IRS Investigations of Unpaid Employment Taxes: A Step-by-Step Guide
It’s an old story that the IRS combats everyday: When a business struggles and cash flow is tight, when there is not enough money to pay both rent and employment taxes, the IRS takes a back seat, and the business uses employee withholding taxes to keep the lights on.
The result is that the IRS is made an unwilling lender to fund operations. Your hope is that the tide will turn and the IRS can be repaid before they come calling. Your business is your baby, but this is can be a dangerous bet, and as we will see, it is especially dangerous in employment tax cases.
Liability for employment taxes does not just stay with the business; rather, the IRS spreads it to you, too – the business owners, officers, and even employees – anyone who had decision-making power over the company’s finances can be personally liable for a part of the unpaid taxes. This is called a trust fund recovery penalty investigation.
Simply put, unpaid employment withholding taxes are a cancer.
As the IRS casts a wide net to collect employment taxes, a three-tiered defense is usually required: to the initial collection of the employment taxes from the business (Tier-1); to the ensuing trust fund recovery penalty investigation into who in the company made the decisions not to pay the IRS (Tier-2); and to the eventual collection of the trust fund taxes from those in the business who were responsible for the decisions not to pay the IRS (Tier-3).
The best employment tax defense will recognize each step the IRS will pursue in advance, will see what is coming, and will prepare for it. With that background, here is the IRS’s step-by-step game plan in a civil employment tax investigation.
STEP 1. ASSIGNMENT OF AN IRS REVENUE OFFICER TO COLLECT THE TAXES FROM THE BUSINESS.
The IRS considers employment tax liabilities to be a serious matter, and as a result, will assign an employment tax case to its highest level collection personnel, a Revenue Officer.
Chances are, the first move the Revenue Officer will make is to have an unannounced visit your business. Expect the Revenue Officer to drop off her business card, along with (1) ) Form 9297, Summary of Taxpayer Contact and (2) Letter 1058, Final Notice of Intent to Levy and Notice of Your Right to a Hearing.
The Revenue Officer’s initial knock on the door is to collect the employment taxes from your business. That will soon change.
You do not know it yet, but the Revenue Officer does not intend to just investigate collection of the employment taxes from your business. The Revenue Officer will also be launching an investigation into the operations of the business. The investigation will be focused on control over company finances: Who had the decision-making authority that resulted in the employee withholding taxes not being paid to the government? That could be you, that could be your CEO, a co-owner, or your spouse.
This is called a trust fund recovery penalty investigation. It permits the IRS to collect part of the unpaid employment taxes personally from the individuals who were in control of the business and were able to make financial decisions to not pay the IRS.
The IRS can collect unpaid employment withholding taxes from both the business and from its owners, officers and employees in any manner it deems fit. For example, the IRS could collect 50% from the business, 25% from the owner of the business, and the remaining 25% from the Treasurer, not to exceed 100% of the trust fund amount.
The trust fund recovery penalty gets its name from the trust involved in handling employees’ tax withholdings. When a business deducts tax withholdings out of an employee’s paycheck, there is a trust imposed on the decision-makers to ensure the employee’s taxes are paid over to the IRS. When this does not happen – usually because the business is in financial distress – Internal Revenue Code Section 6672 permits the IRS to charge the decision-makers personally with the unpaid employment taxes, and to then proceed to collect it from them and the business at the same time.
The trust fund recovery is called a penalty, but the amount of the penalty is the taxes that were withheld from employees’ paychecks – that is, income taxes and the employer’s contribution to the employees’ Social Security and Medicare accounts. The IRS can collect trust fund taxes from your business and from the individuals in the business who were responsible for the non-payment. The non-trust fund portion of the employment taxes – that is, the withholding taxes that were not deducted out of employees’ paychecks – can only be collected from the business.
The Revenue Officer will be getting to you, but at first, the Revenue Officer’s focus is on the collection of the taxes from the business (Tier-1)
STEP 2. REVENUE OFFICER INVESTIGATING COLLECTION OF THE EMPLOYMENT TAX LIABILITY FROM THE BUSINESS.
The Summary of Taxpayer Contact dropped off by the Revenue Officer at her first visit will contain a list of the items the RO wants from the business to determine how it can repay the taxes – expect the initial demands to include items such as any unfiled returns; proof of current compliance with Federal tax deposits; IRS Form 433B, Financial Statement for Businesses (which includes disclosure of a profit and loss statement and itemization of the company’s assets); and recent bank statements. There will be a deadline provided on the form – usually 2-3 weeks out.
The Revenue Officer will likely send the business a Final Notice of Intent to Levy – this notice is important as it permits the Revenue Officer to levy the business’ bank accounts, receivables, vehicles, and equipment 30 days after it was delivered. Within those 30 days, your business has the right to file a request for Collection Due Process Hearing (CDP), disputing the intent to levy and seize.
There are three reasons why it is recommended to file a request for a Collection Due Process hearing with the Revenue Officer:
1. The CDP prevents the Revenue Officer from taking levy action against the business to collect the taxes while you work out a payment solution.
2. The CDP also requires the Revenue Officer to send her case file on collecting the employment taxes from the business to the IRS Office of Appeals. This results in the Revenue Officer no longer having a collection case against the business; rather, the case has been transferred to an IRS appeals settlement officer.
3. Even the playing field, IRS collection on hold. You will be negotiating solutions to the IRS debt with IRS appeals without a so-called gun to your head – no enforcement against your business while you negotiate a repayment plan or settlement while a collection due process appeal is pending.
The most common payment alternatives for the business will either an installment payment plan or uncollectible status (IRS forbearance). These solutions will be based on negotiations surrounding the Form 433B financial statement. Although the IRS can liquidate business assets if there is equity in them, it is hesitant to do so and should not interrupt business operations if the business is in compliance on its employment tax filings and deposits.
If the financial investigation into the business’ ability to repay the taxes reveals that it is unable to pay the debt quickly, then the Revenue Officer will start looking into its other sources for collecting employment taxes – i.e., you, and any other person who has decision-making authority over the business – and will launch her trust fund recovery penalty investigation.
STEP 3. DETERMINATION BY THE REVENUE OFFICER THAT THE BUSINESS WILL BE UNABLE TO QUICKLY PAY ITS EMPLOYMENT TAX LIABILITIES.
The Revenue Officer is under guidelines to commence investigation of the trust fund recovery penalty within 120 days after her initial contact. See Internal Revenue Manual 220.127.116.11, Determination to Pursue and Recommend Assessment of the TFRP. At that time, the RO will make a determination whether the business can quickly pay the taxes in full; if the business cannot quickly pay in full, the RO will proceed to Tier-2 and expand her case to investigation of the trust fund recovery penalty to collect from you and others in control of the business.
Note that if the business owes under $25,000 and can enter into a payment plan that will satisfy the debt in 24 months, the Revnue Officer can forgo the trust fund investigation. See Internal Revenue Manual 18.104.22.168, Streamlined Installment Agreements.
If the business is able to make voluntary payments on the employment taxes, it is important that these payments get specifically designated as applied to the trust fund portion of the liability. This reduces the exposure of the individuals to the trust fund recovery penalty. Payments pursuant to an installment agreement, however, are not considered voluntary by the IRS.
STEP 4. TRUST FUND RECOVERY PENALTY INVESTIGATION.
With the business unable to pay in full, the trust fund penalty investigation will start. The trust fund recovery penalty can only be investigated by a Revenue Officer. Automated Collection Service cannot conduct the investigation – it is localized with high level enforcement personnel. See Internal Revenue Manual 22.214.171.124(2), TFRP Assessment Process.
If you have not heard from a Revenue Officer, then there is no pending trust fund recovery penalty investigation against you and your associates in the business. And there is three year statute of limitations on the IRS investigation of the TFRP – so no news can be good news for targets of the trust fund recovery penalty.
STEP 5. IRS SUMMONS TO THE BUSINESS’ BANK ACCOUNTS.
As part of determining who had financial control over the business, the Revenue Officer will want copies of the business’ bank signature cards and copies of its cancelled checks. Bank signature cards tells the Revenue Officer who had the ability to sign checks on behalf of the business. Cancelled checks lets the IRS know who actually did sign the business checks.
There is a reason the IRS wants to know about check signing: Check signers are considered by the IRS to be individuals in control of company finances. In other words, decision-makers. Control over company finances by decision-makers is an element of proof that permits the IRS to collect the unpaid employment withholding taxes from you and others in the business.
Sometimes, the bank signature cards and checks have a check signer who did not have control over the company finances, such as an accounting clerk. These duties likely were ministerial in nature, which is not enough for imposition of the trust fund recovery penalty. But the checks will make those individuals targets of a trust fund investigation, and a defense must be mounted to show the IRS that the checks are, in essence, a false positive indicator of liability – the check signing was delegated authority vs. real control. Those who are under investigation but did not have control over the business’ finances will need to show the IRS that they lacked decision-making ability.
STEP 6. IRS NOTIFICATION TO THE DECISION-MAKERS THAT THEY ARE UNDER INVESTIGATION FOR THE TRUST FUND RECOVERY PENALTY.
irs Letter 3586 is short and to the point – it identifies the business with the payroll tax liability, states the payroll quarters that are owed, and that you are under civil investigation for the failure to pay trust fund taxes to the IRS. The letter is often based on what the IRS learned from the bank records, i.e., who had signature authority, although more letters can be sent out to others as the IRS learns more as its investigation continues.
The letter will propose a date and time for an in-person interview with the Revenue Officer at the IRS’s office. The purpose of the interview is for the IRS to gather more facts as to your involvement in the company (past what the IRS has learned from the bank checks and signature cards)..
STEP 7. YOUR INTERVIEW WITH THE IRS.
With an interview pending, it is important to determine if you have a defense to the trust fund recovery penalty. If you are clearly responsible for company finances (i.e., an owner, officer, and check signer), then there may be no need to submit to the interview. Many Revenue Officers, if told that you are agreement to the trust fund recovery penalty, will cancel the interview and request that you sign Form 2751, Proposed Assessment of Trust Fund Recovery Penalty. This cuts your investigation short and allows the IRS to assess the trust fund recovery penalty and move your case to the collection function.
If there is a trust fund penalty interview, here is a sample of the questions the Revenue Officer will likely ask:
– Who could review, sign and authorize payroll?
– Who was capable of making financial decisions for the business?
– Who could direct or control the payment of bills?
– Who had knowledge of that the payroll taxes were not being paid?
– Who was in charge of making Federal Tax Deposits?
During the interview, the IRS Revenue Officer will also question you as to what you know about others in the business – in other words, ask you to spill the beans. Expect to get questions like “Besides you, who else could authorize payroll, or controlled bill payment?”
To conduct the interview, the RO will use Form 4180, Report of Interview with Individual Relative to Trust Fund Recovery Penalty. If you are submitting to the interview, review the Form 4180 in advance. Needless to say, it is extremely important to be prepared and educated on the IRS interview process in advance.
STEP 8. IRS THINKS YOU ARE A DECISION-MAKER, AND WANTS TO HOLD YOU LIABLE FOR THE UNPAID TAXES.
If, from the interview, the Revenue Officer believes that you had control and responsibility over the business’ finances, she will send Letter 1153, Proposed Assessment of Trust Fund Recovery Penalty, proposing personal liability to you for the taxes withheld from the employees. It is important to keep in mind that Letter 1153 is only a proposal of potential liability; it is not a final determination, and is subject to administrative appeal within the IRS and review by U.S. District Court.
STEP 9. YOU DISAGREE, AND FILE AN APPEAL DISPUTING LIABILITY FOR THE TRUST FUND RECOVERY PENALTY.
If there is disagreement over the Revenue Officer’s findings, the Proposed Assessment of the Trust Fund Recovery Penalty (IRS Letter 1153) provides a 60 day right to file an administrative appeal. While the appeal is pending, remember that the liability remains proposed – nothing is on the IRS’s books and the result of the trust fund investigation is not yet considered final.
Trust fund recovery penalty cases are usually fact intensive. You will need to prepare for the appeals hearing, which often involves interviewing others in the business with first-hand knowledge of your lack of control over the business’ financial decisions. Take the results of your interviews and draft supporting affidavits for signature by the business associates for submission to appeals.
If IRS administrative appeal is unsuccessful, further appeal to the U.S. District Court is available. The IRS is not the end of the line in disputing the results of a trust fund recovery penalty investigation. A court filing can be made to U.S. District Court to further dispute the IRS’s findings; this is commonly referred to as a “refund claim.” The U.S. Department of Justice will defend the IRS’s position in court.
STEP 10. IRS COLLECTION OF THE BUSINESS’ EMPLOYMENT TAXES AGAINST YOU.
By now, hopefully the business has reached resolution with either the Revenue Officer or an IRS appeals officer on collection of the taxes direct from it, and the business either has an installment agreement in place or it has been placed in uncollectible status (IRS forbearance).
When the trust fund investigation concludes, and if there is personal liability, a new collection case will start against you and any one else in the business who was found to be responsible for handling the company’s finances. This is Tier-3 – collection of the trust fund taxes after assessment from the individuals.
If the trust fund taxes have not been paid by the time they are assessed against you, the same collection process the business went through starts for you. This means an IRS request for a personal financial statement (Form 433A) from you, and supporting personal records, such as personal bank statements, mortgage balances on personal residences, and balances in retirement accounts. The IRS may send a Final Notice of Intent to Levy to you to collect the trust fund taxes; you have the same right to appeal that as the business did when the Final Notice of Intent to Levy was sent to it.
In summary, an IRS employment tax investigation is likely to have multiple tiers of simultaneous enforcement, including collection of the liability from the business, investigation of the responsibility for the trust fund recovery penalty from the individuals who ran the business, and then collection of any resulting trust fund assessments from the individuals.
To defend an employment tax case, it is necessary to have a clear understanding of each step the IRS will take, and when they will take it. While most businesses can maintain their operations unaffected during an employment tax investigation, the failure to pay does implicate the individuals who operated the business, and the IRS will attempt to penalize them and drag their finances into the mix.