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​The IRS is stepping up its pursuit of criminal sanctions where there has been a failure to collect and pay over employment taxes.
Where an employer has failed to meet its employment tax obligations, the IRS can pursue the civil sanctions (the 100% trust fund penalty) under Sec. 6672 or criminal sanctions of imprisonment and fines under Sec. 7201 or 7202.
Both the civil and criminal statutes include the element of willfulness on the part of the taxpayer.
The IRS has provided little guidance on what will cause it to refer an employment tax case for criminal prosecution. However, case law sheds some light on certain factors that make referral more likely.
A taxpayer's answers to questions in a Form 4180 interview conducted in a civil investigation to determine whether he or she is a responsible person for unpaid employment taxes can be used against the taxpayer in a criminal investigation.
Practitioners who have clients that have failed to meet their employment tax obligations should consider and advise clients of the possibility of criminal prosecution.

Many practitioners who counsel business clients, both small and large, are familiar with the difficult challenges that quickly arise when taxes are withheld from employee wages but not turned over to the federal government. On occasion, these taxes are not paid over due to the misdeeds of an in-house bookkeeper or a third-party payroll service responsible for ensuring that a business meets its tax obligations. More often than not, however, employers, acting without bad intentions, use the withheld money to satisfy pressing trade obligations or to meet payroll, debts the nonpayment of which is likely to lead to the shutdown of the business and loss of employee jobs. Unfortunately, this strategy can prove extremely costly to both the business and its principals, generating exposure to substantial penalties for late payment or failure to pay at all.

Making the stakes even higher, the federal government has taken steps in recent years to increase the likelihood that employment tax cases will be handled criminally. All of this means that tax advisers working with business clients cannot focus solely on strategies to minimize and pay the business's income tax obligations but also must be extremely vigilant regarding employment tax duties.

This article focuses on the potential criminal consequences that can arise when a business fails to collect or pay over withheld tax. Included is an analysis of the key tax crimes that can be charged in these cases. The article provides suggestions to help practitioners recognize when a business's failure to pay employment tax may be treated criminally. It also provides guidance about how best to proceed to minimize a client's potential jeopardy. The article includes a discussion of the difficult issues practitioners face as they seek to resolve civil cases through cooperation, while remaining cognizant of the potential for criminal referral and prosecution. Ultimately, however, the article notes that advisers best serve clients by detecting nonpayment early and promptly crafting payment plans to bring delinquent obligations current and ensure new periods do not become delinquent.

Policy change: Increased emphasis on federal criminal prosecution

The Tax Division of the U.S. Department of Justice (DOJ) pursues both civil litigation and criminal investigations and prosecutions for failure to comply with employment tax obligations.1 Recently, the DOJ has increasingly emphasized criminal prosecution of those who fail to comply with their obligations to withhold, account for, and pay over federal employment taxes. In an April 2016 press release, the DOJ stressed that the failure to comply with federal employment tax obligations is "not simply a civil matter."2 Instead, employers that fail to pay employment tax, and treat amounts withheld from employees' wages as the employers' own property "are engaging in criminal conduct and face prosecution, imprisonment, monetary fines and restitution."3

The DOJ's emphasis on the criminal prosecution of employment tax evasion was further demonstrated by an amendment to the federal sentencing guidelines.4 The "Background" commentary provided with the guideline for sentences imposed for "Failing to Collect or Truthfully Account for and Pay Over Tax" formerly read as follows:

The offense is a felony that is infrequently prosecuted. The failure to collect or truthfully account for the tax must be willful, as must the failure to pay. Where no effort is made to defraud the employee, the offense is a form of tax evasion, and is treated as such in the guidelines.5

The Guidelines Manual was amended in November 2016 to remove the first sentence of that background comment, eliminating the premise that employment tax criminal prosecutions are rare or infrequent.6 When it proposed this amendment, the U.S. Sentencing Commission provided the following reason for the change:

The Department of Justice in its annual letter to the Commission has proposed that the "infrequently prosecuted" statement should be deleted. The Department points out that while that statement may have been accurate when the relevant commentary was originally written (in 1987), the number of prosecutions under section 7202 have since increased substantially. The use of §2T1.6 increased from three cases in 2002 to 46 cases in 2014.7

Employment tax criminal statistics

n light of the Sentencing Commission's reliance on statistics in support of its revisions to the manual's commentary, it is interesting to look at some numbers. The IRS's data regarding employment tax evasion8 show that the numbers of investigations, recommended prosecutions, sentences imposed, incarceration rates, and average sentence length vary from year to year. In 2014,9 the IRS initiated 120 criminal investigations and recommended 92 prosecutions. In that same year, the government sentenced 88 persons with an incarceration rate of 73.9% and an average sentence of 17 months. In 2015, the IRS initiated 102 criminal investigations and recommended 80 prosecutions.10 Sixty-two persons were sentenced in 2015, with an incarceration rate of 77.4% and an average sentence of 24 months. In 2016, the IRS initiated 137 criminal investigations and recommended 77 prosecutions. Eighty-seven persons were sentenced in 2016, with an incarceration rate of 70.1% and an average sentence of 14 months.

The statistical trends are not entirely clear, at least in part because a case may cross fiscal years — so that an investigation that the IRS begins in one year may not result in a recommended prosecution or sentencing until a later year.11 However, two significant facts should concern anyone representing a client in an employment tax audit. First, the number of employment tax criminal investigations initiated in 2016 increased significantly — over 14% more than the number of investigations begun in 2014 and 34% more than the number initiated in fiscal year 2015. Second, although the incarceration rate and average sentence length vary from 2014 to 2016, the average incarceration rate has remained above 70%. In other words, if a client is convicted for criminal employment tax evasion, there is a greater than two-thirds likelihood of incarceration when sentenced.12

Statutory provisions

The government has great latitude in deciding whether to handle an employment tax case civilly or criminally. Three Code sections potentially apply. Sec. 6672(a) imposes a 100% civil penalty on responsible officers in cases of failure to withhold and/or pay over employment taxes. Sec. 7202 makes failing to meet employment tax obligations a felony, punishable by a fine of not more than $10,000, prison for up to five years, or both. Sec. 7201 is the statute criminalizing tax evasion, a crime also punishable by a much larger fine than that imposed under Sec. 7202, and may also impose imprisonment, or imprisonment and a fine.

The portions of these sections that define the activity that is subject to a penalty (i.e., the willful failure to collect and/or pay over employment tax or the willful attempt to evade or defeat tax) are virtually indistinguishable. Sec. 6672, titled "Failure to Collect and Pay Over Tax, or Attempt to Evade or Defeat Tax," provides:

(a) General rule. Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over. No penalty shall be imposed under section 6653 [regarding the failure to pay stamp tax] or part II of subchapter A of chapter 68 [regarding the accuracy-related and fraud penalties] for any offense to which this section is applicable.

Sec. 7202, which by its title applies to willful failures to collect or pay over the tax, provides, in its entirety, as follows:

Any person required under this title to collect, account for, and pay over any tax imposed by this title who willfully fails to collect or truthfully account for and pay over such tax shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $10,000, or imprisoned not more than 5 years, or both, together with the costs of prosecution.

Sec. 7201 is titled "Attempt to Evade or Defeat Tax." It provides that "[a]ny person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony." Persons convicted of violating Sec. 7201 may be fined "not more than $100,000 ($500,000 in the case of a corporation)" or, like Sec. 7202, "imprisoned not more than 5 years, or both, together with the costs of prosecution."

The government uses this provision to prosecute many kinds of tax evasion — not just cases involving employment tax obligations. Also, it clearly applies to what may be unsuccessful attempts to evade tax, which the language of Sec. 7202 does not specifically cover. In the context of employers who fail to meet their employment tax responsibilities, however, the key difference among all three of these provisions relates to consequences: 100% of the unpaid tax as a civil penalty against a responsible individual under Sec. 6672 as compared to a criminal fine and/or imprisonment.

Given the similarity between Sec. 6672 and Secs. 7202 and 7201, one would expect some administrative guidance regarding the circumstances in which the IRS will pursue a criminal prosecution. In fact, however, the only guidance that might help a tax adviser counsel a client in determining whether the IRS will seek a criminal prosecution in a particular case is in the Internal Revenue Manual (IRM). The only regulation issued under Sec. 6672 essentially just restates the Code section,13 and no regulations exist for either Sec. 7202 or Sec. 7201.

Specifically citing Sec. 7202, the IRM includes the willful failure to account for, collect, or pay over taxes in a list of the most common Code sections "used by employment tax examiners when developing criminal fraud cases."14 The manual also notes that "[f]or a taxpayer to be guilty of a crime in which willfulness is an element, that individual must have acted deliberately, knowingly, and with the specific intent to violate the law."15 Examiners are referred to another portion of the manual, which "notes several elements that may be indicative of fraud" and are admonished to "remain continually alert for these and other 'badges of fraud.'"16 The manual's "Fraud Handbook" states that tax fraud "is often defined as an intentional wrongdoing, on the part of a taxpayer, with the specific purpose of evading a tax known or believed to be owing," and "requires both a tax due and owing; and fraudulent intent."17 The latter, of course, is necessary because of the element of willfulness required in Sec. 7202.

Proving fraudulent intent generally requires proof of an affirmative action to evade or defeat a tax, or the payment of tax. As noted in the handbook, taxpayers who knowingly take those actions often leave indicators that serve as a sign that they may have done something "for the purpose of deceit, concealment or to make things seem other than what they are."18These indicators of fraud primarily relate to income tax evasion and "include substantial unexplained increases in net worth, substantial excess of personal expenditures over available resources, bank deposits from unexplained sources substantially exceeding reported income, and documents that appear to be altered or false."19 The handbook further notes that establishing fraud requires affirmative acts of fraud, such as "omissions of specific items where similar items are included; concealment of bank accounts or other assets; failure to deposit receipts to business accounts; and covering up sources of receipts."20

Similarly, the IRM indicates that courts have interpreted the term "attempt" as implying that an "affirmative act or the commission of some overt act" is a necessary element of the violation of Sec. 7201.21 Examples of those actions that may be relevant in the employment tax evasion context include concealing assets; misappropriating, converting, and diverting corporate assets; filing late returns; and failing to withhold taxes as required by law.22

The DOJ's internal Criminal Tax Manual also addresses the willfulness element of the criminal employment tax provisions, and states that willfulness requires the government to show "that a defendant voluntarily and intentionally violated a known legal duty."23 The manual's examples of circumstantial evidence that can be used to prove willfulness include intentionally preferring creditors over the government and paying wages and debts owed to creditors in lieu of remitting employment taxes.24

What case law tells us

Comparing the indicators of fraud noted in the IRS's "Fraud Handbook" and what may be evidence of willfulness as noted in the DOJ's Criminal Tax Manual to what may occur in an employment tax situation, one might expect that a responsible person's willfully filing an erroneous return, failing to remit withheld employment taxes, or hiding or using those taxes for other purposes might be considered an indicator of fraud. At least historically, however, the IRS generally has only brought criminal charges in "the most egregious cases . . . rather than situations where an owner or other responsible person in a business that was facing hard times used the money to pay other creditors in a misguided attempt to keep the business afloat."25

A recent decision from a district court in Pennsylvania is a good example of one type of extreme circumstance likely to invite criminal prosecution — when the defendant is a tax professional who clearly knowingly violated the law. In Lynch, the defendant was convicted of 16 counts of willfully failing to pay over employment taxes in violation of Sec. 7202. The court described Lynch as a "highly skilled tax attorney" who shifted assets and employees among multiple entities to avoid IRS collection efforts for more than 10 years.26 Similarly, in Lord,the defendant's conviction for failing to pay over to the government withheld employment taxes was affirmed. The court noted that prior to accepting her job as acting president and CFO, the defendant had worked as an accountant for almost 20 years and in at least two prior jobs was involved with or in charge of filing and paying employment tax.27

Other cases where a criminal prosecution may be more likely are those that involve multiple acts of wrongdoing. For example, in Demuro, an engineer and his wife/office manager were convicted of conspiracy to defraud the government and of failing to pay over trust fund taxes. The Demuros owned a limited liability company that withheld but failed to pay over more than $500,000 in tax. Although it did not lead to a charge in federal court, the opinion held that evidence of the wife's use of her ill father's assets for personal purposes rather than to pay the delinquent tax was properly admitted, since it undercut her defense that she and her husband were attempting to structure a payment plan with the IRS.28

In Farr, the defendant was the general manager/administrator of an alternative medicine clinic run by her husband until his death. The clinic filed employment tax returns but failed to pay the withheld taxes, apparently avoiding detection by frequently changing its name and tax identification numbers. Farr was charged with tax evasion under Sec. 7201 after she failed to pay a civil penalty as a responsible officer under Sec. 6672.29

The defendant in Brennick was convicted of three crimes: failing to pay over withholding taxes, structuring currency transactions to avoid reporting requirements, and corruptly impeding the IRS, in violation of Sec. 7212. Brennick involved over $1.4 million in delinquent tax.30 In Thayer, the defendant also was convicted of multiple crimes, including failing to pay over withheld taxes, willfully filing false claims for refunds, and willfully concealing bankruptcy estate assets. The latter charge arose because Thayer used corporate funds to make payments on a condominium held in his personal name in an effort to hide assets from the bankruptcy court and from creditors.31

Another factor that may trigger criminal prosecution is inconsistent documentation. For example, in McLain, the owner-operator of a health care staffing LLC was convicted of violating Sec. 7202. The LLC did not file employment tax returns nor did it withhold and pay over withheld taxes. The defendant argued as a defense to the charges that the nurses working for the LLC were actually independent contractors and thus the LLC was not required to withhold employment taxes. Evidence against him included a certification, required by state law, that the nurses who worked for the company were employees, and not independent contractors.32 Similarly, William Crabbe was convicted of both failing to pay over withholding taxes and filing false returns where Forms 941, Employer's Quarterly Federal Tax Return, filed on behalf of the corporation showed only some of the company's employees. The court noted that Crabbe saw and signed state tax forms that reported inconsistent information.33

By comparison, some of the cases involving unpaid employment tax that generated only civil proceedings under Sec. 6672 presented either routine situations of financial distress, or even sympathetic circumstances. In Boyajian, for example, the president and sole owner of a company was held liable for payroll tax under Sec. 6672, but he was not prosecuted criminally. He admitted his status as a responsible person and the court found he acted willfully, showing reckless disregard for whether the taxes were paid while he made payments to other creditors. His wife, who had mostly administrative and client contact responsibilities, was not held liable.34

The defendant in In re Lee, also faced only civil action. He was held to be a responsible person even though he was not involved in daily management because he had general control over business matters, met with the company's manager once or twice a month, had absolute authority over finances, and was the only person authorized to sign checks.35 In Bernabe, a case presenting more sympathetic facts, the defendant was held liable under Sec. 6672 but was not prosecuted criminally. She had been abused verbally by the company's president, who instructed her not to give payroll taxes first priority.36 In Wells a defendant faced only potential civil liability as a responsible officer; in that case the defendant's husband assured her that he was handling all tax matters, lied about the extent of the problem, and intercepted IRS correspondence addressed to her.37

Other factors

Apart from extreme circumstances, it is likely other factors may also be at play in the decision whether to handle a case civilly or criminally. The strength of the government's evidence is one consideration. Criminal cases must be proven beyond a reasonable doubt, and the burden of proof is on the government. By comparison, in responsible officer cases the IRS issues a civil assessment. Thereafter, the person challenging the assessment must prove by a preponderance of evidence that he or she is not a responsible person or did not act willfully.38

The requirement that a defendant act "willfully," common to both civil and criminal actions for unpaid employment tax, may also be a consideration. In criminal cases, willfulness has been defined as "a voluntary, intentional violation of a known legal duty . . . [it] need not include bad faith or bad purpose."39 The Tenth Circuit's opinion in Quinn, which upheld the defendant's convictions under Sec. 7202 for failing to pay employment tax, and Sec. 7203 for failing to pay individual income tax, quoted the instructions to the jury on the subject of willfulness at length:

An essential element of the crimes charged is that defendant must have acted willfully. The word "willfully" means voluntarily and intentionally in violation of a known legal duty. In other words, the defendant must have acted voluntarily and intentionally and with the specific intent to do something she knew the law prohibited, or fail to do something she knew the law required; that is to say, with intent either to disobey or disregard the law. Conversely, the defendant did not act willfully if you find that she acted or failed to act because of negligence (even gross negligence), inadvertence, accident, mistake, reckless disregard for the requirements of the law, ignorance of the law, or a good-faith belief, based on a misunderstanding of the law, that she was not violating any of the provisions of the tax laws.40

Since the government is not required to prove motive as part of willfulness, a defendant's financial situation is not relevant.41

For Sec. 6672 purposes, willfulness has been defined similarly as a voluntary, intentional, and conscious decision, not requiring proof of an evil motive or a specific intent to defraud or deprive the government of money.42 The Kobus courtnoted:

There are two basic ways that a person can willfully fail to pay over withholding taxes: a person acts willfully if the employer has funds to pay the taxes and the person either (1) knowingly chooses not to pay over the withholding taxes or (2) acts with a reckless disregard of a risk that the withholding taxes will not be paid.43

Note that in both civil and criminal cases, proof of an evil motive is not required. However, while a reckless disregard for the law is not sufficient under Sec. 7202, a reckless disregard of a risk that taxes will not be paid can be used to establish willfulness in a Sec. 6672 action.