Your partnership’s employment tax debt: Are you liable?

July 2015 | Around the ABA

The old saying an ounce of prevention is worth a pound of cure is most commonly associated with preventive medicine. But in an age of complicated tax laws and hidden liabilities, it can just as easily be applied to the perils of running a modern business.

Betty J. Boyd represents clients before the Internal Revenue Service on tax matters in the greater Los Angeles area. In an article in the March issue of Business Law Today titled “Your Partnership’s Employment Tax Debt May Come Back to Bite You,” she stressed that if you are a partner in a business experiencing financial troubles, prudence and your future financial and credit standing require that you take immediate action to avoid being penalized by the IRS.

Failure to do so could lead not only to mounting debt and penalties from the IRS, but very likely devastating tax liens that will adversely impact your credit worthiness for years to come.

Boyd noted that one of the surest, yet ominous signs that a business is suffering financial difficulties is the failure to pay employment taxes. “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,” she writes. “What else? Much of this tax debt may not be dischargeable in bankruptcy.”

The fact is a business may sometimes pay wages to its employees and make payments to its vendors, but neglect to pay the IRS’ employment taxes in hopes of catching up with its liabilities when its financial situation improves. But as Boyd noted, 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.

She used the tragic example of the case of Wendy K. Pitts, a general partner of DIR Waterproofing in California:

“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, 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.”

Boyd stressed that a general partner should ensure that the partnership timely files employment tax returns and 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.

Other steps to help prevent businesses from falling into such circumstances include:

  • The partnership regularly setting 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, consider hiring independent contractors, since they pay their own self-employment taxes.

  • If a partnership cannot fully pay its employment taxes, 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 also 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 nontrust portion. Otherwise, the IRS can apply the payments to whatever is most advantageous to the IRS (i.e., nontrust portion).

Neither a partnership nor a partner should ignore a bill or notice from the IRS. Boyd said that if the balance is not paid after the IRS issues a second bill, the IRS usually 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.

Attorneys would also do well to remind clients that the 10-year statute of limitations on collecting outstanding assessments is not a large barrier for the IRS. In fact, it is fairly flexible.

“This 10-year statute of limitations may be extended by certain circumstances such as an offer and compromise 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,” Boyd wrote.

“So 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.”

However, as aggressive as the IRS is, they are also willing to work with both individuals and businesses to avoid taking such drastic measures. Over the years the department has introduced various programs to help facilitate payment plans that accommodate the taxpayer’s financial situation.  

The bottom line is that it is critically important for the partnership to be transparent and above board. But equally as important is if the partnership or a partner disagrees with the deficiency or is unable to pay the bill, they should notify the IRS and work out a mutually agreed-upon payment arrangement.

When it comes to dealing with Uncle Sam’s money, an ounce of prevention is, indeed, worth a pound of cure.

Business Law Today is a publication of the Business Law Section.