Unpaid Payroll Tax Liability
Owners of a corporation or LLC with employees can be held personally responsible for the unpaid payroll tax liability. Businesses must withhold income tax and Social Security tax from paychecks and pay the IRS. Any owner, officer, manager or employee of the business who exercises control or supervision over any tax and financial affairs of the entity; handles or supervises any disbursement of funds; or sets priorities of payments among creditors are known as a responsible party.
According to the IRS, a responsible person is a person or group of people who has the duty to perform and the power to direct the collecting, accounting, and paying of trust fund taxes. Responsible persons include those who sign the SS-4 to obtain the FEIN, sign tax returns, have the authority to sign checks, have signed checks, or direct such actions. Responsible persons include offices, directors, members, managers, employees or any other responsible party. Persons with nominal authority but without actual authority (i.e., they do not have the authority to decide who gets paid) usually avoid liability. An example is an accountant who prepares and signs checks but does not have the authority to send the checks without prior approval of a responsible person.
The responsible party is personally liable for any unremitted required withholdings. These withheld taxes are “trust fund” taxes. In addition to being personally liable for the amount of the tax, there is an additional penalty equal to 100 percent of the amount owed. The IRS can assess a Trust Fund Recovery Assessment, also known as a 100-percent penalty, against each and every “responsible person.” The IRS says that every officer is responsible and that some non-officers with signature authority are also.
The TFRA penalty may be assessed against any person who:
- is responsible for collecting or paying withheld income and employment taxes, or for paying collected excise taxes; and
- willfully fails to collect or pay them
Using available funds to pay other creditors when the business is unable to pay the employment taxes is an indication of willfulness.
Misclassification as an independent contractor
You can be personally responsible for payroll tax liability by not classifying yourself or any other employee as an independent contractor. When the IRS and state taxing authorities find businesses have inappropriately avoided payroll taxes, the taxes, interest, and penalties can be severe. In some cases, there can even be criminal liability. Many people try to call themselves or some officer or direct an independent contractor to the corporation, but in reality, they are employees. When companies use independent contractors, the IRS frequently will assert that those workers are really company employees.
Your state’s taxing authority also may claim that independent contractors really are employees. If you’re the officer of an S corporation, for example, you cannot issue a 1099 to yourself. You cannot be a contractor to your own corporation. You cannot be an independent contractor as the sole shareholder and officer of your own S corporation. You will end up paying self-employment taxes anyhow if you don’t pay yourself wages, just on all of the income you earn.
You can’t be an independent contractor performing services on behalf of the corporation and still be an officer. An officer/shareholder of a corporation is generally an employee, but an officer who performs no services or only minor services, and who neither receives nor is entitled to receive any pay, is not considered an employee, according to the IRS. Courts have consistently held S corporation officers/shareholders who provide more than minor services to their corporation and receive, or are entitled to receive, compensation is subject to federal employment taxes. The IRS has said over and over again that S-Corporations must pay their shareholder-employees a “reasonable compensation” for services rendered to the company. The courts have consistently found shareholder-employees are subject to employment taxes even when shareholders take distributions, dividends or other forms of compensation instead of paying wages.
A director of a corporation may not be an employee of the corporation, but he or she can be one depending upon the specific responsibilities. The employee relationship would be considered as separate from his or her position as a director. Generally, being a mere director without more will not make one an employee of the Company. But, if he or she is managing director or executive director, or is getting a salary for rendering some services, then that person will be considered to be an employee. State law is similar to the IRS rules, but you must check any applicable state laws to know for sure how your state classifies employees.
Because LLC members are not considered employees of the LLC, but rather self-employed, they are not subject to withholding taxes. Instead, each LLC member is responsible for setting aside enough money to pay taxes on his share of the profits. However, an outside manager who is not a member will be considered to be an employee. In general, equity owners of an LLC may not be treated as employees of that LLC. Also, with respect to an LLC that has elected to be taxed as a corporation (either C or S), the members may be treated as W-2 employees of the LLC in this case. The bottom line is that to the extent someone is classified by the IRS or any state taxing authority as an employee of your business, you can be liable for any unpaid employment taxes if you are a responsible party.
Although rare, officers of a company can face personal liability for non-payment of wages. In Boucher v. Shaw, the Ninth Circuit Court of Appeals held employees of a bankrupt business could pursue claims against the CEO and CFO. Despite the bankruptcy, the plaintiffs were able to successfully sue these officers personally for unpaid wages. However, this case was in the 9th Circuit and may not be followed in other Circuits.
In addition, some states, such as Illinois’s Wage Payment and Collection Act (820 ILCS 115/13), provide certain requirements regarding wage payments, including frequency and final payments. Illinois’s act imposes personal and sometimes criminal liability on the officers and agents of any employer for violating certain provisions of the Act. Many states have similar laws so be sure to review the wage and employment laws of any state your business has employees.
Unpaid Worker’s Compensation Insurance
Most states impose personal liability, even criminal liability in some cases, on the individual officers and directors, members and partners for failure to provide worker’s compensation insurance coverage as required under state statutes.
Many states provide for personal liability (sometimes criminal liability) of the officers, directors and members of LLC’s for violating state unemployment contribution/tax laws. Unemployment contributions are required by businesses with employees under state law. Again, be sure to check the laws of the specific state where any of your employees reside.
Other than payroll tax liability, there can be other avenues of potential personal liability stemming from a violation of some state or federal law with regard to your employees. Specifically, the Family Medical Leave Act states that claims against individual managers and officers who have played a role in denying an employee’s FMLA rights can be made personally against them.
The bottom line: if you have or are planning on hiring employees, you should really speak to an employment attorney familiar with the laws of the domicile of the employees.