Employment Tax Crimes.
Taxpayers who employ workers have obligations under federal law to withhold and remit federal employment taxes to the IRS. In addition to this withholding and payment requirement, federal law also imposes certain reporting obligations, such as filing IRS Form 941 and 940. Taxpayers who fail to comply with either of these requirements can face significant civil penalties for their non-compliance.[i] Indeed, another unique weapon commonly used by the government in these instances is the imposition of the trust fund recovery penalty, which permits the government to bypass the employer entity entirely to go after any responsible persons who made the decision not to pay the employment taxes.[ii]
But can the failure to satisfy employment tax obligations also arise to a criminal violation of the law? The answer, of course, is yes. In fact, multiple federal criminal statutes throughout the Internal Revenue Code (the “Code”) protect the government’s interest in ensuring that employment tax obligations (both payment and filing) are met.[iii] And in recent times, the government has focused a lot of its efforts on imposing criminal sanctions against employers who fail to timely pay employment taxes and/or file employment tax returns. This article discusses those efforts. It also provides an option to many taxpayers to regain compliance with the federal employment tax laws and at the same time mitigate their criminal exposure.
Recent IRS Employment Tax Compliance Efforts.
The government’s efforts to combat evasion of employment tax obligations is nothing new. For some time now, the government has made its intentions clear that it intended to crack down on violations of the federal employment tax laws. And even today, federal court decisions confirm that the government has made good on its promises. For example, recent Department of Justice (“DOJ”) press releases show the following successful criminal employment tax convictions.
Taxpayer was an office manager and bookkeeper at an architectural firm where she managed payroll between 2014 and 2018. Despite knowing that the company withheld payroll taxes from its employees’ paychecks, taxpayer did not pay over taxes to the IRS, resulting in a total tax loss of $1.9 million. Taxpayer pleaded guilty and now faces a maximum sentence of five years in prison.
Taxpayer controlled a company that sold software in automotive dealerships. He controlled the business and financial affairs of the company. From the fourth quarter of 2011 through the third quarter of 2015, taxpayer collected more than $2.1 million in withholdings from company employees and issued them Forms W-2. However, company only paid $760,000 of these funds to the IRS. Taxpayer was sentenced to 18 months in prison and ordered to serve three years of supervised release.
In 2010, taxpayer was the sole owner and operator of a home health care business that provided daily living services to individuals. Taxpayer was responsible for all financial matters relating to the company, including handling the company’s payroll. From 2013 through 2016, the company did not pay all the employee withholdings it collected to the IRS. Rather, the taxpayer used some of the funds to pay corporate expenses and various personal expenses. After the IRS began collecting unpaid taxes in 2016, the taxpayer provided fraudulent bank records to the IRS and did not fully disclose all bank accounts. As a result, the company failed to pay over $320,000 of employment taxes. Taxpayer pleaded guilty and now faces a maximum penalty of five years in prison.
Given recent events within the IRS, these criminal convictions should only increase. For example, last year, the IRS revised its “Fraud Handbook” to provide Revenue Officers (“ROs”) with additional guidance for detecting employment tax fraud. In a section aptly entitled “Employment Tax Violations,” the Fraud Handbooks advises ROs to watch for the following conduct or indicia of fraud, which may result in a criminal referral to IRS-CI: (1) owners using business funds to pay personal expenses; (2) false statements or documents; (3) disorganized, incomplete, or non-existent payroll records; (4) business owners maintaining a living or lifestyle that is not consistent with reported income; (5) usage of nominees (particularly for pyramiding schemes); (6) uncooperative business owners; and (7) usage of undocumented workers.[iv]
In addition to these recent Fraud Handbook revisions, the IRS has seemingly reorganized, particularly with respect to fraud cases, by creating the following two offices in 2020: the Office of Fraud Enforcement (“OFE”) and National Fraud Counsel (“NFC”). The OFE now functions as the central processing unit for the IRS across all of its divisions and provides support to IRS employees in detecting and prosecuting tax fraud. Similarly, the NFC—which consists of more than 120 attorneys—provides legal and other support to the IRS in making sure that fraud cases are properly developed for eventual criminal prosecution in the federal courts.
The Government’s Primary Weapon: Section 7202.
Although the government has no shortage of federal statutes to bring a criminal employment tax case, the government routinely tends to favor I.R.C. § 7202. Under that statute, taxpayers commit a criminal violation of the federal employment tax laws where they have a duty to collect and/or truthfully account for and pay over employment taxes and willfully fail to do so. Generally, willfulness for these purposes is defined as the voluntary, intentional violation of a known legal duty. As shown by federal court cases, the bar is not a particularly high one.
Example. Employer filed employment tax returns for 2 years but failed to remit $2.9 million of withholding taxes. IRS employees testified that they attempted to make contact with the employer—i.e., they sent correspondence to the employer indicating that payroll taxes were due and should be paid. In addition, employer’s tax preparers (presumably under a subpoena or summons) testified that they advised employer of his employment tax obligations but that the employer “wouldn’t listen.” Taxpayer charged with violations of I.R.C. § 7202.[v]
Example: Employer failed to pay employment taxes to the IRS for the 4Q 2001 through 2Q 2004. CFO and acting president of employer controlled the day-to-day operations and finances of the company throughout the periods at issue. On these facts, government brought I.R.C. § 7202 criminal case against CFO/acting president.[vi]
The Voluntary Disclosure Program.
As shown above, the government can successfully bring a criminal prosecution against a taxpayer for violations of the employment tax laws. However, taxpayers should recognize that the IRS does provide a criminal amnesty program in certain instances, provided those taxpayers come forward timely and meet all of the program’s requirements. Significantly, the timely requirement means that the taxpayer comes forward prior to the government having information of the violations and initiating a civil and/or criminal investigation. After this period ends, the taxpayer must choose alternative methods without the criminal protection of the program.
Background of the Voluntary Disclosure Program.
The IRS’s Voluntary Disclosure Program (“VDP”) has been around for some time. In more recent times, though, the program has undergone some significant developments. Interested readers can read more about some of those developments in a cover story my colleague, Jason Freeman, and I wrote in the January/February 2021 edition of Today’s CPA.
To meet the VDP requirements, a taxpayer must make a timely, accurate, and complete voluntary disclosure to the IRS and otherwise cooperate with the IRS in the examination and collection of the taxes at issue. In exchange, the IRS provides an opportunity for taxpayers to regain compliance with their federal tax obligations with a more limited risk of criminal prosecution.
Under the VDP, taxpayers with unfiled employment tax returns and/or unpaid employment taxes can reduce their criminal risk exposure. Generally, to enter the VDP, the taxpayer must file the employment tax returns and pay the employment tax to the IRS. There are some civil penalties associated with the VDP—and many of these penalties, including employment tax penalties, have been clarified through recent penalty guidance provided by the IRS. That guidance as relevant to employment taxes is reproduced below.
Employment Tax Penalties: A civil fraud penalty or a fraudulent failure to file penalty, sections 6663 or 6651(f), respectively, will apply to the tax quarter of the voluntary disclosure period with the highest employment tax liability. The application of a single fraud or fraudulent failure to file penalty assumes that all terms of the Voluntary Disclosure Practice are complied with. The single fraud penalty is in lieu of accuracy-related penalties (section 6662) and delinquency penalties (sections 6651(a)(1) and (2)). The failure to deposit penalty under section 6656 will apply when it is normally applicable. The calculation of the employment tax liability will be made without regard to section 3509(a) or (b) rates. The applicable supplemental income tax withholding rate will be applied in cases where the employer failed to deduct and withhold income tax from employees’ wages. Relief under Section 530 of the Revenue Act of 1978 is unavailable. Suspension of interest provisions of section 6205 will not apply. Acceptance into the Voluntary Disclosure Practice and execution of a closing agreement does not obviate the taxpayer’s obligations, if any, pursuant to section 6051 to file Forms W-2, Wage and Tax Statement, or Forms W-2c, Corrected Wage and Tax Statement, with the Social Security Administration reporting adjustments contained in the closing agreement; however, no amount will be reported in Box 1 of Forms W-2c.
The new guidance also provides helpful examples of how the new employment tax penalties will be applied under the VDP:
Example 1: Taxpayer failed to treat one or more workers as employees and failed to withhold and remit federal employment tax: one fraud penalty on the tax quarter with the highest tax liability and no accuracy-related penalties for all other quarters; failure to deposit penalty applied for all periods; tax liability calculated without regard to section 3509 with the income tax liability calculated using the supplemental income tax withholding rate applicable for the periods at issue.
Example 2: Taxpayer failed to include in employees’ wages all remuneration for employment: one fraud penalty on the tax quarter with the highest tax liability and no accuracy-related penalties for all other quarters; failure to deposit penalty applied for all periods.
Example 3: Taxpayer failed to obtain taxpayer-identification numbers from payees before making a reportable payment or failed to withhold income tax when required: one fraud penalty or fraudulent failure to file (in the case of non-filed Forms 945) on the tax year with the highest tax liability and no accuracy-related penalties for all other years; failure to deposit penalty applied for all periods.
Example 4: Taxpayer submits delinquent returns: one fraudulent failure to file penalty on the tax quarter with the highest tax liability with no delinquency penalties on the other periods; failure to deposit penalty applied for all periods.
Example 5: Taxpayer submits three years of delinquent returns and three years of amended returns (24 tax quarters in total): a single penalty for either fraud or fraudulent failure to file on the tax quarter with the highest tax liability and no accuracy-related or delinquency penalties on the other periods; failure to deposit penalty applied for all periods.
Although a taxpayer who enters the VDP will no doubt have some heartburn from having to pay a fraud penalty (generally 75% of the tax) in addition to the failure-to-deposit penalty (generally, 10%-15% on the underpayment), such taxpayers should take solace in knowing that the government had considered imposing the 75% fraud penalty on an entire employment tax year, rather than employment tax quarter, prior to finally opting for the shorter tax period. Even more, taxpayers must remember the primary advantage of the VDP, which is to mitigate against criminal prosecution for criminal violations of the employment tax laws.
Taxpayers should expect the government’s criminal efforts to detect employment tax violations to continue for the foreseeable future. In light of these efforts, taxpayers should carefully consider their options, which may include submitting a disclosure under the VDP.
[i] See I.R.C. § 6651(a)(1) (failure-to-file); § 6651(a)(2) (failure-to-pay); § 6656 (failure-to-deposit).
[ii] See I.R.C. § 6672.
[iii] See I.R.C. § 7201 (tax evasion); § 7202 (willful failure to collect or pay over tax); § 7206 (false statements).
[iv] See IRM pt. 126.96.36.199 (7-15-2021).
[v] See U.S. v. Sertich, 879 F.3d 558 (5th Cir. 2018) (affirming 41 months of imprisonment and 3 years of supervised release on substantially similar facts).
[vi] See U.S. v. Lord, 404 Fed. Appx. 773 (4th Cir. 2010) (affirming 21 months of imprisonment and 3 years supervised release on substantially similar facts).
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