Improving Payroll Tax Compliance

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On December 8, 2015, the IRS announced a “New Early Interaction Initiative [that] Will Help Employers Stay Current with Their Payroll.”  I am not sure how the resource strapped IRS will accomplish the effort but it makes great sense to try.  Unpaid payroll taxes create the most frustrating part of the tax gap because employees actually pay their taxes yet the IRS never sees the money because the employers who collect it do not pay it over to the IRS.

From my perspective working on these cases within the IRS, the failure of employers to pay over the collected taxes usually resulted from poor cash management. While a small fraction of employers failed to pay with theft in mind, most employers simply had a bad business model or bad execution of their model.  Businesses with cash flow problems would ignore the IRS as long as possible because the IRS ignored them.  While other creditors lined up at the door to make sure they were paid, the IRS might take six to nine months to get around to pursuing the employer that failed to pay over the taxes they had collected for the IRS.  The delay by the IRS not only caused it not to receive payment but also caused problems for the responsible officers of the business who typically did not realize the long lasting consequences of not paying the taxes such as their personal liability for this debt and the inability to discharge the liability in bankruptcy.

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The announcement does not say what caused the IRS to suddenly wake up to the fact that getting involved early with employers who were not depositing their payroll taxes could make a huge difference in the amount of taxes collected. The announcement says that the “initiative will seek to identify employers who appear to be falling behind on their tax payments even before an employment tax return is filed.”  Because two thirds of federal taxes are collected through the payroll system, maximizing recovery of the payments taxpayers make to their employer who acts as an agent for the IRS is critical to a successful collection system.

The states face the same problems the IRS has with agents who fail to pay over collected taxes. States not only face the problem with employment taxes but their use of sales taxes makes the collection by agents even a larger problem for them.  The IRS should look to the states for ideas on how to improve success in collecting from their agents.  The recent passage by Congress of the ability of the IRS to work with the State Department to revoke the passport of someone with substantial unpaid federal taxes, suggests that Congress is looking at the use by states of licenses as a way to “encourage” compliance in this area or to shut down business that fail to comply with their responsibility to collect and pay over taxes.  The federal government does not issue many licenses but could work with the states to create use of licenses as leverage for payment of federal taxes just as it cooperates with the states to offset state liabilities with federal refunds and vice versa.

Just in case the IRS is interested in more ways to improve this system now that it has announced it will take this first step, I offer and link to several more ideas, based on law review articles I have previously written on this subject, some of which require Congressional action and some do not:

  1. The trust fund recovery penalty (TFRP) serves as a collection device for collecting the payroll taxes when the business does not pay. It generally takes the IRS two or three years to assess the TFRP after the period giving rise to the liability has passed. The person charged with TFRP, however, does not pay interest from the due date of the return but only from the date of assessment because 6672 was placed in the chapter for assessable penalties in 1954. I suggest changing the system to charge interest from the due date of the return not only to pick up additional revenue but also to remove the incentive for the responsible person to fight against imposition of the penalty as long as possible to save on interest charges. If the penalty remains in the assessable penalty section of the Code, no statute of limitations on assessment should exist to have it align with other penalties in that section.
  2. The IRS should require business to identify the responsible officers when they obtain their EIN and on each successive payroll tax return so that it can immediately assess the TFRP against the self-identified individuals and pursue other responsible individuals within the statutory period.
  3. The IRS should provide incentives for small businesses that timely pay their employment taxes. Large business run by executives rather than owners do not need incentives to pay the employment taxes but small business might be encouraged by a small incentive. About half the states provide some incentive for prompt payment of sales taxes.
  4. The IRS should require bonds of individuals seeking to run businesses who have a history of non-payment of employment taxes. If the person has proven untrustworthy, why allow them to serve as an agent again with no safety net? About 80% of the states have some form of bonding requirement for businesses collecting sales taxes.
  5. The IRS should eliminate the withholding credit and the Social Security credit for the responsible officers who fail to pay over the withheld employment taxes. The present system allows the responsible officers to receive the credit on their individual accounts even though they made the decision not to have the agent pay the withheld taxes to the IRS. Why should the responsible person receive credit against their personal liability? Of course, the innocent employees should receive credit for the monies withheld from them by the agent of the IRS but allowing the credit to the person(s) who made the decision not to pay over the withholding does not make sense.
  6. The current IRS practice concerning collection of the TFRP provides an incentive not to pay in situations in which more than one responsible officer exists. The IRS keeps the money of the first responsible officer that pays and either stops its efforts to collect or refunds any excess collected to the later paying responsible officers. The IRS should create a system that incentivizes the responsible officer to pay first and not last. The current system creates a bad collection model by placing the incentive to pay in the wrong place.
  7. The trust fund portions of employment tax returns should be public documents and not documents protected by the disclosure laws. The collection of federal taxes for the IRS and the payment of those taxes over to the IRS should not be treated as private information subject to the disclosure laws but rather as public information to which we are all entitled. These businesses are acting as trustees for us all in this aspect of their business and it should not be cloaked with the privacy to which their returns are entitled with respect to their own tax liabilities.

As an author of law review articles I often had the feeling of a tree falling in the forest with no one around. I questioned whether the article really made any sound other than to advance my effort to obtain tenure or to secure a writing bonus.  Writing the blog gives me much greater gratification that someone is actually reading what I write even though having people read what I write inevitably leads to people pointing out what I have written is wrong or does not make sense.  I appreciate this opportunity to rehash old law review articles that I think still offer some ideas in the area of collected taxes that have not been explored at the federal level.  We all benefit from the efficiency of our current system where most taxes are collected from intermediaries.  We all also benefit when those intermediaries follow through on their obligations to pay over collected taxes.  The businesses that do not follow through on this gain an inappropriate competitive advantage over those that do comply in addition to harming all of us by reducing the amount that enters the federal coffers.

As a part of the announcement Commissioner Koskinen stated that “Employers play a key role in our tax system, and we want to offer them the information and assistance they need to carry out that responsibilities [sic]. With early interaction; we will be able to offer help weeks or even months sooner, when it can often do the most good.”  While getting the employers to pay over the collected taxes obviously benefits the IRS and makes the remarks somewhat self-serving, I agree with the Commissioner that the IRS can assist small businesses by getting on the scene early.  For too long the IRS has played the role of bad guy coming in at the end to shut down the business after the owners paid creditors of lower priority who would not have had the ability to pierce the corporate veil and hold the officers personally responsible.  By getting their early, the IRS can perhaps make small business owners aware of the importance of paying the collected taxes before it is too late to save the business and before it is too late to avoid a significant and non-dischargeable personal liability.  It will be interesting to see if the IRS can actually do this at a time of significant austerity at the agency.

 

 

 

 

 

 

Comments

  1. Keith, thanks for focusing on this very important issue. My experience in the area is much more limited than yours, but my attitude is similar. I hope my initial reactions to some of your ideas may help in refining them into workable and equitable proposals that may gain traction:
    1. Interest on TFRP: I agree that interest should start running sooner in at least some cases. But I think it would be unfair for interest to start running against a specific potentially responsible person [“PRP”] unless and until the date as of which it’s been established that the PRP had both the necessary control over the employer’s finances and had willfully failed to pay over a specific amount of the delinquency [i.e., had paid or permitted others in the company to pay third party creditors before paying over the withheld taxes to the IRS]. (I don’t know enough about the statute of limitations in these cases to have an opinion at this point.)
    2. Identifying “responsible persons” when an EIN is obtained and on each payroll tax return: Sounds good, but I think it’s too complicated for many businesses. The legal and factual determinations required to do this are often hard for experts. Changes in personnel and responsibilities could cause innocent employees to be burdened by being required to hire professionals to defend them or have adverse collection action taken against them while they try to prove a negative.
    3. Incentives for small businesses to pay over withheld taxes promptly: Good concept. The devil might be in the details.
    4. Requiring surety bonds for persons who previously violated their obligations to pay over withheld taxes: Sounds good on paper, but the costs of administration may make it unworkable. There aren’t a large number of individuals who have been “proven untrustworthy,” and those individuals might try to avoid the provision by using someone else to hold the title to which the bonding requirement would otherwise apply.
    5. Eliminating withholding credit for persons finally determined to have been subject to the section 6672 penalty: I think I’d support this, but I’d want to be sure the amount of credit denied was commensurate with the responsible person’s degree of responsibility for specific dollar amounts. I’m not sure how I’d make that determination.
    6. Incentivizing responsible persons to pay sooner rather than later: The present statutory scheme seems to eliminate the incentive for the IRS to collect from more than one responsible person or to determine the relative degrees of responsibility where there’s more than one PRP. The first responsible person who pays the IRS is then left to his/her own devices as to how to obtain contribution from other PRPs, without the kinds of collection powers that the IRS can exercise [or has exercise] against him/her. This is a tough dilemma that may need a legislative solution that would be hard to craft. I’d be interested in seeing a more specific, detailed proposal.
    7. Public availability of “trust fund portions” of employment tax returns: I think this is a non-starter, as a practical matter. I admit that’s a gut reaction rather than a thoughtful analysis. I’d be interested in hearing the detailed pros and cons.

    Thanks again for raising this in the context of what can be done to improve current practices. Most of the time, this issue only gets hand-wringing attention without specifics as to how to improve the current broken system.

    Ron

  2. Bob Kamman says:

    Doesn’t IRS announce such an initiative every decade? I suggest Commissioner Koskinen (age 76) adopt the Mario Savio model of tax administration. Don’t trust anyone over 30 to solve these problems with 20th-Century thinking.

    Back in the old days, making federal payroll tax deposits was relatively inconvenient. Most employers had to write a check to a bank, then present it to a teller in a face-to-face transaction. (I think I sometimes used a night-deposit box.) Today, it can easily be done online. In many cases, even small employers don’t write paychecks. They use payroll processing companies like ADP, or they deposit funds themselves directly to employee bank accounts.

    The law should require a payment to IRS, every time a payment with tax withheld is made to an employee. There could be a de minimis exception, say for total annual payrolls of less than $25,000. And why should the payday deposits be made to the employer account? If Congress wanted to eliminate many identity-theft problems, it could fund a modern computer system that allows an account for every employee. Workers could check online to see if the amounts on their pay statements matched the amounts in their tax account. If not, it would be a clue that they should start looking for another job.

    Employers could be given a credit for using software or a third party processor to comply with this system. Give them a huge credit, in fact. Maybe as much as half the savings from the staffing cuts made possible in IRS revenue officers (many of whom, at their age, should be retired anyway).

  3. What if we implement this new approach, which is consonant with this purportedly free republic we call home:

    Relieve employers of all responsibility for others’ taxes.

    Why should we impose on one person a duty that properly belongs to a different person? The law compels employers to deduct, withhold, account for, and pay over others’ taxes without recompense. It thus effectually conscripts employers to serve as unpaid state and federal tax collectors. That compulsion has no place in the alleged land of the free.

    Let the actual taxpayer take care of his own taxes. If he cannot or will not do so, then the tax system is at fault and must be replaced with one that better suits the people’s preferences.

    The author of this post, and its two commenters, suggest compulsory measures one would find in a Fascist state. Their suggestions may make “the trains run on time,” but at what cost to our rights as a free people?

    • Bob Kamman says:

      Ronald Reagan certainly would have agreed with you in 1967. Even as his California budget included the largest tax hike ever proposed by any governor in the history of the United States, he remained opposed to collecting state income taxes through payroll withholding. It was party dogma. The California deficits remained, however, and in 1971 he signed off on payroll withholding. Say what you will about Reagan, but at least he could be a realist.

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