A payroll tax is a tax that is withheld from an employee’s wage that is in turn paid to the state or to the federal government. The employer effectively acts like a trustee of those funds for the government. The withheld amount is called “trust fund taxes” since it is deemed to be held in trust to the government. IRC § 6672. For this reason, the IRS is particularly aggressive in pursuing a payroll tax violation; in practice, it is often more aggressive than pursuing personal income tax violations.
A mistake made in withholding or paying one’s payroll taxes may result in a monetary penalty, but if the IRS is convinced the act was done “willfully”, it will pursue criminal prosecution — which may result in more serious consequences.
An employer is subject to a variety and variegated array of payroll and withholding requirements. They include the following:
- A duty to withhold a certain amount for income tax purposes from the wages paid to their employees;
- A duty to collect and pay Social Security and Medicare taxes on the worker’s compensation pursuant to the Federal Insurance Contribution Act (FICA);
- A duty to pay unemployment taxes on the employee’s wages pursuant to Federal Unemployment Tax Act (FUTA);
- A duty to comply with the workplace safety and labor laws, which includes worker’s compensation laws;
- A duty to provide certain fringe benefits, for example to make contributions to a pension or retirement plan, or health or life insurance, vacation pay, paid sick leave, and certain other duties.
The employer is responsible for this duty, even if it is delegated to a payroll firm. Reg. § 31.3403-1. However, even a non-employer may have a duty to withhold tax (e.g. lenders, or others who pay the employees their wages; and creditors who lend funds knowing that the loan will be used for payroll purposes). IRC § 3505(b).
An employer who must withhold income taxes from wages must make a quarterly return on Form 941. Withheld income tax must be paid into to a Federal Reserve bank within a certain period of time, and there are specific timing rules for that.
Who is an “Employer”?
Sometimes it’s not always clear whether you are the employer of other persons. Perhaps you view your workers as “independent contractors.” This classification is important since an employer is not required to withhold amounts from an independent contractor.
An employer may include individuals, partnerships, estates, trusts, corporations, and unincorporated organizations. Furthermore, even churches, and organizations that are exempt from income tax must withhold from employees. IRC § 3401(d); Reg. § 31.3401(d)-1.
“Employee” vs. “Independent Contractor”
It is also sometimes not always clear whether your workers are “employees” or “independent contractors.”
The usual definition of whether an employer-employee relationship exists asks whether the “employer” has the right to control and direct the “employee,” including the details and the means that the services, even if the employer did not actually directly control the employee. Reg. § 31.3121(d)-1(c). In addition, the IRS also uses a 20-factor test. Rev. Rul. 87-41; 1987-1 CB 296. The complexity of this 20-factor test results in a grey area of the law, since it is not always clear which factor the IRS will weigh most heavily. Competent legal counsel will be able to advise you whether you are likely deemed an “employer” subject to payroll and withholding tax.
A worker may be classified as an “independent contractor” if certain tests are satisfied (e.g., judicial precedent, IRS rulings or technical advice, letter ruling, or a past audit). Legal counsel can advise you on this. A “skilled professional,” like a physician, attorney, CPA sometimes is classified as an independent contractor, sometimes as an employee. The number of employees and their length of the employment is immaterial; nor does it matter that the employee is not employed at the time the wages are paid; the duty remains. Reg. § 31.3401(d)-1(b).
Simplified greatly, if you hire a worker and set all the rules, the workers will be deemed “employees.” But if the workers “call the shots,” then the workers are “independent contractors.”
Solution for Misclassification of Workers as “Independent Contractors” (IRC § 530 Relief)
Suppose you have classified a worker as an independent contractor when, really, he is an employee — and, accordingly, you did not withhold the required payroll taxes. Once the IRS discovers this, they will exact a liability.
However, there is good news. An employer may escape liability for past and future employment taxes (FICA, FUTA, and federal withholdings) by qualifying for “IRC § 530 relief.” This relief is available if three conditions are satisfied:
- The employer has filed all federal tax returns (“reporting consistency”);
- The employer has treated all similarly situated workers as independent contractors (“substantive consistency”); and
- The employer has a reasonable basis for not treating the worker in question as an employee (“safe harbor”).
This last condition’s “reasonable basis” must generally be based on case law, IRS rulings, technical advice, or private letter rulings. Legal counsel will be able to advise you whether your worker classification should be defended against the IRS, or whether to strike a compromise with the IRS on the matter (under the IRS’s so-called “Classification Settlement Program” or CSP).
What is a “Wage” According to the IRS?
Like the definition of “employer”, “employee”, the definition of “wage” is not always straightforward. This is important to an employer because only payments that are deemed “wages” for income tax purposes are subject to withholding.
A “wage” is pay to an employee for services. IRC § 3401(a). This term is very broad, and includes salary, fees, a bonus, award, commission, vacation pay, retirement pay, among others. In fact, the IRS’s approach is to look at the substance of an economic transaction, and to ignore its form. Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929)(employee must include in gross income the amount a third party paid on his income taxes, even though it is classified as an employee fringe benefit).
Some distributions of funds to an employee are more complex. For example, is employee commission subject to withholding? Are employer contributions to an IRA subject to withholding? Below market loans to an employee? Pension distributions? Overtime pay? May a shareholder (owner) of a closely-held corporation avoid employment tax by characterizing wages as a royalty or a rent? These are the sorts of questions your attorney can answer for you.
Civil and criminal penalties may be imposed for one’s employment or payroll tax fraud. An employer who fails to report or pay the employment tax may be liable for failing to deposit and failing to pay, as well as underpayment interest.
In addition to the employer, any “responsible person” for collecting, accounting for, or paying the withheld taxes may be liable for the following if she willfully fails to comply with her duty: (i) a 100 percent penalty of the withheld amount (IRC §6672), (ii) additional $10,000 penalty, and (iii) imprisonment up to five years (IRC §7702). IRC § 6672; § 6671(b).
Employers may be liable for civil and criminal penalties for: (1) failing to collect (withhold) and pay tax, (2) failing to file a return, (3) failing to deposit the withheld amount, (4) failing to file correct a false returns, (5) fraudulently withholding information from the IRS. We consider the details of these.
(1) Failure to Collect (Withhold) and Pay Tax
Generally, an employer required to withhold tax is liable for that tax, plus interest, even if she has not actually collected and paid the tax from the employee. IRC § 3403; Reg. § 31.3403-1. The responsible person may even be held personally liable, meaning that the tax may be paid by collecting from the person’s personal assets—his house, car, other business, and the like. In practice, what this means that that the IRS may seek to close your business and liquidate its assets, and then go after the your personal possessions to satisfy your tax obligation.
Furthermore, this personal obligation may not be escaped by declaring bankruptcy, as a discharge in personal bankruptcy will generally not shield one from tax liability. United States v. Sotelo, 436 U.S. 268 (1978) (holding that a IRC § 6672 liability was a “tax” for bankruptcy purposes).
(2) Failure to File
Many people are surprised to learn how serious the government is about its filing requirements. Generally, when an employer fails to file a return, she may receive a penalty of up to five percent of the total unpaid tax for that month, plus an additional five percent for each subsequent month. And, if the employer acted “willfully” in failing to file a return, to supply required information, or to keep proper records, a fine of $25,000 may be imposed ($100,000 for corporations). IRC § 7203. Further, if the employer is found to willfully evadetaxes, he is guilty of a felony, and may be fined up to $100,000 ($500,000 for corporations), and imprisoned for up to five years. IRC § 7201.
(3) Failure to Deposit
A failure to make a timely deposit of the withheld tax amount in an authorized deposit may result in a penalty, with the penalty amount increasing by the tardiness of the payment. IRC § 6656(b).
(4) Failure to File Correct Information Returns
An employer may be liable for (1) failing to file an information return (like a W-2 Form) by the due date, (2) failing to include all required information on a return, or (3) for including incorrect information on a return. The amount of the penalty will depend upon the when/if the correct information is supplied. IRC § 6721(a)(2). The amount may vary from as low as $15 to as high as $250,000.
(5) Fraudulently Withholding Information
Employers who willfully provide the IRS with false or fraudulent wage or tax statement may be subject to a $50 penalty for each statement (IRC § 6674), plus a $1,000 fine, and imprisonment up to one year (IRC § 7204).
It is not just an employer who may be liable. Employees may be subject to civil or criminal penalties for filing a fraudulent withholding allowance certificate or failing to provide a correct tax identification number (TIN). IRC § 6682(b); § 7205(a).
We Can Help.
It is not difficult to get into payroll tax trouble. Employment tax law is notoriously complex, so it is understandable that mistakes occur. The IRS, however, is not so forgiving. That is why if you are an employer who has reason to believe that you have intentionally or unintentionally committed one of the above offenses, you need competent legal counsel. Due to the complexity of the intersection of taxation and criminal law, few attorneys are competent to handle this sort of controversy.
The Tax Law Office of David W. Klasing, however, specializes in this area of law; we can help you navigate through your legal options. After reviewing the facts of your case, we are able to inform you whether you are likely to obtain an arrangement with the IRS to deal with your payroll tax program, to eliminate or reduce your liability, or to pay it at a manageable level.
Contact my law office or call 800.681.1295 for a reduced rate initial consultation, in Orange County, Irvine, or Los Angeles.