IRS to start assessing the Trust Fund Recovery Penalty Against Payroll Services

Internal Revenue Service will Start Going After Payroll Services in addition to the Willful and Responsible Parties of Businesses for the Trust Fund Recovery Penalty 

A recent IRS memorandum emphasizes that third party payroll services, or their officers or employees, can be liable for the 100% penalty of section 6672 if the payroll service, or an employee of the payroll service, is responsible for failing to withhold and deposit payroll taxes.  However, a client company of such a service cannot avoid the penalty by outsourcing payroll services if the client company, or a responsible employee of the client company, either intentionally or through failure to provide oversight, itself causes or condones the failure of the third party payroll service.  Both third party payroll services and their clients must be careful to know and follow the rules in order to avoid these substantial penalties.

Avoiding that tired feeling by failing to withhold, however, may be very costly, even where withholding is supposed to be accomplished by a third party payroll service on behalf of the employer.
In a recent memorandum prepared by the director of collection policy for the IRS Small Business/Self-Employed Division, the IRS revealed a new focus on withholding tax enforcement aimed at third party payers of payroll, including payroll service providers (PSP’s) hired by companies to perform payroll and tax accounting duties.  The memo says that this does not represent a change in policy, but is a clarification that such entities can and should be held liable for penalties if they fail to properly withhold and deposit payroll taxes.  

Under section 6672 of the Internal Revenue Code, any person who willfully fails to collect, account for, and pay over taxes withheld from employees (so-called “trust fund taxes”) is liable for a penalty of 100% of the taxes that should have been withheld and deposited.  The penalty is most commonly asserted against officers or employees of the business that is the actual employer of the employees from whom the taxes should have been withheld and deposited.  It is a strong deterrent to the temptation that a business may face to pay other creditors with withheld trust fund taxes rather than turning them over to the government for credit to the employees from whom they were withheld.  

The Internal Revenue Manual lists as potential “responsible persons” against whom the penalty may be assessed persons such as corporate officers, directors or shareholders, employees responsible for the withholding function if they made the decision not to pay the taxes, partners in partnerships, and Professional Employer Organizations (PEO’s) (otherwise sometimes called employee leasing organizations) who have responsibility for the payroll taxes.  The new memorandum reminds IRS personnel that PSP’s may also be responsible persons, as well as officers or employees of the PSP.  

However, the fact that an employer hires a third party to perform payroll functions does not relieve the employer itself, or its employees, of the responsibility to make sure that trust fund taxes are withheld and paid over to the IRS.  Nor does the requirement that the failure to withhold and pay over be “willful” imply that there must be any evil intent or bad motive; it is enough that the failure is knowing, intentional, and voluntary.  The IRS memorandum lays out a number of factors to be considered when determining “willfulness” on the part of the client company or its employees in the event that a third party payroll service fails to withhold or deposit trust fund taxes:
  • Whether the responsible person had knowledge of a pattern of noncompliance by the third party payer;
  • Whether the third party payer used fraud or deception to conceal the noncompliance from detection by the client;
  • Whether the client company had received prior IRS notices indicating that employment tax returns had not been filed, were inaccurate, or that employment taxes had not been paid;
  • The length of time the delinquency went on;
  • Whether the client simply turned a “blind eye” to the fact that the third party payer was not complying with payroll requirements;
  • What actions the client has taken to ensure that its federal employment tax obligations have been met.
Consequently, either the PSP, or the client company, or employees of either or both, may be held liable for the 100% trust fund penalty.   In each case, an IRS Revenue Officer will attempt to sort out who had responsibility for ensuring that the taxes were withheld and paid over, and significant control over payment of the taxes.  IRS will look at factors such as duties of officers under the company bylaws, who had the authority to sign checks, who had control of the financial affairs of the business, who had the authority to determine which creditors would be paid, and who controlled payroll disbursements.
Although the IRS cannot collect more than 100% of the taxes by asserting the trust fund penalty, it is very common for the Revenue Officer to assert the penalty against multiple individuals or companies, each of whom must defend against the penalty and may be held liable for a portion of it. 
In the case of PSP’s, it can be expected that the IRS will closely examine the relationship between the PSP and its client, both contractual and otherwise, to determine whether the PSP had independent authority to collect and pay over the taxes, or whether it could act only at the direction and under the control of the client company.  

The section 6672 penalty has been a part of the tax code for a very long time, and it is a key enforcement tool that IRS has always used vigorously.  However, the new focus on third party payroll services promises to lead to additional fights over who ultimately was responsible for collecting and paying over payroll taxes.  It is an area that companies in the mobility industry who provide payroll accounting services for their clients should understand completely, and manage their services accordingly.  It is important not only that such companies perform their duties responsibly, but that they organize the services provided so that it is clear that it is the client company that controls the ultimate decision whether or not to pay over withheld taxes.  Failure to do so can lead to some very expensive penalties.

In addition, the companies that hire such services must remain vigilant to ensure that the third party is properly performing its duties.  If it does not do so, the client company itself, or its officers or employees responsible for accounting and payroll, may also face stiff penalties.