March 19, 2015

Your Partnership’s Employment Tax Debt May Come Back to Bite You

Betty J. Boyd

If you are a general partner, you can be liable for your partnership’s employment tax debt, even if there was no tax assessment or judicial action against you personally. What else? Much of this tax debt may not be dischargeable in bankruptcy.

This is what happened to Wendy K. Pitts, a general partner of DIR Waterproofing (DIR). When DIR failed to pay all of its employment taxes under the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA), Ms. Pitts was faced with a tax bill of nearly $135,000 dollars. When Ms. Pitts was unable to pay this amount, the IRS placed liens on her personal property.

In an attempt to be relieved from her hefty tax bill, Ms. Pitts filed for Chapter 7 bankruptcy and argued the IRS liens were invalid and the tax debt was dischargeable. The bankruptcy court disagreed, ruling that Ms. Pitts was completely liable for all of her partnership’s employment taxes in her position as a general partner. Worse yet, the court found the bulk of these taxes not to be dischargeable, meaning she was still liable to pay the partnership’s tax bill. When Ms. Pitts appealed her case to the Central District Court of California, this ruling was upheld. What can you do to help prevent this from happening to you?

This article presents a brief primer on employment taxes and their interaction with bankruptcy law. Next, this article comments on In re Pitts, 497 B.R. 73 (2013); 515 B.R. 317, 320 (C.D. Cal. 2014), and briefly discusses the lessons to be learned from this case.

What are Employment Taxes?

Ms. Pitts’ financial trouble began when her partnership DIR failed to fully pay its employment taxes. Generally, a business is required to pay employment taxes to the federal government. A portion of these taxes is paid by deducting a certain amount from employees’ wages or salaries and placing it in trust until payment is made to the government (this portion is known colloquially as “trust fund” taxes).

Failing to pay its employment taxes is one of the early signs that a business is suffering financial difficulty. A business may sometimes pay wages to its employees and make payments to its vendors, but neglect to pay the IRS’ employment taxes in hope of catching up with its liabilities when its financial situation improves. Often, the business does not financially catch up and the business’ employment tax liability becomes larger, due to penalties and daily interest accruing on the delinquent tax liability and penalties.

In the Pitts case, the two main forms of employment taxes that DIR failed to fully pay were FICA and FUTA. FICA is a payroll tax used to fund Social Security and Medicare. It is comprised of 6.2 percent Social Security tax and 1.45 percent “regular” Medicare tax. (An additional 0.9 percent Medicare tax was added to FICA, starting in 2013.) This tax is paid by both employee and employer contributions through employees’ wage or salary withholdings and by employers’ payments of excise taxes, respectively. Employers withhold these taxes from employees’ wages (this withholding is the trust-portion of FICA) and pay a matching amount (this excise tax contribution is the non-trust-portion of FICA). The matching portion represents the business’s share of FICA.

FICA is reported on Form 941, or the Employer’s Quarterly Federal Tax Return, for the quarters ending March 31, June 30, September 30, and December 31. (These are quarter-ending dates, not tax return due dates; wages paid after these dates are applied to the next quarter). Using the electronic fund transfer, FICA is deposited monthly (if the look-back period exceeds $50,000) or semiweekly (if the look-back period is equal to $50,000 or less).

FUTA is a payroll tax used to fund unemployment compensation programs. Unlike FICA, only employers pay FUTA, based on a percentage of their employees’ wages or salaries (6.2 percent on the first $7,000 of the employee’s wages). There are no employee withholdings for FUTA.

FUTA is reported annually on Form 940, or the Employer’s Annual Federal Unemployment Tax Return. FUTA is calculated on a quarterly basis and is generally deposited on a quarterly basis (unless the partnership’s liability is $500 or less, in which case it can be deposited on the Form’s due date of February 2). Like FICA, FUTA is deposited through the Electronic Federal Tax Payment System (EFTPS).

The IRS does not take the failure to pay employment taxes lightly. A business is liable for employment taxes, even if it outsources its payroll duties to a payroll agent. There are penalties for deposits that are one day late, and these penalties increase in percentage as the delay lengthens. Thus, it is important for a business to periodically verify that the appropriate deposits and payments are made. If the payroll agent misappropriates the employment-tax funds, the IRS can collect employment taxes and penalties against both the payroll agent and the business (but can collect these amounts only once, whether from the payroll agent or the business).

The IRS especially scrutinizes the trust-fund portion of employment taxes (i.e., those FICA taxes that a business withholds from employees’ wages and salaries). The IRS imposes additional hefty penalties upon those individuals responsible for paying these taxes if they willfully evade doing so.

Are Employment Taxes Dischargeable in Bankruptcy?

The first and harshest rule about employment taxes is that the trust-fund portion of employment taxes are never dischargeable in bankruptcy (we shall refer to this rule as the “Trust-Fund Rule”).

Additionally, tax liabilities that are not self-reported are never dischargeable in bankruptcy; even if these tax liabilities would otherwise be dischargeable (we shall refer to this rule as the “No-Return Rule”). Thus, it is important that a business timely files its Form 940 and 941 Returns. Substitute Form 940 and 941 Returns that are prepared by the IRS do not constitute a return for dischargeability purposes. Therefore, if the IRS prepares a substitute form return before the business does, the tax liability arising from that form is not dischargeable in bankruptcy, unless the subsequent business’ form return reports a tax amount greater than the IRS’ substitute form return. That is, the amount assessed in the IRS’ substitute form return is not dischargeable in bankruptcy – only the difference between the business’ subsequent form return and the IRS’ form return is potentially dischargeable in bankruptcy (or the amount exceeding the amount assessed in the IRS’ form return).

The non-trust portion of employment taxes (i.e., the business’s matching share of FICA) and FUTA taxes are also not automatically dischargeable in bankruptcy. Tax liabilities are dischargeable only if they meet all of these three rules:

  1. “Three-Year Rule”: The income taxes must relate to a year in which the tax return was due (including requested extensions) at least three years prior to the filing of the bankruptcy petition.
  2. “240-Day Rule”: The income taxes must have been assessed more than 240 days from the filing of the bankruptcy petition.
  3. “Late-Return Rule”: If the tax return is late, then at least two years need to have passed before the filing date of the bankruptcy petition. Substitute returns prepared by the IRS do not count as a filed return for this rule. Beware, thus far, the Fifth and Tenth Circuits have held that a return filed one day late is not dischargeable.

Further, it goes without saying, that any return based on fraud or any attempt to willfully evade a tax is not dischargeable in bankruptcy.

The Facts in the In re Pitts Case

In the Pitts case, DIR failed to fully pay its FICA and FUTA employment taxes for 2005, 2006, and 2007. Consequently, on June 21, 2007, and August 7, 2007, the IRS issued Notices of Taxes Due to the partnership, addressing the partnership DIR as the taxpayer and Ms. Pitts as the general partner, for a total tax liability of nearly $135,000. Then, when these taxes remained unpaid, the IRS filed four Notices of Federal Tax Lien from January 2007 through January 2008. The end result was that the IRS encumbered Ms. Pitts’ personal property, because her partnership failed to pay all of its employment taxes.

Hoping to be relieved of this enormous tax debt, Ms. Pitts filed a voluntary Chapter 7 bankruptcy petition, on March 1, 2012. The bankruptcy court first determined whether Ms. Pitts was liable for her general partnership’s tax debts and, second, whether these tax debts were dischargeable.

Ms. Pitts Was Liable for All General Partnership’s Tax Debts

Ms. Pitts argued that she was not liable for DIR’s tax debts, but the bankruptcy court disagreed. Ms. Pitts’ first argued that the tax liability is barred by the three-year statute of limitations of the California Corporations Code Section 16307, which made a general partner liable for her general partnership’s debts. The court rejected this argument, holding that “the collection of federal taxes (which has a 10-year statute of limitations after assessment) is a sovereign function and that the IRS’ ability to collect taxes cannot be constrained by state collection statutes.” Citing the seminal case, U.S. v. Galletti, 541 U.S. 114 (2004), the bankruptcy court held that a single assessment (which is the recording of a tax, penalties, and interest charged to a taxpayer’s account, acting as a judgment for taxes due) against the partnership is sufficient against a general partner. In short, the IRS may proceed with administrative collection procedures against a general partner personally, with a single assessment against the general partnership and without commencing litigation.

Next, the bankruptcy court rejected Ms. Pitts’ second argument that she did not receive proper notice, because DIR was addressed as the taxpayer with its EIN, while Ms. Pitts was addressed as only the general partner without referencing her Social Security number. The bankruptcy court held that the IRS gave proper notice by mailing the notices of deficiency and demand for payment to DIR’s offices and/or Ms. Pitts’ residence and by identifying both parties in these notices.

In summary, the bankruptcy court found that Ms. Pitts was liable for all of her partnership’s tax debts. Next, the bankruptcy court determined the extent to which these tax debts were dischargeable.

Ms. Pitts’ Tax Debts Were Not Dischargeable

Having found that Ms. Pitts was liable for all of her partnership’s tax debts, the bankruptcy court first held that all the trust fund portions (FICA taxes withheld from the employees’ wages) of DIR’s employment taxes were not dischargeable. This was explained above as the “Trust-Fund Rule” Thus, the trust portion of DIR’s taxes was not dischargeable for all the quarterly employment-tax periods that ended December 31, 2005, through December 31, 2007.

Similarly, the non-trust portion of DIR’s taxes for the quarterly employment-tax periods for ending March 31, June 30, September 30, and December 31 in 2006, was not dischargeable because of the “No-Return Rule.” The IRS prepared substitute form returns and assessed these taxes before DIR filed its form returns for the quarters at issue. Thus, the taxes for these form returns were not dischargeable. However, the penalties associated with all of these 2006 tax quarters are dischargeable because they relate to a transaction or event that occurred more than three years before the March 12, 2012, bankruptcy petition date.

On the other hand, DIR’s annual FUTA taxes for the period ending December 31, 2006, were partially dischargeable and partially not dischargeable. In this case, DIR failed to timely file its Form 940 Return, and the IRS prepared a substitute form return before DIR, as explained above in the “No-Return Rule,” in which tax liabilities associated with a return that has not been filed are not dischargeable. A substitute return does not constitute a return filed by the business. If a business files a subsequent form return that reports a greater tax liability than the IRS’ substitute form return, then only the portion that would be dischargeable is the excess (that is, the amount exceeding what was reported in the substitute form return). Here, the amount of taxes reported on the IRS’ Form 940 Return was not dischargeable, but the excess amount reported on DIR’s subsequent Form 940 Return was dischargeable.

The balance of DIR’s tax liabilities was dischargeable, because of the “Three-Year Rule” explained above. The non-trust portion (DIR’s matching-share of FICA taxes) of DIR’s taxes and penalties for the quarterly employment-tax period ending December 31, 2005, was dischargeable, because the December 31, 2005, Form 941 Return was due on January 31, 2006, which was more than three years before the March 12, 2012, bankruptcy petition date.

Likewise, the non-trust portion of DIR’s quarterly FICA employment-tax periods ending March 31, June 30, September 30, and December 31 in 2007 was dischargeable, because the quarterly 2007 Forms 941 were due more than three years before the March 12, 2012, bankruptcy petition date. Additionally, the penalties associated with these taxes were dischargeable, because they related to a transaction or event that occurred more than three years before the petition date.

Additionally, DIR’s annual FUTA taxes ending December 31, 2005, and December 31, 2007, were both dischargeable, because the 2005 and 2007 Form 940 Returns were due more than three years before the petition date.

In the end, after filing for Chapter 7 bankruptcy, Ms. Pitts was still held liable for all of her partnership’s employment tax debts and was still stuck with at least 60 percent of her partnership’s tax bill (approximately $81,702), because of the non-dischargeable employment taxes, namely the trust-fund portion of the FICA taxes and those stemming from delinquent returns, resulting in the IRS preparing substitute returns.

When Ms. Pitts appealed the bankruptcy court’s decision in the U.S. District Court, Central District of California, the ruling was upheld. In a nutshell, the district court held that, like the seminal Galletti case, once a tax has been properly assessed against the primarily-liable partnership, a duplicate assessment on the same tax is not needed against a secondarily-liable general partner.

Ms. Pitts’ attorneys have appealed her case to the Ninth Circuit. This appeal is pending. It will be interesting to watch for the results, especially since Ms. Pitts’ attorneys are the same attorneys who argued on behalf of Galletti.

Lessons from the In re Pitts Case

So, what can we learn from the In re Pitts case? A general partner should ensure that the partnership timely files its employment tax returns and timely pays its employment taxes, even if the partnership delegates this responsibility to a third party. If a partnership goes out of business or stops making payments to employees, it still needs to file a final return.

It is a good general business practice for a partnership to regularly put aside money for a “rainy day,” so that when profits are low, it will still be able to pay its employment taxes. If a partnership finds it difficult to put aside money for quarterly employment taxes, it may consider hiring independent contractors, since they pay their own self-employment taxes.

If a partnership cannot fully pay its employment taxes, as a general rule, it should apply whatever it can pay toward the trust-fund portion of employment taxes first, since this portion is never dischargeable in bankruptcy and is subject to large penalties. The partnership should instruct the IRS that the employment tax payments are, first, to be applied toward the trust-fund portion of the FICA taxes for the quarter designated by the partnership; and, second, the balance toward the non-trust portion. Otherwise, the IRS can apply the payments to whatever is most advantageous to the IRS (i.e., non-trust portion). It is also a good practice to make these payments via certified check or money order, so as to keep better track of these payments.

Neither a partnership nor a partner should ignore a bill or notice from the IRS. Generally, if the balance is not paid after the IRS issues a second bill, the IRS will commence the collections process, ultimately resulting in a federal tax lien on the partner’s property and rights to property. Interest and penalties accrue on a daily basis until the balance is paid. Generally, the IRS has 10 years from the date of assessment to collect outstanding assessments; however, this 10-year statute of limitations may be extended by certain circumstances, such as an offer and compromise (discussed below) or bankruptcy. The IRS can also extend the collection statute an additional 20 years or more by obtaining a judgment against the taxpayer and renewing this judgment. So, the statute of limitations is not a large barrier for the IRS.

The federal tax lien remains in effect until the tax bill is satisfied. What’s more, the IRS is not subject to bankruptcy exemptions like the homestead exemption, so that it can foreclose on a home and collect its taxes. Further, the IRS can tap into assets, like a retirement account, that are forbidden to private creditors.

Thus, it is important for the partnership and a partner to heed to the IRS’ bill or notice and to carefully follow any instructions. Generally, if the partnership or the partner disagrees with the deficiency or is unable to pay the bill, the taxpayer should notify the IRS no later than the specified due date in the bill or notice.

A business or a self-employed individual unable to pay all of its employment taxes may consider an offer-in-compromise (OIC), which is an agreement between the taxpayer and the IRS in which the parties settle a taxpayer’s tax liability for less than the full amount. However, to qualify for an OIC, the taxpayer must have filed the required tax returns and paid the required federal tax deposits (or estimated tax payments). An OIC can be based on any one of the following three situations: (1) doubt as to collectability, (2) doubt as to liability, or (3) to promote effective tax administration (i.e., exceptional circumstances creating economic hardship).

Only the first situation will be addressed in this article. An OIC based on “doubt as to collectability” contends that the taxpayer does not have the financial ability to ever pay the taxes owed, because the tax liability is greater than the taxpayer’s assets and income. An OIC requires the taxpayer to reveal all of the taxpayer’s assets and liabilities, on a Form 433-A(OIC) for individuals, or on a Form 433-B(OIC) for a business. Additionally, an OIC requires the taxpayer to complete a Form 656, which requires the taxpayer to provide the reasons or explanation for the offer, and the payment terms. 

A taxpayer can file an OIC before or after bankruptcy – but not simultaneously. So, in Ms. Pitts’ situation, she was unable to apply for an OIC while her bankruptcy proceeding was still pending. She was, however, able to apply for an OIC before she filed for bankruptcy or after her bankruptcy proceeding concluded. Her attorneys, however, have decided to appeal her case to the Ninth Circuit.

Whether to choose to apply for an OIC or to file for Chapter 7 bankruptcy is based on the specific facts of the case. (Filing for Chapter 13 bankruptcy is not discussed in this article, but is another consideration.) Timing is key, since some taxes may be dischargeable because sufficient time may have passed to meet the Three-Year and/or Late-Return Rule. But then, as time progresses, the taxpayer may have more income or assets, which may make an OIC not feasible.

There are advantages and disadvantages to an OIC. For example, an advantage to an OIC is that it can completely settle all tax liabilities, even trust taxes and those that fall within the timing rules mentioned above (e.g., the Three-Year Rule). Moreover, an OIC does not leave a negative mark on the taxpayer’s credit reports. However, some of its disadvantages are that it takes several months to process and is subject to the IRS’s discretion (i.e., there is no guarantee that the taxpayer’s offer will be accepted and interest continues to accrue on the tax liability in the meantime). Also, unlike bankruptcy that can discharge other debts (e.g., credit card debts), an OIC resolves only tax debts. 

The bottom line is to always make sure your partnership files timely tax returns and that it pays its employment taxes in full (especially the trust taxes). Don’t let these taxes come back to bite you!

Betty J. Boyd

Betty J. Boyd represents clients before the IRS on tax controversy matters in the greater Los Angeles area.