Avoid Paying Someone Else's Tax Bill: IRC 6672 and 3505

Imagine the following scenario: you are a surety or general contractor. Your obligor or primary subcontractor is encountering some financial difficulties and you are fearful it will become unable to satisfy its payroll obligations. To prevent liens by the employees, you agree to deliver joint checks to the obligor/subcontractor in the name of the obligor/subcontractor and the employee. The payroll associated with the project is satisfied and the project is completed lien-free. At some point thereafter, an IRS agent calls you with a demand for the payment of taxes associated with the payroll of the obligor/subcontractor.

Your immediate reaction may be that you have paid out on behalf of the obligor/subcontractor the maximum amount of the loan, bond or contract amount and that you couldn't be forced to pay more. In fact, you could be forced to pay up to 100% of the withholding taxes on the wages, together with interest.

This article will address the Internal Revenue Code ("IRC") sections applicable to the scenario described above as well as other pitfalls that may bring you within the scope of those Code sections. Finally, this article will address the ramifications of the obligor/subcontractor's default and ultimate insolvency.

IRC Provisions

Sections 3102(a) and 3402(a) — Together, those sections require an employer to deduct and withhold income and social security taxes from an employee's wage.

Section 7501 — Under this section, the amount of the collected or withheld is deemed to be held as a special fund in trust for the United States.

Section 6672 — Any person ("person" includes a corporation or other entity as well as an individual) that meets the following criteria is responsible for the full amount of any tax that isn't collected or paid to the United States:

1. The person must have been required to collect, truthfully account for, and pay over the employment taxes; and
2. The person must have willfully failed to collect and pay the taxes to the government.

The first criteria typically includes a CEO, officers, or employees of corporations or partnerships who are directly responsible for the collection and reporting of the taxes. However, the government's net is much larger and has been interpreted to cover any entity which assumes the function of determining whether an employer will pay the taxes withheld from its employees. It reaches those who have the final word as to what bills should or should not be paid, and when.

A court gave the following example of a lender [Pacific] as a "responsible person" under the first criteria:

Central, a borrower of Pacific, prepared payrolls showing the gross wages, deductions for income and social security taxes, and net wages of its employees. Central then drew checks on its own account in the amount of each employee's net wages. Pacific examined the payroll calculations and each check, and had each employee endorse their check. Pacific then carried the endorsed checks back to its bank, deposited an amount sufficient to cover the net amount of the total payroll to Central's account, cashed the checks, and returned to the jobsite to pay the employees cash.

It is important to note that there may be more than one "responsible person" under Section 6672. Moreover, merely because one person is deemed a "responsible person" does not preclude others from also being responsible.

If a responsible person's failure to withhold and pay the taxes was a voluntary, conscious and intentional act, it is willful, and the second criteria is satisfied. In fact, a responsible person willfully fails to withhold and pay taxes if he (1) clearly ought to have known that (2) there was a grave risk that withholding taxes were not being paid; and if (3) the responsible person was in a position to find out for certain very easily.

Section 3505 — After the enactment of Section 6672, lenders and prime contractors in the construction industry, learned to avoid Section 6672 by merely lending a subcontractor/employer who was financially strapped, only the net payroll funds. The lender or prime contractor did not become a "responsible person," they simply loaned just enough to pay the wage and not the tax. The government plugged this loophole by enacting Section 3505.

Under Section 3505(a), a lender, surety, or other person who is not an employer, but who pays the employer's employees directly, is liable for taxes that should be withheld and paid to the government. Therefore, even if the lender or prime contractor is not a "responsible person" under Section 6672, or did not willfully fail to withhold and pay the tax, they are nonetheless liable for the tax if they pay the wage directly.

Under Section 3505(b), if a lender lends money to an employer for the purpose of enabling the employer to pay wages, and the lender knows the employer will not, or cannot pay the withholding tax due on those wages, the lender is liable for the taxes. Even if the loan is not specifically for the purpose of paying wages, if the lender knows a portion will be used to pay wages, the government can prove its case against the lender under Section 3505(b). It is not necessary for the government to prove the lender knew in advance the exact amounts that were to be used for wages. Moreover, a written agreement stating a purpose for the funds other than wages is irrelevant.

Section 3505(b) does not cover an ordinary working capital loan even though the lender knows that part of the funds may be used to make payroll payments in the ordinary course of the borrower's business. Though subtle, the difference between liability or not depends on whether the loan is specifically for the payment of net wages or whether the payment of wages is an incidental use of the funds.

There are three additional points to remember about IRC 3505. First, the maximum exposure under Section 3505(b) is 25% of the amount supplied for wages. Second, the government can bring an action for taxes under Section 3505 at any time within six years of the assessment even if the government only notifies the borrower of the assessment. Finally, even if you prevail on a tax claim brought by the government, the court must find that the government's position was unreasonable before you will be entitled to an award of your attorney fees and costs of defending yourself.

Conclusion

The impact of the foregoing IRC sections on lenders, sureties and prime contractors is substantial. In a worst case scenario, you could owe a subcontractor $10,000, pay the $10,000 to the subcontractor's employees, and end up paying the government the taxes on the $10,000. Consequently, you could end up paying more than you owed to the subcontractor. Additionally, you must anticipate you will be unable to collect from the borrower or subcontractor the amount you have to pay in taxes. Consult with us on the method or manner of loaning money to distressed borrowers, structuring a loan workout, or paying off a subcontractor's employees. This is one area where an ounce of prevention beats a pound of cure.

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should consult with competent counsel with regard to specific situations.

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