The Trust Fund Recovery Penalty: Why the IRS Can Come After You Personally for Payroll Taxes, and Why Bankruptcy Will Not Save You

One of the cruelest features of the federal tax system is the trust fund recovery penalty. It allows the Service to take what began as a corporate payroll tax liability and convert it into the personal liability of an individual officer, director, or employee. The person assessed did not necessarily earn the wages, did not personally owe the tax, and may not have even known the tax was going unpaid. None of that matters if he or she meets the two statutory tests. The assessment is personal. It does not dissolve when the business dissolves. It does not discharge in bankruptcy. It follows the responsible person until it is paid, and for many business owners it has been the defining financial catastrophe of their working lives.

The statutory basis is Internal Revenue Code section 6672, which imposes a penalty equal to one hundred percent of the unpaid trust fund portion of employment taxes on any person required to collect, truthfully account for, and pay over the tax who willfully fails to do so. The trust fund portion is the part of payroll tax that the employer has withheld from the employee's paycheck. This includes the income tax withheld, the employee's share of Social Security tax, and the employee's share of Medicare tax. The employer's share of FICA and FUTA is not part of the trust fund. Only the amounts the employer holds in trust for the employee are. The distinction matters because the penalty is equal to the trust fund portion, not the total payroll tax, and because the moral weight of the penalty rests on the idea that the withheld amounts were never the employer's money to begin with.

Section 6672 imposes liability on responsible persons who acted willfully. Those two elements, responsibility and willfulness, are the terrain of essentially every trust fund case. The Supreme Court's decision in Slodov v. United States, 436 U.S. 238 (1978), established the modern framework. A responsible person is any person required to collect, account for, or pay over withheld taxes, and responsibility is a matter of status, duty, and authority, not a matter of day-to-day knowledge of whether the taxes were being paid. Courts have applied the test broadly. Corporate officers, members of boards of directors, day-to-day managers of payroll operations, signers of corporate checks, holders of authority to make financial decisions, people with significant input over which bills get paid, all have been treated as responsible persons in the right circumstances. There can be more than one responsible person, and the Service can assess each of them individually. Liability is joint and several among responsible persons, although the Service's practice is to collect only one hundred percent of the underlying trust fund tax across all of them.

Willfulness under section 6672 does not mean an intent to defraud the government. The leading Fifth Circuit case, Mazo v. United States, 591 F.2d 1151 (5th Cir. 1979), describes willfulness as a voluntary, conscious, and intentional decision to pay other creditors when the responsible person knows that trust fund taxes are unpaid. Willfulness can also be shown by reckless disregard of an obvious and known risk that the taxes are not being remitted. This typically takes the form of failing to investigate or failing to correct mismanagement after being notified. The practical effect of this definition is that a responsible person who learns of the unpaid taxes and then authorizes a payment to any other creditor, even a payment to suppliers to keep the business open, has acted willfully. Good-faith belief that the taxes would be paid later is not a defense. Delegation to an accountant or a controller is not a defense. The only real defense to willfulness, once responsibility has been established, is a showing that the funds available during the relevant period were legally encumbered in favor of some other creditor with priority over the government, and that defense is narrow and rarely successful.

The Service's investigative tool is the Form 4180 interview, conducted by a revenue officer. The interview is a structured set of questions designed to establish, on the record, the interviewee's authority over financial decisions, knowledge of the tax delinquency, involvement in decisions about what bills to pay, and so on. The form is not optional in the sense that refusal to participate brings its own consequences, but the interview is profoundly consequential. Answers given in a Form 4180 interview are used by the Service to propose section 6672 assessments. Misstatements or poor framing in the interview often turn into assessments that are difficult to reverse later. The number of trust fund cases in which the Form 4180 interview is the decisive event is larger than most clients realize, and no client should ever participate in one without counsel.

Once the assessment has been made, the responsible person can appeal administratively through the Service's Office of Appeals. Failing administrative resolution, the responsible person has two litigation paths. One is the refund suit. The responsible person pays a divisible portion of the assessment, typically the tax on one employee for one quarter, files an administrative claim for refund, waits for denial or six months, and then sues in federal district court or the Court of Federal Claims for refund of the amount paid. The government then counterclaims for the balance, and the responsible person is essentially plaintiff and defendant in the same case. The second path is collection due process, which offers a more limited set of remedies but can preserve certain arguments that the refund path cannot. The choice between paths depends on the specifics, and the timing rules on each path are unforgiving.

What makes the trust fund recovery penalty especially difficult is the combination of its scope and its durability. On scope, it reaches people who never took a salary from the business and were not involved in payroll on a daily basis. On durability, the penalty is not dischargeable in bankruptcy. Most tax liabilities can be discharged if they meet the priority rules of Bankruptcy Code section 507 and the timing rules of section 523, but section 523(a)(1)(A) specifically exempts priority tax claims from discharge, and section 6672 assessments qualify as priority claims. A business owner who closes his business, files personal bankruptcy, obtains a discharge, and believes he is starting fresh will discover that the trust fund assessment is still there. The Service can, and will, collect it. The assessment survives bankruptcy, follows the responsible person into his next career, and continues to accrue interest and failure-to-pay penalties until it is resolved.

The ten-year collection statute of limitations under Internal Revenue Code section 6502 eventually runs, but it runs slowly and it can be extended or suspended by many events. Offers in compromise, collection due process appeals, bankruptcy petitions, installment agreement proposals, and extended absences from the United States all toll the statute in various ways. A responsible person who hopes simply to outlast the collection statute will usually find that the statute outlasts him.

For Houston business owners and officers facing potential exposure, the practical advice sits in a short list of principles. First, trust fund taxes must be paid. Not paying the employer's own operating vendors is bad. Not paying the trust fund portion of payroll is catastrophic and personal. Cash flow crises in small businesses sometimes tempt owners to prioritize the vendors over the government because the vendors will stop shipping product if they are not paid. This is almost always the wrong choice. The vendor can be replaced. The section 6672 assessment cannot.

Second, when the trust fund tax has already gone unpaid, the situation is dangerous but not hopeless. Responsible persons have defenses. Not every officer is a responsible person. Not every payment decision is willful. Not every encumbrance argument is frivolous. The Form 4180 interview is not the end of the case. But the defenses have to be preserved and developed, and they have to be preserved by someone who understands both the procedural posture and the substantive standard. General business counsel who has not handled a federal tax controversy case before is not the right person to lead this defense. The case needs to be in the hands of a practitioner who knows the statute, the case law, the Service's administrative practice, and the federal district court practice in the circuit where the refund suit would sit.

Third, once the assessment is in place, compromise options exist. Offers in compromise for section 6672 liabilities are real and sometimes granted, particularly when the responsible person's financial circumstances are modest and the Service's realistic collection potential is low. Installment agreements are available. Currently-not-collectible status is available. The menu of resolution tools is broader than many clients assume, and the right tool depends on the specifics of the case. But none of the tools work if the responsible person ignores the problem, misses deadlines, or believes that bankruptcy or the passage of time will solve it. Neither will.

The trust fund recovery penalty is a blunt instrument. It was designed that way, because Congress wanted to make sure the trust fund portion of payroll tax was, in fact, treated as a trust and not as working capital. The instrument works. It catches a lot of people who did not fully understand what they were exposed to, and it stays with them long after the business that generated it is gone. Understanding how it works, and preparing for it before it becomes a problem, is not a luxury for a business owner or an officer. It is part of the job of running a business that has employees at all.