The “trust fund recovery penalty” can impose sizeable liabilities on officers and other employees of financially struggling or failed companies that fail to pay withholding or employment taxes. Individuals facing this penalty will often claim that they had no choice, that there were no funds not already spoken for or controlled by others. To their chagrin, these employees learn that the trust fund recovery penalty imposes a strict obligation on any person with knowledge of unpaid employment taxes, with only a narrow exception for encumbered funds.

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The Trust Fund Recovery Penalty

Under Internal Revenue Code (IRC) section 6672, “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 … shall … be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.” Section 6672 is referred to as the “trust fund recovery penalty,” because the person collecting tax owed by a third party is meant to hold the funds in trust for the IRS. Liability for the trust fund recovery penalty rests on two elements: it applies to a “responsible person” who “willfully” fails to collect or pay over the tax.

A “responsible person” is anyone with a duty to collect or pay over the tax. The term may include officers and employees as well as other persons under the duty, but it does not automatically apply to all persons with a given position with an employer. Whether a person is a “responsible person” depends on whether he has some control over the finances of the employer, including the disbursement of funds and the priority of payments to creditors. Many people can fit this definition, and if the tax is not collected and paid, the IRS will try to assess the penalty on all of them.

A responsible person is only liable if he or she “willfully” failed to collect or pay over the tax. Willfulness is broadly defined as “deliberate, voluntary, conscious choice to prefer another creditor over the United States government.” Willfulness does not require specific intent to deprive the government of the taxes, only knowledge that taxes are owed and a payment to another creditor instead of the government. Once a person learns that taxes have gone unpaid in past quarters during which she was a responsible person, she has a duty to use all current and future unencumbered funds available to the corporation to pay those taxes. Any other use of funds will be considered willful.

Encumbered Funds

Responsible persons who are assessed a trust fund recovery penalty will frequently assert that the company’s funds were and are encumbered, so that no penalty is owed. Unfortunately, most if not all court decisions on this question run against the responsible person. Under the rule laid down by the courts, almost no funds are encumbered funds.

The Court of Appeals for the Eighth Circuit, in Honey v. United States [963 F.2d 1083 (8th Cir. 1992)], stated the rule as follows: “Funds are encumbered only where the taxpayer is legally obligated to use the funds for a purpose other than satisfying the preexisting employment tax liability and if that legal obligation is superior to the interest of the IRS in the funds.” This rule follows from the definition of willfulness. If a taxpayer is legally obligated to use funds for another purpose, and the obligation is superior to the IRS’s interest in the funds, then the responsible person cannot be said to have made a voluntary choice to prefer the other creditor over the U.S. government.

Three recent decisions, however, illustrate how rare it is for a court to find such an obligation. In Nakano v. United States [742 F.3d 1208 (9th Cir. 2014)], the CFO of a bankrupt airline claimed that the airline’s funds were encumbered by bankruptcy law. The law states that a company in bankruptcy is allowed to pay “the actual necessary costs and expenses of preserving the estate” [11 U.S.C. section 503(b)(1)(A)], and then states that the company is allowed to pay taxes [11 U.S.C. section 503(b)(1)(B)]. The CFO argued that bankruptcy law required the airline to pay the actual necessary costs and expenses of preserving the estate before trust fund taxes. The court disagreed, holding that the Bankruptcy Code “mandates equally the payment of operating expenses and taxes.” The funds were not encumbered, and the CFO was found willful.

In Cherne v. United States [2015 WL 5611586 (D. Idaho 2015)], the responsible person was the CFO and a director of a struggling hospital. The hospital’s principal lender agreed to lend it additional funds, on the condition that the lender approve how the funds were spent; only once the hospital and the lender agreed on what payments were to be made would the lender advance funds for payment. Under this agreement, payments to other creditors were approved and paid, but the IRS was not. Even though the funds would not have been available to the hospital unless the hospital agreed to the approved payment list, the advanced funds were not encumbered, and the responsible person was liable for the penalty. The court reasoned that the terms of a loan from a third party cannot change an employer’s obligations to the IRS without the IRS’s consent.

In a third case, Ruscitto v. United States [2015 WL 7423811 (3rd Cir. 2015)], a financially distressed construction company entered into a surety agreement with an insurance company. Under the surety agreement, the insurance company controlled the employer’s cash flow from all bonded projects, which amounted to 75% of its total revenue. The employer failed to pay trust fund taxes, and the section 6672 penalty was imposed on the employer’s sole shareholder. The shareholder argued a lack of adequate unencumbered funds; however, as other creditors were paid and the trust fund taxes were not, the shareholder was found willful and therefore liable. The court did not need to decide whether the funds held by the insurance company were encumbered or not; it was sufficient that the employer had used funds from unbonded projects to pay wages and other debts, preferring those creditors over the IRS.

It is very difficult to avoid a trust fund recovery penalty on the grounds that the funds that could have paid the taxes were encumbered.

As shown by these cases, it is very difficult to avoid a trust fund recovery penalty on the grounds that the funds that could have paid the taxes were encumbered. The results appear harsh, particularly when the responsible person has given control of the company’s funds to a lender or the bankruptcy court. The absence of a generous encumbered funds defense underlines the necessity of paying trust fund taxes. Responsible persons who know that such taxes have gone unpaid should consider those taxes their first priority. Any other use of available funds is, from a legal standpoint, willful.

Henry Stow Lovejoy, JD is of Counsel to Kostelnatz & Fink, LLP, in New York, N.Y.