Payroll taxes kill businesses. It is very easy to get behind, whether the business owner uses the funds to pay other expenses or due to a mistake. Once there is a payroll tax balance, it can be very difficult to catch up. The penalties and interest compound the problem.
If you’re a business owner and have unpaid payroll taxes, you might be wondering if there’s a way to simply start fresh with a new business entity and sidestep the burden of settling those tax obligations.
The answer to this question isn’t a straightforward “yes” or “no.” It is more of a “maybe” type of answer.
The recent Hyped Holdings LLC v. United States, No. 2:22-cv-00530 (E.D.N.Y. 2023) case provides an opportunity to consider this situation.
Facts & Procedural History
This case involves two temporary staffing companies, with the older one owned by the father and the newer one owned by his daughter. The daughter’s company had unpaid employment taxes owed to the IRS. After the IRS contacted the daughter’s company about the tax debt, the daughter entered into an asset purchase agreement where her father’s older staffing company acquired assets like trade names and a client list.
Subsequently, the IRS levied the daughter’s company’s clients to recover owed payments from third parties to the staffing company. In response, the father’s older staffing company filed a wrongful levy suit. The IRS then filed a motion for summary judgment, which is the subject of this post. The issue before the court was whether the father’s staffing company had the standing to pursue a wrongful levy claim when the tax liabilities were associated with the daughter’s staffing company.
About the IRS Collection Process
The IRS’s activities to administer our tax laws start with the assessment of tax. This is usually accomplished when a taxpayer files a tax return or the IRS does so or makes an adjustment on audit. If the taxes are not paid, the IRS process moves on to collections.
If the IRS does not hear from the taxpayer for some time, the IRS may start trying to contact the taxpayer to address the outstanding tax debt. This may not happen for months, years, or ever. But when it does, this typically involves a series of notices, starting with seemingly innocuous reminders and progressing to more serious warnings if the taxpayer fails to respond or make payment.
Before the IRS can proceed with a levy, it is obligated by law to issue a Final Notice of Intent to Levy. Upon receipt of the Final Notice, the taxpayer has the right to request a Collection Due Process (“CDP”) hearing. This can halt the IRS collection actions and give the taxpayer the ability to discuss collection alternatives, such as installment agreements, etc.
If the taxpayer does not respond to the notices or does not achieve a resolution through the CDP hearing, the IRS can then proceed with the levy. This empowers the IRS to initiate asset seizures to satisfy the outstanding tax debt. The IRS still has to follow the procedures to do so. The IRS will often start with a bank levy. If a revenue officer is assigned by the IRS to work on the case, they may also issue levy notices to third parties who owe money to the taxpayer. These notices direct the third party to relinquish the taxpayer’s assets to the IRS for the purpose of settling the tax debt. Once the levy notice is received, the third party is legally obligated to comply with the IRS’s directive. This can include freezing bank accounts, garnishing wages, or selling property through public auctions.
The IRS also has to inform the taxpayer about the levy action, providing a detailed notice that specifies which assets have been seized, the amount collected, and the remaining tax debt. The taxpayer can still work out terms with the IRS. This includes paying the debt in full, setting up an installment agreement, making an offer in compromise, or demonstrating financial hardship to get the case put on currently not collectible status.
The taxpayer can also take steps to work with the IRS to get it to release the levy and return any seized assets. The IRS will often do this when the taxpayer establishes a payment arrangement or can demonstrate that the levy has caused financial hardship.
If the levy is wrongful or violates the rules, the taxpayer also has the right to challenge a levy by filing a wrongful levy claim. That is the type of suit we have in this case.
About Wrongful Levy Actions
The code sets out the rules for wrongful levy actions. The rules are found in I.R.C. § 7426(a)(1). They say that a person who claims an interest in property that the IRS has levied upon can bring a civil action in federal courts to challenge that levy.
A levy is considered wrongful if three conditions are met:
- The IRS filed a levy against property held by the plaintiff.
- The plaintiff possesses an interest or lien on that property that is superior to the IRS’s interest.
- The levy is wrongful because the taxpayer who owes taxes does not have ownership rights to the property, at least in part.
If the plaintiff fails to meet these criteria and prove that the levy was wrongful, the IRS’s levy on the property interest will be upheld.
To succeed in an action for a wrongful levy, the plaintiff must first establish their title to or ownership interest in the levied property. Once the plaintiff demonstrates their ownership interest, the burden shifts to the government to establish a connection between the property and the taxpayer whose liability triggered the levy. Finally, the plaintiff must prove that the levy was wrongful, typically by showing that the tax debtor did not have ownership rights to the property that was subject to the levy.
Ownership in Accounts Receivables
In this case, the government argued that the plaintiff, which was the father’s staffing company, did not possess a clear ownership interest in the levied funds. The government’s position was that the asset purchase agreement did not transfer contract rights from the daughter’s staffing company to the father’s staffing company. Thus, according to the government, the funds were owed to the daughter’s staffing company and therefore the father’s staffing company had no interest in the litigation.
The plaintiff, which was the father’s staffing company, conceded that it did not acquire the receivables or contractual rights related to the daughter’s clients. Instead, it argued that the purchase of the daughter’s staffing company’s client list and claimed entitlement to receivables that were earned separately and independently from the daughter’s staffing company’s services. Thus, according to the plaintiff’s argument, they provided services to these clients and the funds were payment for their own services.
The court sided with the government. It noted that the taxpayer has the burden of proof to show their title to or ownership interest in the property subject to the IRS levy. The court found that the informal nature of the agreements between the daughter’s company and the father’s company was not sufficient to meet the burden. This decision seems to be based on the lack of evidence of when services were rendered, and which entity rendered the services.
Did the Government Win This Case?
The IRS successfully enforced a levy, resulting in the collection of some funds. But if there were no significant financial transfers or transactions between the daughter’s staffing company and the father’s staffing company, the IRS might have no means to collect the remaining unpaid taxes.
The newer entity owned by the daughter is likely not operating. The IRS has likely put the business on currently not collectible status. If there are no assets to collect and no transfers out of the business, the IRS’s only other remedy would be to pursue criminal liability to collect restitution or pursue a trust fund recovery penalty for the daughter to collect a portion of the balance from the daughter. The daughter is also probably not collectible, perhaps intentionally so.
The older business owned by the father is generally not obligated to pay the outstanding payroll taxes of the daughter’s entity. This is true even if the daughter continues to be involved in the father’s business. Furthermore, there is nothing preventing the daughter from establishing another similar entity to start anew without having to address the taxes associated with the older business.
Complicating matters is the statute of limitations on tax collection that the IRS must contend with. This legal time limit restricts the IRS’s ability to collect taxes after a certain period, and there is a tendency for the IRS to be slow in collections, often missing this collection window.
So while the IRS did achieve a victory in this specific court case and managed to secure some funds, the substantial outstanding tax debt may never be fully recovered. The government’s gains from this legal victory may be overshadowed by the unpaid taxes.
What this case shows is that a service business can actually just stop operating, and a new entity with different ownership can start up with the old business’s clients. This can be feasible as long as there are no transfers between the entities and if the IRS does not pursue criminal liability or a trust fund recovery penalty. Even if there is a trust fund penalty, that only covers a portion of the unpaid taxes. If the new business is started, it takes careful planning. As pointed out by this court case, transfers such as payments for past services should be identified and segregated, as those payments can be subject to the IRS’s levy and the new business may not have the ability to contest the levy.