The Misappropriation of Trust Fund Taxes under the Guise of Reasonable Cause

I. THE CASH FLOW DILEMMA Employers are generally required to withhold income, Social Security, and Medicare taxes from their employees' paychecks. Employers hold these taxes until they are deposited or otherwise paid over to government.1 Since one of most common problems faced by owners and managers of businesses is lack of adequate cash to satisfy their numerous immediate obligations, this system creates a temptation for employer to use withheld funds to cover its costs. Short-term bank loans are often either unavailable or unaffordable, and employer's own debtors may be unable to pay or not yet obligated to pay.2 Certain creditors, such as landlords, suppliers, shipping agents, and employees, must be paid on time or business would cease to operate. When confronted with this dilemma, employer may turn to one source of cash immediately available: taxes withheld from employee paychecks.3 This decision is usually seen as a short-term fix to a temporary cash flow problem; employer believes it will be able to meet its tax obligations when due. If employer manages to replenish its cash before withheld taxes are due, employer satisfies its obligation and avoids sanction. If payment is late, employer may be liable for penalties. On other hand, if cash flow problems are permanent, employer may be entirely unable to fulfill its obligation to pay over withheld taxes. If company fails to pay taxes when required, a full range of tax collection devices are available to Internal Revenue Service (IRS). Withheld taxes are referred to as fund in reference to Internal Revenue Code (Code) section 7501, which states, the amount of tax so collected or withheld shall be held to be a special fund in trust for United States.4 Under general trust principles, employers' use of funds held in trust, as are fund constitutes a misappropriation of those funds.5 However, general common law trust principles cannot be applied wholesale to this context.6 For example, despite creation of a trust, there is no requirement that trust fund taxes be segregated from employer's general operating funds as soon as trust taxes are incurred.7 While IRS has right to demand segregation, and even criminalize failure to do so, segregation does not help government collect trust fund taxes that have already been misappropriated.8 Generally, withholding system only requires that employer deposit withheld taxes, pay taxes with quarterly employment tax return, or both.9 Collection is further complicated by fact that, under withholding system, employees are entitled to a credit against their personal tax liability for all taxes withheld from their paychecks, regardless of whether employer actually pays government.10 The IRS has no recourse against employees for unpaid withheld taxes but, rather, must seek payment from employer. To this end, IRS has a number of statutory devices to effectuate collection.11 For example, if employer has other assets, IRS may seize and sell those assets to satisfy trust fund tax obligation.12 Criminal sanctions are also available.13 This Note focuses on two other collection devices. The first device includes two mandatory penalty provisions assessed when employer pays trust fund taxes late.14 Section 6651(a) imposes a monetary penalty on an employer who fails to timely pay, taxes with quarterly employment tax return.15 Section 6656(a) imposes a monetary penalty on an employer who fails to timely deposit trust fund taxes into a government depository.16 Both penalty provisions are additions to tax, and their assessment is mandatory unless employer shows that failure to pay17 is due to reasonable cause and not willful neglect.18 The circuit courts are currently split as to whether an employer's financial difficulties may constitute reasonable cause, excusing late payment of trust fund taxes. …