider whether a responsible person recklessly disregarded an obvious risk that payroll taxes were not being paid.

That can become important when responsibility for payroll deposits has been delegated to:

a bookkeeper;
another officer;
an outside accountant;
a payroll processing company; or
another third-party service provider.

Delegation does not necessarily eliminate responsibility.

A person who learns that payroll taxes may not have been paid and then fails to investigate or correct the problem may face a materially different situation from someone who reasonably had no knowledge of the delinquency.

Outsourcing payroll does not necessarily outsource the risk

Many businesses use third-party payroll companies or professional employer organizations to handle payroll processing, deposits, and tax filings.

That arrangement can reduce administrative burdens, but it does not automatically eliminate the employer's federal tax obligations or the potential exposure of responsible individuals.

A limited statutory regime applies to certified professional employer organizations. Under I.R.C. section 3511, a certified PEO is treated as the employer for specified federal employment-tax purposes, but only under a qualifying service contract and only with respect to remuneration the certified PEO actually remits to qualifying work site employees, and related-party and self-employment limitations apply. Ordinary payroll processors and non-certified PEO arrangements do not receive that treatment, and certification is something to verify rather than assume.

When payroll taxes go unpaid, the IRS may examine authority within both the employer and, depending on the arrangement, the third-party provider.

Business owners should therefore treat payroll tax compliance as something to verify rather than something that disappears merely because it has been outsourced.

Financial distress is usually not a defense

TFRP disputes frequently arise when a business is running out of cash.

Management may face what appears to be an impossible choice. Pay employees, keep critical vendors supplying the business, make rent, satisfy a lender, or deposit payroll taxes.

The financial pressure may explain what happened. But it does not necessarily defeat willfulness.

Using trust fund taxes as working capital is precisely the problem section 6672 is designed to address.

This makes payroll tax delinquency materially different from many other business debts. Management should not assume that unpaid withholding taxes can simply be treated like another obligation to be negotiated later.

Voluntary payments can be directed to the trust fund portion

A business that is paying down a payroll tax liability has one meaningful tool available.

When a taxpayer makes a voluntary payment to the IRS, the taxpayer may designate how the payment is applied. Rev. Proc. 2002-26, 2002-1 C.B. 746. Directing voluntary payments to the trust fund portion of the liability reduces the amount that can later be asserted personally against responsible persons.

Involuntary payments do not carry that right. The IRS generally may apply involuntary or undesignated payments in the government's best interest, which can leave more of the trust fund portion outstanding and preserve potential TFRP exposure.

A struggling business making a voluntary partial payment should designate it deliberately and in writing and retain proof of the designation. Not every partial payment is voluntary. For example, a business under an approved installment agreement may not designate its monthly installment payment to the trust fund portion. An undesignated payment can forfeit a protection that costs nothing to claim.

What if new management inherits an existing payroll tax problem?

The rules become more complicated when someone assumes control of a business after payroll taxes are already delinquent.

The Supreme Court's decision in Slodov v. United States, 436 U.S. 238 (1978), limits the idea that new management automatically becomes a guarantor of preexisting trust fund tax liabilities merely by taking control of a financially troubled company.

But the protection is not unlimited.

Once new management assumes responsibility, later decisions concerning taxes, payroll, and available funds can create exposure for periods or obligations within that person's control.

The timing of when authority began, when the individual learned of the tax problem, and what happened to company funds afterward can therefore be critical.

How the IRS investigates a TFRP case

The IRS ordinarily investigates potential personal liability separately from the employer's underlying payroll tax liability.

Revenue officers may interview officers, owners, employees, and others with knowledge of the company's finances. The investigation often examines documents such as:

bank signature cards;
cancelled checks and payment records;
payroll records;
tax deposit records;
corporate governance documents;
financial statements;
records of payments to other creditors; and
documents showing when particular individuals acquired or lost financial authority.

The IRS commonly uses Form 4180, Report of Interview with Individual Relative to Trust Fund Recovery Penalty or Personal Liability for Excise Taxes, when interviewing a potentially responsible person.

That interview should be treated as substantive, not administrative housekeeping. Statements about authority, knowledge, creditor payments, payroll, and internal responsibilities may become important evidence in determining whether the IRS asserts the penalty.

A potentially responsible person is entitled to representation in connection with the interview. Whether, when, and how a Form 4180 interview occurs is itself something experienced counsel can often manage.

Letter 1153 and the proposed assessment

Before assessing the TFRP in an ordinary case, the IRS generally must provide written notice that it proposes to assess the penalty.

That notice is commonly issued through Letter 1153, accompanied by Form 2751, Proposed Assessment of Trust Fund Recovery Penalty.

The deadline is short. A recipient generally has 60 calendar days from the mailing date of Letter 1153, or from the delivery date if the letter is hand delivered, to file a written protest and obtain consideration by the IRS Independent Office of Appeals. The period is 75 calendar days if the letter is addressed to a person outside the United States. Missing that window generally permits the IRS to assess the penalty, leaving only the more cumbersome post-assessment remedies described below.

A protest can address issues such as:

whether the individual actually had sufficient authority to be responsible;
which tax periods fall within that person's period of authority;
when the person first learned of the delinquency;
whether allegedly preferential payments occurred after that knowledge;
whether the IRS's calculation of the trust fund portion is correct; and
whether relevant evidence concerning other responsible persons has been considered.

Because TFRP liability is individual, a representative authorized only to represent the company does not necessarily have authority to represent an officer, owner, or employee personally.

What defenses are available?

Most substantive TFRP disputes focus on responsibility, willfulness, or both.

Lack of responsibility

A person may argue that he or she lacked the actual authority necessary to control payroll tax payments or creditor priorities.

Evidence matters more than titles. Bank authority, check-signing practices, internal reporting structures, actual decision-making power, and the person's ability to control payments can all be relevant.

Lack of willfulness

A responsible person may still avoid liability if the failure was not willful.

Mere negligence is not necessarily sufficient. Important questions can include when the person became aware of the problem, whether that person reasonably relied on others before receiving warning signs, and what actions were taken once the delinquency became known.

Timing

Responsibility may change over time.

Someone who lacked authority during one payroll period may have possessed it during another. Likewise, a resignation, sale of the company, promotion, change in banking authority, or transfer of financial control may affect the periods for which liability can be asserted.

For that reason, TFRP analysis should ordinarily be performed quarter by quarter and person by person.

What happens after assessment?

Once assessed, the TFRP is collected in essentially the same manner as a tax.

The IRS can use ordinary federal tax collection remedies against the responsible person, including collection from that person's assets, subject to applicable procedural protections and exemptions. The responsible person also has collection due process (CDP) protections. The IRS generally must provide an opportunity for a CDP hearing before levy under I.R.C. section 6330, and after filing a notice of federal tax lien it must generally provide notice of the right to request a CDP hearing under I.R.C. section 6320.

CDP is not always a second chance to contest the TFRP itself. A responsible person generally may challenge the existence or amount of the underlying liability in a CDP hearing only if that person did not previously have an opportunity to dispute it, and a prior Letter 1153 appeal opportunity can foreclose that challenge. In addition, certain levies, including jeopardy levies and disqualified employment tax levies, are subject to post-levy rather than pre-levy CDP procedures.

A responsible person who disputes the assessment retains a judicial route. Because the TFRP is divisible, a responsible person generally need not pay the entire assessment before bringing a refund action. For employment-tax liabilities, the person may pay the trust fund tax attributable to one employee for each quarter being challenged, file a claim for refund, and, after satisfying the applicable procedural requirements, bring a refund suit in a United States district court or the Court of Federal Claims. The government may counterclaim in that suit for the unpaid balance of the assessment.

A separate procedure under I.R.C. section 6672(c) can temporarily restrict collection of the unpaid balance. Within 30 days after notice and demand, the responsible person may make the required divisible payment, file a claim for refund, and furnish a bond equal to one and one-half times the unpaid portion of the penalty. The bond requirement makes the procedure uncommon in practice, but it can matter when halting collection during the dispute is essential.

Because TFRP assessments involve specialized procedural rules and strict deadlines, the available route should be evaluated promptly after assessment.

One further point distinguishes the TFRP from ordinary business debt. The liability is generally nondischargeable in bankruptcy.

Contribution from other responsible persons

Where multiple individuals are liable for the same TFRP, one person who pays more than his or her proportionate share may have a statutory contribution claim against other liable persons under I.R.C. section 6672(d).

That right does not prevent the IRS from collecting from a particular responsible person in the first instance. It addresses allocation among responsible persons after payment. A contribution claim also must be brought in a separate proceeding and cannot be joined or consolidated with the government's collection action.

The practical lesson

Payroll tax problems should be addressed before they become chronic.

For owners, executives, and financial personnel, three points are especially important.

First, withheld taxes are not ordinary working capital. They are amounts collected from employees and held for the United States.

Second, personal liability turns on actual authority, not merely ownership or title. A person with meaningful control over financial decisions may face exposure even if someone else was formally assigned responsibility for payroll taxes.

Third, knowledge changes the analysis. Once a responsible person knows that payroll taxes are unpaid, continuing to pay other creditors can transform a corporate cash-flow problem into personal tax liability.

When a business begins falling behind on payroll taxes, determining who had authority, when each person knew of the delinquency, what funds were available, and where those funds went should be done immediately. Those same facts are likely to determine whether the IRS can ultimately collect the unpaid trust fund taxes from the individuals behind the business.

Frequently asked questions

Can the IRS collect a company's unpaid payroll taxes from an owner or officer personally?

Yes. If an individual was a responsible person who willfully failed to collect, account for, or pay over withheld taxes, I.R.C. section 6672 permits the IRS to assess the unpaid trust fund portion against that individual personally. The corporate or LLC form does not shield a responsible person from this liability.

What makes someone a "responsible person"?

Actual authority over the company's finances, not title. Courts look at control over bank accounts, check-signing authority, the power to decide which creditors get paid, control over payroll, and ownership, among other factors. A bookkeeper with real financial control can be responsible. A vice president with no financial authority may not be.

What should a person do after receiving Letter 1153?

Act quickly. A written protest is generally due within 60 calendar days of the mailing date of Letter 1153, or of the delivery date if the letter is hand delivered, and within 75 calendar days if the letter is addressed to a person outside the United States. Letter 1153 notifies the recipient that the IRS proposes to assess the TFRP, and a timely written protest preserves the right to challenge responsibility, willfulness, the covered periods, and the calculation before the IRS Independent Office of Appeals prior to assessment. The person should also obtain individual representation, since counsel retained by the company does not automatically represent its officers or employees personally.

Does using a payroll company or PEO protect owners from the TFRP?

Not by itself. Outsourcing payroll does not eliminate the employer's deposit obligations or a responsible person's potential exposure, and a person who learns of a delinquency cannot simply rely on the provider. A narrow exception exists for certified professional employer organizations under I.R.C. section 3511, but certification should be verified rather than assumed.

Can the IRS assess the same trust fund taxes against more than one person?

Yes. The IRS may assess the full trust fund amount against every responsible person and collect from any of them, although it may not keep more than one full recovery. A person who pays more than a proportionate share may have a contribution claim against other responsible persons under I.R.C. section 6672(d), brought in a separate proceeding.

Related guides

This article provides general information concerning federal tax law and is not legal advice. The application of the Trust Fund Recovery Penalty depends heavily on the particular facts, tax periods, and authority of each potentially responsible person.