When facing financial difficulties, a corporation may be tempted to divert to corporate operations the federal taxes that have been withheld from employees’ paychecks. Corporate executives contemplating a “self-help short-term loan” of this type usually expect that the corporation’s financial situation improve so that the Internal Revenue Service (IRS) can be paid.
Giving in to this temptation exposes an executive to severe personal liability under Section 6672 of the Internal Revenue Code (26 U.S.C.) That statute imposes a penalty, in an amount equal to the amount of the tax funds that were diverted, upon an executive who willfully fails to discharge a responsibility for paying over employment taxes to the IRS. The penalty, known as the “responsible person” penalty, has been imposed upon officers, directors and controlling shareholders, as well as upon lower-level employees.
The severity of the penalty is manifested in several different ways. The penalty is not dischargeable in bankruptcy. An official hit with the penalty may have difficulty obtaining reimbursement from the corporation in view of the financial difficulties that led the corporation not to pay over its taxes in the first place. (A right of contribution exists against other officials with responsibility for the diversion.) An official may have difficult recovering under a directors’ and officers’ policy because this “penalty” is imposed only where a “willful” breach of the pay-over responsibility has occurred.
For the penalty to be warranted, the prevailing view is that a corporate official must have had significant control over the financial affairs of the corporation. In addition, the official must have “willfully” allowed the payment of creditors other than the IRS at a time when a tax arrearage exists. This term has been interpreted to mean that liability for the penalty exists if the official allowed other creditors to be paid at a time when the official either knew of the tax arrearage or recklessly disregarded a known or obvious risk that there was a tax arrearage.
The penalty applies to situations in which “willfulness” is far from intuitive. Liability may be imposed even if the corporate officer lacked responsibility or knowledge of the arrearage at the time the arrearage arose. Thus, an executive with a significant responsibility for a corporation’s financial affairs who belatedly learns of an arrearage that arose on his or her watch is obliged, upon learning of the arrearage, to apply all available funds to the IRS obligation, i.e., to pay the IRS before allowing any other creditors to be paid.
Moreover, a newly hired executive who joins a corporation after an arrearage arises and who obtains significant responsibility for the corporation’s financial affairs has a duty to insure that all available unencumbered funds are paid over to the IRS to satisfy the arrearage as soon as the executive acquires knowledge of the arrearage or recklessly disregards a known or obvious risk that an arrearage exists. Thus, an executive trying to decide whether to accept “a new and challenging opportunity” with a distressed corporation would be well advised, before making a decision, to obtain a thorough understanding of all employment-tax arrearages that exist.