Section 6672 of the Internal Revenue Code is seldom considered when forming a corporation. Discussion of Section 6672 is conspicuously absent from texts and treatises on corporate formation. Yet, failure to heed its provisions can be the cause of many sleepless nights for shareholders, officers, directors and employees of failing or cash-poor corporations.
IRC Section 6672 imposes a penalty, equal to the full amount of the tax withheld, upon persons responsible to collect, account for and pay over employment taxes if they willfully fail to do so. It is commonly referred to as the 100% penalty.
Officers and directors are frequently not forewarned of the 100% penalty or its consequences. The 100% penalty has been applied against corporate officers, directors, employees, purchasers, lenders and accountants. those with responsibility for signing checks, paying bills and those with authority to do so may be liable in their individual capacity, for the corporate employee withholding taxes.
The 100% penalty may place liability upon corporate insiders, as well as unsuspecting employees. Among those we currently represent are several examples of the unfortunate consequences. A young former secretary/bookkeeper for a small corporation paid bills, calculated and issued payroll checks and prepared and filed her employer's quarterly tax returns. While she enjoyed her position of trust and authority, there was seldom enough cash available to pay the withholding taxes. Consequently, payment was regularly delayed. She is now among those targeted for assessment under section 6672.
Another client, a young salesman, considered himself as climbing the corporate ladder of success when placed on the board of directors of his employer's corporation. He was appointed vice president and given authority to sign checks. Occasionally, he exerted that authority by signing payroll checks. The Internal Revenue Service seeks to assess a large 100% penalty. Neither client had knowledge of the risk or liability involved.
New corporations formed with marginal funds often lack cash to meet start-up and other expenses necessary to remain in operation. Wages, inventory and rent must be paid to keep the doors open. Taxes due quarterly are delayed without immediate consequences. The "trust fund portion" may be assessed against responsible persons, however, with no guaranteed administrative review. The Internal Revenue Service does not give 90 days' notice as is required for income tax deficiencies. The Tax Court lacks jurisdiction, and there is no judicial forum available prior to payment. A potentially responsible person may be forced to incur heavy accounting and legal expenses to avoid assessment and collection or to obtain refunds through the U.S. District Court or U.S. Court of Claims after payment.
Attorneys involved in corporate formation should stress the necessity to set aside and pay withholding taxes. Some planning is also possible.
1. Direct application of payment - A taxpayer may direct the application of a voluntary payment of taxes. The Internal Revenue Service has declared itself bound by such direction. If a corporation lacks funds with which to discharge an entire employment tax liability, those payments made may be directed first to discharge the trust fund portion. Direction must be made in writing, accompanying the payment.
Without direction, the Internal Revenue Manual directs application to the non-trust fund taxes, interest and then penalties prior to the trust fund application.
A corporate president, prior to engaging our office, voluntarily paid corporate funds upon the corporation's employment tax liability after personally being assessed the 100% penalty. No direction for application of payments was made. The individual liability, which could have been substantially discharged, remains.
2. Clearly establish in corporate records those persons responsible for paying bills, writing checks and paying taxes. Corporate actions intended to protect directors or officers from responsibility will not necessarily bind the Internal revenue Service. However, well-drafted bylaws, corporate minutes and resolutions which define duties and responsibilities will greatly support the lack of responsibility of officers and directors whose duties are not financial. Corporate actions should clearly specify the required approval of an officer or director before payment or transfer of corporate funds.
3. Inform directors and shareholders in advance of the potential liability they face under section 6672. With adequate forewarning, officers can make informed decisions regarding payment of employment taxes. Since officers and employees are often caught off guard with an asserted 100% penalty, knowledge that their personal assets are in jeopardy might change internal decisions. You, as a legal practitioner, may have a professional obligation to advise your corporate clients of this risk.
4. A potentially responsible officer, director or employee should take immediate steps to become distanced from further liability upon learning of unpaid taxes. Although resignation from office does not conclusively end responsibility, resignation may be helpful. Resignation should be complete. No further authority over business affairs should be exerted. Efforts to require payment of past taxes (such as demands made upon controller, etc.) should continue. Correspondence should explain the inability to control the affairs of the business both before and after resignation. Make certain that corporate records reflect the resignation and that the subsequent annual reports to the Secretary of State also reflect the change. We are currently working on a case where successive annual reports did not reflect the change brought about by resignation. The IRS is ignoring the resignation.
5. Leave a paper trail. Instruct corporate clients to document in writing all instructions, limitations of power and authority, demands for payment of withholding taxes, resignations and replacements. Retain copies. Documentation is strong substantive evidence of position. Seldom does a client leave a complete paper trail.
6. Avoid loans to cover payroll. In an interview with unsuspecting corporate employees, officers, shareholders or directors, a revenue officer will typically ask if the interviewee loaned money to cover payroll expense. IRC section 3505 places liability for "trust fund" taxes upon a lender who pays wages or who loans money for wages. Even if used for payroll, a loan should not specify that purpose, unless the lender assures itself that proper withholding is made. This applies to banks and lending institutions, not just "related" parties.
7. Suggest that an expert be present at the pre-assessment interview. The questionnaire, Form 4180, used by the IRS during interview of prospective "responsible persons", seems innocent and straightforward. However, written summaries of answers completed by a revenue officer can be deceptive.
Revenue officers, supervisors and appeals officers will rely heavily upon the information contained in the interview summary, especially if it is at all damaging. Clients should go into an interview thoroughly briefed on the law. Interview summaries should be reviewed. Add explanation or information if necessary before signing.
If a client has a defense to assessment, early expert representation is a necessity. Successful defense at the administrative level may require that thorough and accurate information, documentation and answers be supplied at an early stage.
CONCLUSION
Thorough corporate formation and representation should include information about the potential personal liability that could be faced for nonpayment of employment withholding taxes. Such information and representation becomes even more important during economic slowdown or recession.