Federal and State Withholding – Risk of Personal Liability

Posted by on Jul 6, 2010

As your business grows you will begin to hire employees, with hiring of employees you are required to withhold certain taxes from your employee’s income. Failure to do so could cause severe problems. The message for today is with growth comes responsibility.

Federal Law

Federal Law requires employers to withhold taxes from your employee’s income. Each time wages are paid, certain amounts must be withheld and remitted for federal income tax, social security tax, and Medicare tax. These funds do not belong to the employer, rather they are held in trust for the United States. These amounts are commonly referred to as “trust fund taxes.”

If the employer fails to collect, account for and pay withholding taxes, not only will the IRS impose penalties and interest on the company, the IRS can also impose personal liability against those individuals considered to be responsible and willful. (I.R.C.§6672). Note – this assessment of personal liability pierces the corporate veil and the corporate entity cannot shield the individual from personal liability.

An individual is assessed the trust fund recovery penalty when they are found to be responsible for and willfully fail to collect, truthfully account for, and pay over withholding taxes. The elements for personal liability are defined differently in each federal circuit. In the 8th Circuit (where Minnesota resides) the courts have adopted a two-element test based on responsibility and willfulness (See: Honey v. United States, 963 F.2d 1083 (8th Cir. 1992)).

A person must have been responsible for either collecting, accounting for, or paying over withholding taxes. This may involve one or more responsible persons. For example, if the individual is an officer, shareholder or has a financial interest in the company; if the person has check-signing or wire-transferring authority; or if the person is involved in the day-to-day business operations of the company.

If the individual is found responsible, then the courts look to see if there was willfulness. According to I.R.C. §6672, willfulness means a voluntary, conscious, or intentional failure to collect, truthfully account for, and pay over the taxes withheld from employees. The willfulness element is satisfied if the person had knowledge of payments to other creditors, including employees, after he or she was aware that the taxes were unpaid.

Minnesota Law

Like the federal level, employers have an obligation in Minnesota to hold certain taxes in trust and remit those taxes to the Minnesota Department of Revenue. Also, just like with federal withholding taxes, Minnesota Department of Revenue can pierce the corporate veil and assess personal liability on responsible persons within the company. The two most common taxes that are potential sources for the assessment of personal liability are sales and use tax and withholding tax.

To determine whether an individual is personally responsible for unpaid Minnesota taxes, Minnesota Statute §270C.56 states that a person who has the control of, supervision of, or responsibility for filing returns or reports, paying taxes, or collecting or withholding and remitting taxes and who fails to do so, is liable for the payment of those taxes, as well as the applicable penalties and interest on those taxes (note, this is more severe than federal law). Also notice, in Minnesota willfulness is not an element of assessing personal liability – it is only whether the individual was a responsible person. The analysis in Minnesota of determining whether an individual is a responsible person mirrors the analysis at the federal level.

As you can tell the consequences for not withholding the proper taxes both at the federal and state level can be severe. As your company grows, and you hire employees, make sure you also hire an accountant to help guide you through withholding taxes requirements, and as always, when in doubt talk to your attorney.