Operating a business in corporate form usually protects the individual owner from personal liability for corporate debts. However, the “corporate shield” is pierced in cases involving unpaid payroll taxes. All employers are required to withhold federal income tax and Federal Insurance Contributions Act (FICA) tax from employees’ wages. The withheld taxes are held in trust for the federal government and are generally referred to as “trust fund taxes.”1
When a corporation fails to remit the withheld taxes to the government, the IRS looks through the corporation to the individual or individuals who are responsible for the failure. Once the IRS has identified a “responsible person” or persons, those individuals will be held personally liable if the IRS determines that the failure to pay was willful, and a penalty will be assessed against the responsible person in an amount equal to the unpaid trust fund taxes.2 The trust fund recovery penalty (also known as the 100% penalty) applies to the failure to collect, account for, and pay over third-party taxes, but not to taxes that are paid directly, such as the employer’s share of FICA taxes or to penalties or interest owed on the delinquent trust fund taxes.3 For purposes of the penalty, a person is defined to include an “officer or employee of a corporation” who is “under a duty to perform the act in respect of which the violation occurs.”4 The purpose of the penalty is to encourage prompt payment of the withheld taxes and to ensure they will be collected from a secondary source.
The IRS and the courts have taken a broad view of who is a “responsible person.” Such a person has been described as an individual who has ultimate authority for the decision not to pay the trust fund taxes;5 effective power to pay the taxes;6 authority to direct payment of creditors;7 significant control or authority over the business finances;8 or control over allocation of funds.9
Attempts to defeat the label of responsible person have been largely unsuccessful even when other people act with malfeasance or other parties could also be held liable. Embezzlement of the trust fund taxes by one officer did not relieve another officer of liability,10 nor did the embezzlement of the trust fund taxes by a payroll agent relieve the employer from liability.11 The finding that a third party was a responsible person did not relieve the corporate officer of liability.12 Similarly, the finding that one corporate officer was a responsible person did not relieve another officer of liability.13 The finding that the IRS did not join other parties who were responsible persons did not relieve the taxpayer of his liability.14 The IRS’s entering into preferential settlements with other taxpayers did not relieve the taxpayer of liability.15 An installment agreement between the IRS and the corporation did not relieve a corporate officer of personal liability, because the agreement was between the IRS and the corporation and no delegation of the obligation to pay tax will relieve a responsible person of liability.16 Showing that one responsible person was financially able to pay the penalty did not relieve other responsible persons from personal liability.17
Trust Fund Taxes and Bankruptcy of the Business
As the above discussions illustrate, there is a very real incentive for responsible persons to make sure trust fund payroll taxes are paid. Owners of most owner-managed businesses qualify as responsible persons. Because owner-managed businesses that are experiencing financial difficulties cannot pay all their liabilities with operating income, the owners frequently resort to paying liabilities with borrowed funds for which the owners are personally liable (e.g., credit cards or personally guaranteed lines of credit). In many cases, they use borrowed funds to pay trust fund taxes.
After the business fails, the owners are forced to file for bankruptcy because they cannot pay the personal debts they incurred related to the business. Trust fund taxes are nondischargeable in bankruptcy, and bankruptcy law generally makes debts incurred to pay taxes, including trust fund taxes, nondischargeable. This essentially leaves the owner in little better position than if he had not paid the taxes and the IRS had assessed the 100% penalty. However, as a recent case illustrates, an individual in bankruptcy may be able to avoid this result in certain circumstances.
Van Dyn Hoven
In Van Dyn Hoven,18 a district court reversed and remanded a bankruptcy court decision in Wisconsin and ruled that the taxpayer, Richard Van Dyn Hoven, the sole shareholder of his corporation, was not personally liable for the corporation’s payroll taxes. The corporation was experiencing financial difficulties and regularly overdrew its bank balance at the Bank of Kaukauna. The bank paid many of these overdrafts, some of which were used to pay payroll taxes. Eventually, the overdrafts were rolled into one or more bank notes between the corporation and the bank, which Van Dyn Hoven personally guaranteed.
Van Dyn Hoven filed for bankruptcy and sought to have his obligations to the bank discharged. The bank objected and argued that the overdrafts used to pay the corporate payroll taxes were not dischargeable in bankruptcy.
Bankruptcy Code Section 52319 excepts from discharge any debt to pay a tax owed to the United States or other governmental entity that would itself be nondischargeable to the debtor. This provision is intended to prevent substituting an obligation that is nondischargeable with one that is dischargeable in bankruptcy. For example, an individual could pay his or her income taxes (a nondischargeable debt) with a credit card (a dischargeable debt) and file for bankruptcy to discharge the credit card debt. In the bankruptcy case,20 the bankruptcy court found that the debt used to pay the corporate payroll taxes was not dischargeable and held Van Dyn Hoven personally liable to the bank under his guarantee. According to the court, the payroll taxes are a nondischargeable debt regardless of the personal guarantee of the bank loan, a dischargeable debt, followed by a subsequent bankruptcy declaration.
Van Dyn Hoven argued that the bankruptcy court erred in not allowing him to discharge debt used to pay overdrafts for payments of payroll taxes. He noted that the taxes the bank paid were the corporation’s, the taxes had been timely paid, and therefore he could never have been found to be personally liable for them. The bankruptcy court reasoned that allowing the responsible person to arrange to pay the payroll taxes with money the corporation borrowed would circumvent the intent of the Bankruptcy Code by allowing individuals to substitute nondischargeable debt with dischargeable debt. The court noted that Bankruptcy Code Section 523 defines debt to include contingent claims and that Van Dyn Hoven was at least contingently liable, as a responsible person, for the corporation’s payroll taxes. The court also noted that Van Dyn Hoven’s guarantee of the corporate debt made him personally liable to the bank for nondischargeable debt to the extent of the payroll taxes it paid on his behalf.
Van Dyn Hoven based his argument on White.21 In White, the debtor paid the corporate payroll taxes with borrowed money. In bankruptcy, the creditor argued that the debt should not be discharged because the money was used to pay payroll taxes that were not dischargeable under Section 523. The bankruptcy court in White disagreed, noting that the payroll taxes had been timely paid and that the debtor could not have been said to have incurred the debt to pay the payroll taxes. The court further stated that even if the payroll taxes had not been paid, the IRS would first have to find that the debtor was a responsible person and then show that the debtor willfully failed to pay the payroll taxes. In the words of the court, there was “many a drip between the cup and the lip before liability can be asserted against an individual under 26 U.S.C. §6672” and that the debtor could not be held personally liable merely because the corporation failed to pay the payroll taxes. The court further noted that even if the debtor were found to be liable as a responsible person, the liability is not for the unpaid taxes but rather for the 100% penalty and, therefore, the most that could be said was that the debtor was personally contingently liable for the payroll taxes had they not been paid. Because the debt was not incurred to pay the payroll taxes, it could be discharged in bankruptcy.
In Van Dyn Hoven, the bankruptcy court found White unpersuasive and relied on Cook.22 In Cook, the debtor paid his corporation’s payroll taxes with his personal American Express card. American Express argued that the debt should not be discharged, while the debtor argued that the debt should be discharged because the taxes were not his personal liability but the liability of the corporation. The court in Cook rejected his argument, noting that Section 523 excepts from discharge debt incurred to pay taxes if the taxes would be nondischargeable. The court further noted that the Bankruptcy Code included taxes “required to be collected or withheld and for which the debtor is liable in whatever capacity.” The court concluded that the debt could not be discharged as the debtor would have been personally liable for nonpayment of payroll taxes in the form of a 100% penalty. The court held “[t]here is nothing in the Bankruptcy Code which requires that the IRS must have made an assessment against the responsible official before the exception to dischargeability is triggered.”
On appeal, the U.S. district court reversed the bankruptcy court. The district court agreed with the bankruptcy court that the IRS need not make an assessment against the responsible person before the exception for discharge of debt used to pay payroll taxes is triggered. However, the district court explained that there must be a showing that a debtor willfully refused to pay the payroll taxes. In Cook, the debtor paid four tax payment notices with his personal American Express card. In Van Dyn Hoven’s case, the corporate payroll taxes, like all of the company’s expenses, were paid in the normal course of business. There was no evidence that Van Dyn Hoven knew that the payroll taxes were being paid with borrowed funds. The bank had been honoring overdrafts while the company was regularly depositing monies from operations into the account. Indeed, it was not until Van Dyn Hoven filed for bankruptcy that the bank claimed the payroll taxes were paid with borrowed funds.
The district court also noted that there was no evidence that Van Dyn Hoven incurred the debt to pay the payroll taxes. The court cited Stephenson,23 which determined the phrase “incurred to pay a tax” as used in Section 523 means the debt was incurred “for the purpose of paying Federal or state taxes.” Otherwise, the court reasoned, the exceptions to discharge in bankruptcy would become open invitations to attempt to trace all bank loans to unpaid payroll taxes regardless of how and when the debt was originally incurred.
In Van Dyn Hoven’s case, the corporation paid its payroll taxes from the same account used to pay payroll and other operating expenses in the normal course of business. There was no evidence that Van Dyn Hoven or any other company employee applied to the bank for a loan to pay the payroll taxes. The fact that the bank honored the overdrafts had the effect of extending the company a line of credit that the company used to stay in business. Additionally, the bank rolled previous overdrafts into a series of notes from the bank to the corporation. Extending the bank’s reasoning would allow the bank to attempt to trace the notes to unpaid payroll taxes. This, the district court stated “is far beyond what the exceptions to discharge in section 523(a)(14) and (14A) were intended to accomplish.”24
The district court reasoned that it would be unfair to hold Van Dyn Hoven personally liable by not discharging the debt in bankruptcy as Section 523 was added to prevent individuals who failed to pay their taxes from obtaining a discharge from liability for such a debt by using unwitting creditors to substitute ordinary debt for a nondischargeable tax liability. The court stated that the bank offered no evidence that Van Dyn Hoven incurred the debt to pay the payroll taxes and there was no evidence that the bank acted unwittingly in continuing to extend credit to the corporation. Instead, there was evidence that the bank was aware of the corporation’s financial condition and that the bank carefully monitored the corporate checking account. That set of circumstances is clearly distinguishable from Cook, in which the responsible person used a personal credit card to pay his business’s payroll taxes three months before he and his wife filed for bankruptcy. In that case, the use of credit card debt, a dischargeable debt, was directly traceable to the payment of payroll taxes, a nondischargeable debt.
The district court stated that in Cook
the debtor was aware of the direct tax liability to the taxing authority which was immediately due and owing, and the debtor intentionally borrowed money in his own name for the purpose of paying taxes that were otherwise nondischargeable. Not so here, where the Bank extended credit to [the corporation]—not Van Dyn Hoven himself—for a variety of legitimate business purposes, including but not limited to the payroll taxes.25
The district court reversed and remanded the bankruptcy court and permitted the debt to be discharged in bankruptcy, thereby allowing Van Dyn Hoven to avoid personal liability for the corporation’s payroll taxes.
Warning for Taxpayers
Many failing businesses struggling to pay their bills often put off paying payroll taxes in favor of other creditors to assure continued supply of needed goods and services. Individuals responsible for paying the business’s bills may hope the business improves before the IRS catches up, or they may believe the payroll tax debt will be discharged in bankruptcy. These individuals often fail to realize that not only are the payroll taxes not dischargeable in bankruptcy, but they also may be held personally liable to the IRS for the trust fund recovery penalty.
The likelihood of complications arising from the payment of nondischargeable payroll taxes with loans personally guaranteed by business owners increases as companies try to emerge from the financial crisis of recent years through their quest for business survival or through business or personal bankruptcy. Although the vast majority of cases on this subject have gone against the individuals, the Van Dyn Hoven case shows that individuals may avoid personal liability under the following set of circumstances:
- The debtor does not knowingly use borrowed funds in the ordinary course of business to pay payroll taxes;
- There is no evidence that a creditor unwittingly continues to extend credit to the corporation for the purpose of paying payroll taxes;
- The debtor does not use personal credit cards to pay payroll taxes;
- The debtor does not apply to a bank for a loan to pay payroll taxes; and
- The debtor does not intentionally substitute dischargeable (i.e., ordinary) debt for nondischargeable debt (e.g., payroll taxes).
Because of the factual nature of the inquiry, each situation must be evaluated on its own merits to determine whether a taxpayer can avoid liability.
Authors’ note: The research contained in this paper was supported, in part, by a summer research grant from the Frank G. Zarb School of Business at Hofstra University.
1 Secs. 3402 and 3501.
2 Sec. 6672(a).
3 Regs. Sec. 301.6672-1.
4 Sec. 6671(b).
5 White, 372 F.2d 513 (Ct. Cl. 1957).
6 Gustin, 876 F.2d 485 (5th Cir. 1989).
7 Kinnie, 994 F.2d 279 (6th Cir. 1993).
8 Ruth, 823 F.2d 1091 (7th Cir. 1987).
9 Bowlen, 956 F.2d 723 (7th Cir. 1992).
10 Scott, 702 F. Supp. 261 (D. Colo. 1988).
11 Pediatrics Affiliates, P.A., 230 F. Appx. 167 (3d Cir. 2007).
12 Labowitz, 352 F. Supp. 202 (S.D.N.Y. 1972); Rizzo, No. 71 S-1 (N.D. Ind. 1/4/73); Sinder, 655 F.2d 729 (6th Cir. 1981).
13 Marker, No. 70-1210 (E.D. Pa. 8/24/73); Bernardi, No. 70 C-3316 (N.D. Ill. 12/5/73); Kynell, No. C-72-481 SW (N.D. Cal. 1/24/74).
14 Stiber, No. 72-735 (E.D. Pa. 7/31/73); Borland, 125 F. Supp. 2d 212 (E.D. Mich. 2000); Leiter, No. 03-2149-GTV (D. Kan. 1/22/04); McLaren, No. CV-53-BU-RFC (D. Mont. 9/28/07).
15 Neier, 127 B.R. 669 (D. Kan. 1991); Beeler, T.C. Memo. 2009-266.
16 In re Lynch, 187 B.R. 353 (Bankr. N.D. Ala. 1995).
17 Farrington, 920 F. Supp. 12 (D.N.H. 1996).
18 Van Dyn Hoven v. Bank of Kaukauna, No. 12-C-0076 (E.D. Wis. 5/11/12), rev’g and remanding No. 10-28421 (Bankr. E.D. Wis. 11/3/11).
19 11 U.S.C. §523.
20 Van Dyn Hoven, No. 10-28421 (Bankr. E.D. Wis. 11/3/11).
21 White, 455 B.R. 141 (Bankr. N.D. Ind. 2011).
22 Cook, 416 B.R. 284 (Bankr. W.D. Va. 2009).
23 Stephenson, No. 07-10778-SSM (Bankr. E.D. Va. 11/30/07).
24 Van Dyn Hoven, No. 12-C-0076, slip op. at 9.
25 Id. at 10.
Steven Petra is the director of graduate programs in taxation in the Frank G. Zarb School of Business at Hofstra University in Hempstead, N.Y. Nina Dorata is an associate professor in the Peter J. Tobin College of Business at St. John’s University in Queens, N.Y. For more information about this article, contact Prof. Petra at email@example.com.