Trust Fund Tax: Responsible = Liable (?)

December 11, 2017

Some shareholders are content with being wholly passive investors in a corporation. Others desire some degree of participation in the day-to-day management of the corporation’s business. Still others are willing to abstain from any involvement in the operation of the business, but insist upon having a say with respect to certain “significant” matters (so-called “sacred rights”). Then there are those who, as a result of unforeseen circumstances, are thrust into positions of authority.

Many of these taxpayers fail to appreciate that any shareholder, director, officer, or employee of a corporation who has a “duty to act” for the corporation in complying with the NY sales tax law, may be held personally liable for the sales tax collected or required to be collected by the corporation, even if the circumstances that ultimately led to the imposition of personal liability were not of the responsible person’s doing, as illustrated by a recent decision of NY’s Division of Tax Appeals.

Tale of Two Brothers

Taxpayer was an officer and shareholder of Corp, which was a subcontractor for general contractors on numerous projects in the NY metro area.

Corp was a family-owned business, and was originally owned by Taxpayer’s parents. Taxpayer, who was an attorney, joined Corp as its counsel. Over time, Taxpayer’s brother (“Brother”) became president of Corp, and Taxpayer became its CFO. In addition, the brothers eventually became shareholders, with Taxpayer owning 22% of Corp’s issued and outstanding shares, and Brother owning 28%; their parents continued to own the remaining 50%.

Corp entered into a contract with a general contractor (“GC”) to perform work on a construction project in NYC that was more than double the size of any previous project undertaken by Corp (the “Project”). Brother negotiated the contract on behalf of Corp.

Not long afterward, Brother resigned as president of Corp because he had significantly underestimated Project’s cost in making Corp’s bid, thereby causing significant financial hardship for Corp. Upon Brother’s departure, Taxpayer assumed control of Corp and, along with it, responsibility for all phases of its work on Project.

Despite the financial difficulties, Corp continued to work on Project under Taxpayer’s direction. However, according to Taxpayer, GC began to renege on payments to Corp required under the contract. Further, Taxpayer maintained that he was forced by GC to replace several of Corp’s own employees with those of an unrelated Company, on “a time and material basis.” According to Taxpayer, Company overcharged for the work it performed and abused its overtime allowance, further hampering Corp. In addition, Taxpayer claimed that GC paid Company directly from funds allocated for Corp under their contract, rather than simultaneously paying Corp. These efforts, according to Taxpayer, were made to force Corp to fail to complete Project and allow GC to collect on an insurance bond that would have provided GC with a windfall.

As a result of the difficulties arising from Project, Corp filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. Corp continued to operate as debtor-in-possession while in bankruptcy.

Corp also brought adversary proceedings, in the course of its bankruptcy, against both GC and Company, seeking redress for fraud, breach of contract, and other similar causes of action.

The Responsible Person

In general, the sales tax is a transaction tax, with the liability for the tax arising at the time of the transaction. It is also a “consumer tax” in that the person required to collect tax – the “vendor” (Corp, in this case) – must collect it from the buyer when collecting the sales price for the transaction to which the tax applies.

The vendor collects the tax as trustee for and on account of the State, then holds it in trust for the State until the vendor remits the tax to the State.

NY imposes personal responsibility for payment of sales tax on certain owners, officers, directors, or employees (“responsible persons”) of a corporate vendor.  This means that a responsible person’s personal assets may be taken by the State to satisfy the sales tax liability of the corporation’s business.

Personal liability may attach even where the “responsible” individual’s failure to take responsibility for collecting and/or remitting the sales tax was not willful.

Corporations

Every individual who is under a duty to act for a corporation in complying with the sales tax law is a responsible person required to collect, truthfully account for, and pay over the sales tax.  Whether an individual is a responsible person is to be determined in every case on the particular facts involved. Generally, a person is under a duty to act for a corporation if he is authorized to sign a corporation’s tax returns, is responsible for maintaining the corporation’s books, or is responsible for the corporation’s management.

It is important to note that the personal liability of a responsible person (like a corporate officer) for sales taxes is separate and distinct from that of the business – it extends beyond the business.   For example, a corporate bankruptcy does not affect the officer’s liability for the tax, since the latter involves a separate claim than one that is asserted in the corporate bankruptcy proceeding.

An officer-shareholder may not be held responsible where his role was essentially that of a minority investor who was precluded from taking action with regard to the financial and management activities of the corporation.

Bankruptcy Court’s Findings

Several examiner’s reports regarding Corp were prepared pursuant to an order of the bankruptcy court. One of these reports addressed potential avoidance actions against Corp’s insiders, and reported that disbursements from Corp were made, through the date that the bankruptcy petition was filed, to or for the benefit of Taxpayer, his father, and Brother.

Additionally, the examiner reported that during the two-year period ending with Corp’s petition, Taxpayer deposited funds into Corp’s account, but also withdrew funds from Corp that he deposited into his personal account. The net effect of these withdrawals and deposits was a deposit of $1.5 million into Corp’s account, which was treated by Corp as a loan from Taxpayer.

Another of the examiner’s reports stated that after the filing of the petition, two of Corp’s stockholders received compensation from Corp, and that Corp paid rent to an entity owned by Taxpayer’s father.

Thus, notwithstanding its financial challenges, it appeared that Corp may have had funds available with which to pay the sales tax owing, but chose, instead, to pay other obligations.

The DTA’s Analysis

The State issued notices of deficiency to Taxpayer that asserted sales tax penalties against him as a responsible person of Corp for the periods beginning after Brother’s resignation, noting that each of the sales tax returns for the periods in issue were signed by Taxpayer as president of Corp.

According to NY’s sales tax law, every person required to collect the tax shall be personally liable for the tax imposed, collected or required to be collected.

The law, in turn, defines a “person required to collect” the sales tax to include, in the case of a corporate taxpayer, any officer, director or employee of the corporation (including of a dissolved corporation), who as such officer, director or employee is under a duty to act for such corporation in complying with the sales tax law.

Whether a person is a “responsible person” must be determined based upon the particular facts of each case, including whether the person was authorized to sign the corporate tax return, was responsible for managing or maintaining the corporate books, or was permitted to generally manage the corporation.

The Court explained that the question to be resolved in any particular case is whether the individual had, or could have had, sufficient authority and control over the affairs of the corporation to be considered a responsible officer or employee. The case law, it continued, identified a variety of factors as indicia of responsibility: the individual’s status as an officer, director, or shareholder; authorization to write checks on behalf of the corporation; the individual’s knowledge of and control over the financial affairs of the corporation; authorization to hire and fire employees; whether the individual signed tax returns for the corporation; the individual’s economic interest in the corporation.

Once sales tax liability has been asserted against an individual taxpayer as a “responsible person,” the taxpayer has the burden of establishing the extent of his responsibilities and authority with respect to tax law compliance.

The Court observed that Taxpayer signed all the sales tax returns as president of Corp.

The Court also noted that Taxpayer did not testify to explain why he was not a person responsible for the collection and remittance of sales tax. Instead, Taxpayer’s case rested entirely upon the financial difficulties that Corp found itself in as a result of Project.

The Court pointed out that these financial difficulties did not absolve an otherwise responsible person from liability arising from nonpayment of sales tax. Consequently, the Court affirmed the notices of deficiency and Taxpayer’s personal liability.

Decisions, Decisions

An individual shareholder has to weigh his desire to have some control over his investment in a corporation against the personal exposure for trust fund taxes (like the sales tax) that such control may bring.

In the case of a family-owned business, a family member/shareholder may find himself having to “step up to the plate” because of the family relationship.

In either case, if an individual is to be involved in the corporation’s business and in its management, he must be prepared to subordinate his own economic and personal interests in order to ensure that the corporation’s tax liabilities are satisfied.

He must also be prepared to shut down the business where it cannot satisfy its responsibility for trust fund taxes owing to the government, instead of continuing its operation and further increasing its tax liabilities, in the hope of one day “turning the corner.” After all, the government is not in the business of making loans to a failing business.