You have a client that calls you in a panic. She owns a small business that is currently in a chapter 11 case. Things have been going well for the client as you proceed towards confirmation of a plan. The automatic stay has helped tremendously in keeping company creditors at bay while increasing revenue and reducing expenses. So why the panic-stricken call?
I received one such call not long ago: the client had an IRS Revenue Officer (“RO”) appear at her business — unannounced — and demand an interview due to unpaid taxes. According to the RO, it did not matter that my client was in bankruptcy; the automatic stay did not apply, and the IRS had asked the RO to go to my client’s office. The RO was there to conduct a “Trust Fund Interview,” and there was nothing to prevent her from moving forward. After a brief discussion, the RO agreed to move the interview back a few days so I could attend the interview with my client. I had two days to figure out what, exactly, a Trust Fund Interview entailed.
Trust Fund Taxes and Civil Liability
Trust fund taxes are the federal income taxes, social security taxes, and Medicare taxes withheld from an employee’s wages by an employer. These taxes, therefore, are held “in trust” for the benefit of the IRS by an employer. The trust fund taxes are normally deposited with the IRS through an electronic funds transfer. If an employer fails to remit those funds held in trust to the IRS, the employer will wind up (like my client) with an IRS RO knocking at the door.
For my client, the issue arose shortly before filing the chapter 11 petition. A state-judgment creditor had executed upon my client’s bank accounts, including the one used by my client to deposit the trust fund taxes through an electronic funds transfer with the IRS. There is nothing preventing a creditor from executing on the account in which the trust fund taxes are held, because the amounts held in trust for the IRS do not need to be segregated. Hamstrung by the creditor’s execution on all bank accounts, my client was unable to effectively operate the business. She could not pay any creditors, including the IRS. Post-petition, the IRS filed a proof of claim on the trust fund taxes. It seemed fairly straightforward—my client would pay the IRS through a plan of reorganization. However, the IRS had other plans, and the RO came to my client’s business unannounced.
The Trust Fund Interview is the first step in the process of determining whether any “responsible person” will be held liable for a civil penalty for the employer’s failure to pay the trust fund taxes. The term “responsible person” is not defined in the context of trust fund liability, but it has been used as shorthand to refer to the person referenced in section 6672. See Slodov v. United States, 436 U.S. 238, 246 n.7, 98 S.Ct. 1778, 1784 n.7 (1978). This is, of course, in addition to the IRS seeking recovery of the unpaid trust fund taxes directly from the employer pursuant to 26 U.S.C. §§ 3102(b) and 3403 and any attendant penalties directly attributable to the employer. Section 6672 of the Internal Revenue Code governs personal liability for the Trust Fund Recovery Penalty:
Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.
26 U.S.C. § 6672(a). Here, “[t]he term ‘person’ . . . includes an officer or employee of a corporation, or a member or employee of a partnership, who as such officer, employee, or member is under a duty to perform the act in respect of which the violation occurs.” 26 U.S.C. § 6671(b). The RO’s role is to determine who is responsible for collecting, accounting for, and paying the trust fund taxes to the IRS, and whether the responsible person is liable for the 100% civil penalty outlined in section 6672. For my client, the issue arose after the submission of the quarterly Form 941 tax return for the fourth quarter of the preceding year and first quarter of the then-current tax year. The returns showed outstanding amounts owed for trust fund taxes.
The civil penalty outlined in section 6672(a) can be imposed upon any person determined to be a “responsible person” that “willfully failed” to comply with the requirement to pay the trust fund taxes to the IRS. The Court of Appeals for the Fourth Circuit has developed a non-exhaustive list of factors in determining who is liable for the Trust Fund Penalty:
[W]e examine whether the employee (1) served as an officer or director of the company; (2) controlled the company’s payroll; (3) determined which creditors to pay and when to pay them; (4) participated in the corporation’s day-to-day management; (5) had the ability to hire and fire employees; and (6) possessed the power to write checks.
Erwin v. United States, 591 F.3d 313, 321 (4th Cir. 2010). If an employee of the employer meets these requirements, the second step in the inquiry is whether there was a “willful” failure to collect, account for, or remit the trust fund taxes to the IRS. “Willfulness” hinges on whether the responsible person had “knowledge of nonpayment or reckless disregard of whether the payments were being made,” and, if a responsible person made payments to other creditors rather than the IRS, this “intentional preference for creditors other than the United States establishes willfulness as a matter of law.” Id. at 325. For my client, the willfulness issue was a huge concern. While the responsible person(s) at the company were aware that these tax payments were not made, and could not be made, no other creditors were receiving payment either. As a result, the willfulness standard was arguably met with that knowledge. However, my client could not pay the taxes after the state-judgment creditor executed on the bank accounts.
The Trust Fund Penalty Interview
The Trust Fund Penalty Interview can be an intimidating experience. In my client’s case, the RO showed up at the business for the re-scheduled interview. After identifying herself, she provided a copy of IRS Form 2751, which shows both the outstanding amount of the trust fund taxes and the proposed penalty. This form, entitled “Proposed Assessment of Trust Fund Recovery Penalty,” has a signature line that allows an individual to sign as a responsible person and agree to pay the trust fund recovery penalty. The RO stated my client’s president or officer could sign the form, and the interview would not go any further. As I was there for the interview, I instructed my client not to sign this agreement—but what happens when an employer’s counsel is not there, or the employer is unrepresented? As an additional note, there is some case law that states the trust fund recovery penalty is not a true penalty. Rather, these cases state that section 6672 merely ensures the IRS recovers the amount of unpaid trust fund taxes to which the IRS is entitled. See, e.g., Erwin, 591 F.3d at 319 (“Although labeled as a ‘penalty,’ [section] 6672 does not actually punish; rather, it ‘brings the government only the same amount to which it was entitled by way of the tax.’ ” (quoting Turnbull v. United States, 929 F.2d 173, 178 n.6 (5th Cir. 1991) (internal citation marks omitted))). I would argue that this is incorrect, or, in practice, the IRS does not merely seek the amount owed. As shown on the Form 2751 given to my client, the IRS was seeking the unpaid trust fund taxes plus a nearly-100% penalty.
The Trust Fund Penalty Interview is sworn testimony. During the interview, the IRS RO fills out an IRS Form 4180, entitled “Report of Interview with Individual Relative to Trust Fund Recovery Penalty or Personal Liability for Excise Taxes,” and, at the end of the interview, the individual that was interviewed must review the form and sign it under penalty of perjury. That form is readily available online for review and should be reviewed with your client prior to the Trust Fund Penalty Interview. If there is more than one individual identified as a potential “responsible person,” the individuals are sequestered and interviewed individually. Following the interview, the RO conducting the interview makes a recommendation as to whether the potential “responsible person” was, in fact, a responsible person and whether the individual should be assessed the penalty. The RO’s superior then makes the determination as whether the penalty should be assessed, and the potential responsible person is notified either by mail or in person. See 26 U.S.C. § 6672(b).
Luckily, for my client, the individuals deemed “responsible persons” as employees of my client were not ultimately assessed the penalty due to the mitigating circumstances surrounding nonpayment. Additionally, payment of the taxes owed prior to the beginning of the interview will prevent that interview from moving forward. Alternatively, the potential responsible person can also submit IRS Form 433-A to prove the inability to pay the penalty, and prevent the IRS moving forward. In some instances, such as the one my client was in, these options were unavailable due to the bankruptcy of my client.
Review Tax Consequences with the Client Upfront
While my client’s situation was somewhat unique, all insolvency professionals should be aware of a potential Trust Fund Penalty and Trust Fund Penalty Interview. I now address this topic upfront with potential clients. Potential clients that are better served by a dissolution rather than bankruptcy should certainly be made aware of this potential penalty to ensure that there is no personal liability of company representatives following dissolution. In such cases, all trust fund tax liabilities should be paid to the IRS prior to dissolution, as any funds withheld as trust fund taxes are not really the company’s funds. Rather, they are held in trust for the IRS.
About the Author: Kenny Dantinne is an Associate in the Bankruptcy, Restructuring + Creditors’ Rights Group at Hamilton Stephens Steele + Martin, PLLC (“HSSM”) in Charlotte. Kenny’s practice focuses on representing and counseling financially-distressed corporate clients through out-of-court restructuring, wind-up and dissolution, and Chapter 11 reorganization. Kenny also represents trade creditors and creditor committees in bankruptcy court. Outside of the insolvency context, Kenny is part of the litigation practice group at HSSM, with a focus on commercial litigation and defending engineers and architects in construction litigation.
Legal Disclaimer: This blog post does not create an attorney-client relationship between the author and any reader of this post. This post contains legal information and the opinions of the author but should not be considered legal advice. Any reader of this blog post should consult an attorney rather than relying upon the information contained herein.
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