The IRS Penalty for Unpaid Trust Fund Taxes

Employers are required to withhold federal income tax, Social Security, and Medicare taxes from employee wages. These withholdings are called “trust fund taxes” because the employer holds these funds in trust for the U.S. government before remitting them. This term refers exclusively to employee money a business temporarily holds and is not related to estate or financial trusts. The employer acts as a collection agent for the government, and failing to remit these funds carries significant consequences, including personal liability for those in charge of the company’s finances.

Employer Obligations for Trust Fund Taxes

An employer’s first duty is the accurate withholding of taxes from each employee’s paycheck. Using an employee’s Form W-4, the employer determines the correct amount of federal income tax to deduct. The employer must also calculate and withhold the employee’s share of Social Security and Medicare taxes, known as FICA taxes. These calculations must be precise to ensure the amount held in trust matches the employee’s tax liability.

Once withheld, these funds cannot be used for any other business purpose. The employer must deposit the trust fund taxes, along with the employer’s matching share of FICA taxes, with the federal government. The frequency of these deposits is determined by IRS rules, which classify businesses as either monthly or semi-weekly depositors. Following the correct deposit schedule is a separate compliance requirement from filing tax returns.

The final obligation is to report these activities to the IRS by filing Form 941, Employer’s QUARTERLY Federal Tax Return. This form reconciles the total wages paid, federal income tax withheld, and the Social Security and Medicare taxes for the quarter. The form also records the deposits made during that period, allowing the IRS to verify that the employer has met its duties.

The Trust Fund Recovery Penalty

When a business fails to remit withheld payroll taxes, the IRS can use a collection tool known as the Trust Fund Recovery Penalty (TFRP). The TFRP is a mechanism to collect unpaid trust fund taxes from the personal assets of the individuals responsible for the failure. The Internal Revenue Code provides the legal authority for this action, allowing the government to hold individuals personally accountable.

The TFRP amount is 100% of the unpaid trust fund portion of the taxes, which includes withheld income taxes and the employees’ share of Social Security and Medicare taxes. The penalty does not include the employer’s matching share of FICA taxes. The business itself remains liable for the full tax debt, including the employer’s portion and any other penalties.

Because these funds were never the property of the business, the IRS pursues their collection aggressively. This direct liability ensures that individuals in control of a company’s finances cannot choose to pay other creditors with money that belongs to the U.S. Treasury.

Determining the Responsible Person

The IRS uses a two-part test to determine who is personally liable for the TFRP: the individual must be both “responsible” and “willful.” Responsibility focuses on a person’s status and authority within the business. It is not limited to owners or executives, as anyone with significant control over company finances can be deemed a responsible person, including officers, directors, or a bookkeeper with authority to pay bills.

An individual is considered responsible if they had the duty and power to direct the payment of company funds, regardless of their job title. The IRS investigates who had the effective authority to pay taxes. For instance, a person who can sign checks or has the final say on which creditors are paid meets the responsibility test. Multiple individuals can be identified as responsible persons for the same tax period, and the IRS can pursue collection from any or all of them.

The second part of the test is “willfulness,” which does not require malicious intent to defraud the government. Willfulness is a voluntary, conscious, and intentional act to pay other creditors when the person knew the business had an outstanding trust fund tax liability. Paying vendors, rent, or net payroll while knowing taxes were due is a willful act. This represents a conscious decision to prefer other creditors over the government.

The IRS Assessment and Collection Process

The TFRP assessment process begins when an IRS Revenue Officer identifies that a business has failed to pay its payroll taxes. This may occur when a Form 941 is filed with a balance due or is not filed at all. The officer’s investigation aims to determine why the taxes were unpaid and who had financial control during that time.

A step in this investigation is the interview with potentially responsible individuals, which the Revenue Officer documents on Form 4180. During the interview, the officer asks specific questions about the person’s duties, authority, and knowledge of the unpaid taxes. This information is used as evidence to determine both responsibility and willfulness.

If the IRS determines an individual meets the criteria, it sends Letter 1153 with Form 2751, Proposed Assessment of Trust Fund Recovery Penalty. This letter formally notifies the individual of the IRS’s intent to hold them personally liable. It also outlines the tax periods in question and the total proposed penalty amount.

Upon receiving Letter 1153, the individual has 60 days to file a formal protest with the IRS Independent Office of Appeals. For proposed penalties of $25,000 or less per tax period, a “Small Case Request” may be submitted instead. If the individual does not appeal or the appeal is unsuccessful, the IRS assesses the penalty and issues a Notice and Demand for Payment. The TFRP then becomes a personal debt, and the IRS can use collection powers like federal tax liens and levying personal assets to collect the amount due.