How does the IRS apply partial payments when a trust fund penalty has been assessed? Can the IRS apply payments to the trust fund portion of the employment taxes or must it apply the payment to the non-trust fund penalty portions?
Trust Fund & Non-Trust Fund Tax
Employers are generally required to withhold employment taxes from employee wages. The employer then remits these withheld employment taxes to the IRS. These are referred to as trust fund taxes, as they are held in trust pending payment to the IRS.
Employers are also required to pay employment taxes for employees based on the wages paid to employees. These employer-paid employment taxes are also remitted to the IRS.
The Trust Fund Penalty
Trust fund taxes that are not remitted to the IRS can be subject to a trust fund penalty. This penalty is 100% of the employee withheld taxes. It can be assessed against anyone who has the ability to direct payments for the business. This extends liability from the business to the individuals who control the business.
How the IRS Applies Payments
This brings us back to the question at hand. How does the IRS apply payments if both trust fund and non-trust fund taxes are owed? The IRS addresses this in CCM 200720015.
As noted in CCM 200720015, the general rule is that the IRS will follow the taxpayer’s instructions with the payment if the taxpayer specifically designates how the payment is to be applied. This is described in Revenue Procedure 2002-26.
In cases where the payment is not voluntary (i.e., it occurs via an IRS wage levy) or the taxpayer fails to designate how the IRS is to apply the payment, the IRS will apply the payment “in the order of priority that the Service determines will serve its best interest.”
With federal income taxes, this usually means that the IRS will apply the tax payment to the tax and tax period that has the shortest IRS tax collection statute (AKA CSED or collection statute expiration date).
Where trust fund recovery penalties are involved, the IRS will generally apply the payments “first to the non-trust fund portion of tax, then to assessed lien fees and collection costs, then assessed penalties, then assessed interest, then accrued penalties and accrued interest, and then finally to the trust fund portion of the tax.”
The Strategy for Paying Trust Fund Taxes
In the later scenario, the IRS is able to maximize the trust fund recovery penalty because the penalty is imposed retroactively on the amount of tax that is outstanding at the time that the penalty is assessed. Thus, if the penalty is not assessed before the taxpayer pays off the older tax periods, then the IRS will have lost the penalty amounts and interest that would have accrued on the prior tax years.