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Misuse of 'Withheld' Tax Dollars More Dangerous Than You Think

“Misuse of ‘Withheld’ Tax Dollars More Dangerous Than You Think”

The law empowers the Internal Revenue Service to act firmly and swiftly against companies that withhold income and Social Security taxes from employee paychecks and fail to pay those taxes on time to the IRS.

The deadline for depositing such funds varies according to the amount of withholding taxes. For exact details, contact your accountant, or phone the IRS and request Publication 15 at 1-800-TAX-FORM.

Typical culprits are small- or medium-sized, closely held companies that are short of operating cash and unable to borrow from banks or other conventional sources. Nearly 2 million businesses owed the IRS about $49 billion in withholding taxes in 1998, which includes $19 billion in unpaid tax assessments and another $30 billion in penalties and interest, notes the IRS.

The problem that confronts these companies is how to come up with sufficient funds to meet the gross payroll and also pay apprehensive suppliers who are unwilling to extend additional credit. Their solution is what gets these businesses into bad tax trouble. Management opts to pay employees their net salaries or wages and not to make required deposits with the IRS. After all, rationalize these optimistic officers, they will take care of the "borrowed" taxes as soon as business picks up.

Thousands who have played games with withheld taxes later have been stunned to discover that they were personally liable if their company failed to pay such taxes. The IRS can assert a 100% penalty against "responsible persons" for collecting and paying taxes if they "willfully" failed to do so.

"Responsible persons" are those who decide which creditors to pay and when. Willfulness only requires a conscious, voluntary act, not an intent to defraud, and can include the failure to investigate or correct mismanagement after noticing that taxes are due and other creditors have been paid. Note, too, that personal bankruptcy does not relieve an individual of responsibility for his or her company’s failure to pay withheld taxes.

Who Gets Stuck

Generally, the IRS pursues the owners or top officers of an organization. The official policy is not to assert the penalty against "non-owner employees of the business, who act solely under the dominion and control of others, and who are not in a position to make independent decisions on behalf of the business entity."

Law Changes

A revamping of the tax code makes it easier to challenge penalties. Since many individuals may be unaware of their personal liability, the IRS has to notify those it deems responsible for the shortfall at least 60 days before assessing penalties.

What if the IRS hits several people with the same bill? Predictably, the agency usually tries to collect from the one with the deepest pockets, rather than from the most culpable party. Now, when a responsible person asks the IRS, it has to say in writing who the others are, whether it tried to collect from them, the nature of those efforts and how much it received. And the party who pays more than his or her proportionate share to the IRS can sue in federal court to collect from others for their share.

Help for Volunteers

Another law change confers important protection on people who serve as unpaid members of boards of schools, museums and other tax-exempt groups. No longer can the 100% penalty be imposed on members who solely serve in an honorary capacity, do not participate in the day-to-day or financial activities of the organization, and do not actually know of the failure to collect and relay taxes on time to the IRS.

Despite these changes, the IRS still has lots of leeway.

Consider the plight of Ted Neckles. When the IRS became aware that Task Enterprises Inc. had failed to remit hundreds of thousands of dollars in withheld taxes, there seemed to be little that the government could do to get the money. Task had folded within a year of its incorporation. The IRS looked into the pockets of former officers, but found nothing.

The agency finally focused on Neckles, one of the original organizers and investors, but not an officer or employee of Task. IRS sleuths discovered that he had always been around and had significant control over disbursement of funds. Though without any title and unsalaried, he was authorized to draw on all corporate accounts and signed most of the checks on the firm’s general account. Neckles made decisions as to which creditors would be paid and when. What’s more, he knew of the withheld, but unpaid, tax money.

The IRS forced him to pay the withheld funds. He filed suit to recover the payment. But the court concluded that he was "de facto" — that is, an employee of Task. Clearly, he was someone who could have seen to it that the withheld taxes were paid. Because Neckles had the power and the authority to pay creditors, and was aware of the tax arrears, he was a responsible person and was therefore liable for the taxes.

Writer: Julian Block is a nationally recognized tax attorney in Larchmont, New York. His books include "Julian Block’s Tax Avoidance Secrets."