Payroll Taxes: Pay or Else

Responsible person penalty is deadly

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In this economy, plenty of businesses — and not-for-profits — are being forced to choose who gets paid when there isn't enough cash to meet all obligations. Can you make your lenders wait for the next payment? How about your suppliers? These are tough choices, but if you're the one calling the shots, there's one item you definitely want to put at the top of the list to be paid: payroll taxes.

Money held in trust

Employers are required to withhold income tax and social security tax from paychecks and pay that money over to the IRS. The employer is considered to hold that money in trust for the government. This rule doesn't apply to other payments, such as income tax. Payroll taxes are special, because they're required to be withheld. As a result, this tax debt is in a different category from others. The employer may owe money to many other creditors, but it doesn't hold money in trust for them. When it comes to payroll taxes, the government is considered the owner of the money even before it has been paid over. If you don't pay it over, you're doing a bad thing, and you can expect something bad to happen.

Responsible person

It's one of the harshest penalties in the tax system. If you're a "responsible person" in connection with payment of payroll taxes, and you willfully fail to pay those taxes, the IRS can hit you with a penalty equal to 100% of the tax that wasn't paid, even though you weren't the one who owed the tax in the first place.

You can be hit with this penalty even if you aren't an owner or someone who otherwise might benefit financially from the failure to pay these taxes. If you could have caused the employer to pay the taxes and you failed to do so, you can end up on the hook for the entire amount.

That's what happened to James Doulgeris in a recent case. He was appointed interim president and CEO of a hospital that was in bankruptcy. According to a district court opinion, the hospital was already delinquent in its payroll taxes when he took over. Yet he had authority to sign checks, and in fact signed checks totaling millions of dollars to other payees while the payroll taxes remained unpaid. Despite his argument that the CFO was the person in charge of deciding whom to pay, the court found that Doulgeris was a "responsible person" and entered judgment against him in the amount of nearly $2 million.

Same result for net payment

It may be tempting to suppose that a different rule would apply if the business never had the cash to pay the taxes in the first place. For example, a business might have a $100,000 payroll obligation that includes $15,000 of withholding. If it has only $85,000 on hand, it might pay $85,000 to the employees and plan to come up with the $15,000 required for the payroll tax later. The pay stubs will indicate it withheld $15,000, but in reality that additional money never existed. If the additional $15,000 never appears, the responsible person penalty can apply even though the business never had the money. The reason: if it had only $85,000 on hand, it was not in a position to pay that amount to employees, because any amount paid to employees has to be matched with the appropriate amount of withholding.

You pay a penalty, not the tax

How can the government collect the tax from you, when you weren't the person who owed it in the first place? The answer: they don't collect the tax from you. They collect a penalty, and the penalty happens to be equal to the amount of the tax that wasn't paid by the employer. It's a harsh result, but that's the law as written by Congress. The lesson: when your business is in trouble, make sure the payroll tax is paid, even if other creditors are screaming for their money.