There is a split among the federal Circuit Courts of Appeal whether there is a reasonable cause exception available to avoid the trust fund 100% penalty assessed against responsible persons. The 5th, 6th and 10th Circuits in addition to the Court of Claims holding no: while, the 1st, 7th and 8th Circuits have upheld a reasonable cause exception. The 11th Circuit has not decided that no reasonable cause exception exists but has decided in Thosteson v. U.S. 91 AFTR 2d 2003-2468 that, under any circumstances, no reasonable cause exists when a business owner consciously decides to pay creditors with trust funds.
The trust fund is created when an employer withholds income, social security and Medicare taxes from wages of employees. The funds belong to the government and must be paid to IRS (called deposited although deposit coupons are no longer used as now payments are made on-line) by certain dates depending on the amounts. The withheld taxes are called a trust fund because, in effect, the employer, from the payroll date until the deposit date, holds these funds in trust for the government although the funds are not required to be segregated before being deposited. The trust fund is not to be confused with the employer’s portion of Social Security and Medicare taxes which are an employer obligation but not a trust fund for which a responsible person can be held personally liable. The IRS must credit an employee with withheld taxes reported on Form W-2 whether or not the employer pays over or deposits the withheld trust fund amounts. Obviously, IRS is greatly concerned about undeposited withheld taxes.
In Thosteson, the company in question ran into hard times and used the trust funds withheld from wages to stay afloat by paying its employees and creditors and not depositing the taxes withheld from previous payroll checks. The owner argued that she had no choice but to pay others with the trust fund taxes because to deposit the taxes currently would have made the company close its doors. Because she felt she had no choice, she argued that her failure to deposit was not wilful and that her conduct exhibited ordinary business care and prudence, under the dire circumstances.
The court held that extreme financial stresss does not excuse knowing choices. She intentionally chose not to deposit taxes she knew had to be deposited under law. Thus, she was held reasponsible for the penalty.
Small business owners should follow this simple rule: When you make a payroll, deposit the withheld taxes that very same day regardless of your required deposit date. If you cannot make the deposit do not make the payroll. Not only can you be personally required to pay the undeposited taxes, you can go to jail if certain other factors are present.