It is hard enough to be a CFO of a company that’s struggling financially; it is worse when that role leaves finance chiefs themselves owing tax that the company should have paid.
State and federal tax laws often provide that “responsible persons” are personally liable for unpaid business taxes, particularly “trust fund” taxes collected from third parties, such as wage withholding from employees and sales tax collected from customers. All too often this can lead to hundreds of thousands of dollars in liabilities for executives of a troubled or failed business. Finance chiefs need to put controls in place to ensure that taxes are properly paid over to the applicable state, especially in situations where the business may be unable to pay the missing tax down the road.
The government, after all, can be a jealous creditor. A company struggling to stay afloat may find it all too easy to consider delaying tax obligations, and all too often the delay becomes permanent. If it is a choice between paying a critical supplier to keep the business open or paying a taxing authority tax when due, the short-term choice of paying the supplier can seem obvious. The wheels of government move slowly, and by the time the taxing authority comes to collect, the company, management hopes, will have the wherewithal to pay – or may be completely wiped out.
“Responsible person” liability laws address this dilemma by making the individuals responsible for paying the business’ taxes liable if they fail to ensure that it is done. The business tax liability becomes personal. Indeed, even if the tax liability of the business itself is extinguished in bankruptcy, the government can still – and often does – proceed against the responsible person(s).
What’s more, a company can have many responsible persons. The category of “responsible person” is surprisingly broad, potentially implicating everyone from the CEO to the return preparer. Implicating activities will often include the following (depending on the jurisdiction), any one of which may be enough to establish liability:
- Active involvement in the day-to-day operation of the business;
- Deciding which financial obligations are paid;
- Power to hire and fire employees;
- Check-signing authority;
- Signing tax registration forms;
- Preparation of tax returns;
- Authority over business decisions; and
- Being a tax manager or general manager.
It is not necessarily the case that a revenue agency will seek recovery from the most responsible person first. Any responsible person is potentially liable, although as a practical matter the risk is highest for those individuals whose names are provided on tax registrations, returns or audit responses. CFOs need to ensure that taxes are properly paid not only for their own protection but also for protection of their subordinates and their superiors.
Delegators should, therefore, beware. Delegation does not necessarily protect an executive. Remember, a key indicator of responsible-person status is authority over a business and how it pays its taxes and other bills. While as a practical matter an executive can and often will delegate tax-paying duties, that does not absolve the executive of responsibility.
For example, a vice president of operations was found liable for over $250,000 of federal withholding tax because he delegated payroll and check-writing authority to outside accountants and did not request that tax payments be prioritized. In another example, a court in New York recently found a sole shareholder liable as a responsible person owing over $230,000 of unpaid sales tax, although her husband was the corporate officer actually managing the business and failing to pay the taxes.
In order to minimize responsible-person risks, CFOs should require internal reporting and controls to hold subordinates accountable and ensure that taxes are properly paid.
Finance chiefs should also avoid following instructions to not pay tax. “Just following orders,” the mirror image of the delegation defense, is equally problematic. While an executive might say that he did not have authority to “make the call” on not paying taxes, merely going along with the failure to pay can be enough for responsible-person liability. The duty to hand over trust fund taxes is serious and generally applies even if the individual is under duress.
For example, in a recent case a manager of “Prisoners Legal News” was found liable for failure to pay employee withholding taxes despite claiming to have been forced to do so by the then-incarcerated business owner. While the threat of violence seemed implicit in the owner’s instructions, the court refused to let the manager off the hook given his clear responsibility for paying withholding taxes. If the “following instructions” defense did not work for the employee of a convicted criminal, consider how likely it is to apply in less coercive contexts.
Similarly, a “white knight” who cleans up after embezzlement should be careful. Situations involving fraud or embezzlement pose a particularly hazardous area for responsible persons, because failing to remedy the tax shortfall with available money can trigger liability. Say that embezzlement within a company is discovered, including conversion of employee wage withholding, and a CFO comes in to resolve the issues and wrap up the business’s affairs. The CFO determines that the company is insolvent and needs to be liquidated. The question is whether to pay the taxes or other creditors with the remaining available money.
The tax dollars have already been misappropriated, and so it may seem that the CFO should have discretion. The government, however, expects repayment with any available funds, and so the CFO’s failure to prioritize payment of taxes can trigger personal liability even though it was not the CFO who took the tax money in the first place.
It may be an unfortunate fact that CFOs and other executives have been deputized as tax collectors by federal and state government. Failure to ensure that tax collection and remittance is properly carried out can leave an executive team with personal exposure for tax deficiencies — exposure that can easily exceed an executive’s total compensation from the company. CFOs need to protect themselves and and others by establishing procedures and policies to ensure that taxes are collected and paid as required by law.
Arthur R. Rosen and Matthew C. Boch are partners in the law firm of McDermott Will & Emery LLP.