IRS Can Force Business to Use Payroll Service, Court Rules

Published Categorized as Employment Tax, IRS Debts, IRS Liens & Levies, Tax Procedure
payroll tax injunction IRS

When a business fails to pay its payroll taxes, the consequences can be severe. The IRS has several collection tools at its disposal to collect unpaid payroll taxes. This includes liens, levies, and even criminal charges against the business owners.

The IRS recently attempted to expand its collection powers to prevent future non-compliance. In United States v. Olson, No. 23-1864 (7th Cir. 2024), the IRS sought to compel a business to use a third-party payroll service to ensure future compliance with payroll tax obligations.

Facts & Procedural History

The taxpayers are sole proprietors of a sewer cleaning service. They failed to pay their payroll taxes for about a decade even though they withheld the payroll taxes from their employee’s wages. They also failed to pay their personal income taxes.

The taxpayers claimed that paying these taxes would lead to bankruptcy and that they needed the funds to support themselves and their extended family.

The United States filed a lawsuit seeking a money judgment and an injunction compelling the taxpayers to deposit withholding taxes into a bank using an approved payroll service. The injunction would also require the taxpayers to prioritize tax payments over other creditors, allow IRS inspection of their records outside of its standard audit powers, and notify the IRS if they start another business.

The district court ordered the taxpayers to pay over $300,000, but it denied the government’s request for an injunction. The United States appealed the denial of the injunction and that led to the current court case.

The IRS’s Collection Powers

When a business fails to pay its payroll taxes, the IRS has quite a few tools at its disposal to collect the unpaid amounts.

One common approach is for the IRS to levy the business’s bank accounts, seizing the funds to apply to the unpaid tax debt. The IRS can also levy payments from the business’s customers or clients, intercepting income before it ever reaches the company.

If the business owns significant assets, such as real estate, equipment, or inventory, the IRS can seize and sell these assets to satisfy the tax debt. In addition, the IRS can assess a trust fund recovery penalty against the individuals responsible for the business’s failure to remit payroll taxes. This penalty makes the owners, officers, or managers personally liable for the unpaid taxes.

In extreme cases of willful non-compliance, the IRS can even pursue criminal charges against the responsible individuals. The threat of imprisonment is often sufficient to bring the business into compliance and end future non-payment of payroll taxes.

This is true even if the business operates through a legal entity, like an LLC. The entity is responsible for the payroll taxes, but the owners and those who control the entity can also be held liable by way of a trust fund recovery penalty.

This is why payroll taxes often kill businesses. The IRS collection tools for payroll taxes usually result in the business going out of business.

The Continuing Nature of Payroll Taxes

Payroll taxes present an ongoing challenge for the IRS when a business continues to operate despite falling behind on these obligations. Unlike income taxes, which are based on a company’s profits, payroll taxes are due with each payroll cycle. This means that a business can accrue substantial new tax debts even as the IRS is attempting to collect on previous unpaid amounts.

If a business persists in its non-compliance despite the IRS’s collection efforts, the unpaid payroll taxes can quickly snowball into an insurmountable liability. This is particularly true if the business is labor-intensive with a significant payroll expense. Congress even added the disqualified employment tax levy for this very situation, which takes away some collection rights that taxpayers have.

This gets us to the current court case. Some businesses may be able to avoid the IRS’s collection efforts and remain in business and continue to fail to comply.

The Court’s Injunction Powers

Faced with the ongoing non-compliance of businesses like the one in this case, the IRS sought to leverage the court’s broad injunction powers under Section 7402(a).

This statute allows courts to issue orders “as may be necessary or appropriate for the enforcement of the internal revenue laws.”

In this case, the IRS sought an injunction compelling the taxpayers to use a third-party payroll service, ensuring that future payroll taxes would be properly withheld and remitted.

The district court initially denied this request. In making this decision, the court relied on the traditional four-factor test for permanent injunctions, which requires the plaintiff to demonstrate irreparable injury, inadequacy of legal remedies, balance of hardships favoring equitable relief, and that the public interest would not be disserved. The court found that the IRS had not established irreparable harm, reasoning that the agency would not become insolvent due to the taxpayers’ non-payment and could obtain future money judgments if taxpayers continued to fail to pay their taxes.

However, the Seventh Circuit reversed, finding that the IRS’s injury from the taxpayers’ continued non-compliance was irreparable and that the public interest favored ensuring a level playing field among competitors.

Limitations of the Injunction Remedy

While this court case is a significant victory for the IRS, at least for now, the practical effectiveness of the injunction remedy remains to be seen.

Businesses that have managed to survive the IRS’s traditional collection methods may be particularly adept at evading enforcement. For example, a cash-intensive service business with few tangible assets may be able to operate largely outside the banking system, making it difficult for the IRS to monitor compliance with the court-ordered payroll service (even assuming that a payroll service would even help in this situation). Such a business might also restructure its operations, hiring workers as independent contractors to avoid payroll tax obligations altogether.

In some cases, the owners might simply dissolve or stop the non-compliant business and have a family member or associate start a new company in the same industry. The original owners could then work as employees or contractors of the new entity, effectively sidestepping the court’s injunction.

These are just a few ways noncompliant taxpayers could avoid the court’s injunction. They highlight how ineffective the injunction alone might be. But the injunction would not be the only remedy, as it does not preclude the IRS from collecting using its other tools. Thus, the taxpayer subject to the injunction is likely also subject to continued IRS levies, etc. Most businesses will probably not avoid the injunction and IRS collections tools if the IRS pursues both avenues at the same time.

The answer is, that the business should close its doors, the business owner move on to another activity, and the IRS not collect anything or very little from the past taxes due. This is the outcome in most cases even without the injunction.

The Takeaway

This case is significant because it affirms the IRS’s ability to proactively ensure future payroll tax compliance by compelling taxpayers to use third-party payroll services. This novel approach goes beyond the IRS’s typical methods of collecting back taxes, such as seizing assets or levying bank accounts. As noted by the appellate decision in this case, this issue is likely to be addressed by other courts as it is still unclear whether the IRS can use the injunction rules in this manner.

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