Avoiding Personal Liability for Payroll and Other Employer Tax Obligations

Like most businesses, law firms have payroll and other tax obligations with respect to amounts paid to their employees. Although many firms operate in corporate, LLC or even LLP form in order to protect partners individually from liabilities, their partners may be surprised to learn that they may be personally liable if the firm fails to fulfill its obligations associated with employee compensation and benefits payable by the firm. It is important that firms be aware of this potential personal liability and the ways to avoid it.

There are four major areas where personal liability may arise.

Failure to Timely Pay Wages

Many states have wage payment statutes that require employers to pay wages on a weekly or biweekly basis (or sometimes semi-monthly or monthly to certain salaried employees). In addition to regular salary, wages may include accrued but unused vacation time and sick pay. In some states, employees who are involuntarily terminated also must be paid all earned wages on the day of discharge, and employees who separate from service for any other reason must be paid wages on the first regular payday on or following their separation date.

Penalties for failure to comply with these requirements can be significant. They include in some cases criminal liability, even in cases where a violation of the applicable statute is without willful intent. More onerous statutes may impose not only fines that may reach as high as $25,000 for each violation, but possibly imprisonment. Some also allow a state agency to pursue private causes of action on behalf of the affected employee, or allow the employee to apply to a court to issue a summons to the employer to appear and show cause why a warrant should not issue against the employer for violation of the wage payment statute.

Perhaps most important, some statutes provide that each officer and agent managing an employer will be deemed to be the “employer” for purposes of the statute. In Massachusetts, for example, which has such a statute, courts have held that both local and nonresident officers of a Massachusetts employer could be sued individually in a class action under its weekly payment of wage statute, and that even outside investors could be sued individually where their responsibilities were functionally equivalent to those performed by a corporate president or treasurer. Narrowing the scope of the statute a bit, a later decision held that the “deemed employer” rule could be applied only to corporations and not to LLCs due to the language in the statute.

Employment Tax

As law firm administrators know, an employer is required to withhold federal income and FICA taxes from employee compensation and to pay those amounts, as well as FUTA taxes and the employer's share of FICA taxes, to the IRS. If the employer fails to deposit these employment taxes, it will be subject to a penalty of up to 15% of the underpayment. Of more consequence to certain partners, however, may be the provisions of ' 6672 of the Internal Revenue Code, which provides that, if the person “responsible” for the collection and payment of these taxes willfully fails to pay over the withheld taxes to the IRS, he will be personally liable for a penalty equal to 100% of the delinquent taxes.

The person responsible for these “trust fund” taxes may include a firm partner if the partner has the authority to avoid the default or direct the payment of taxes. Moreover, responsible person status does not require exclusive authority or control over the employer's financial affairs. See, for example, Barnett v. IRS, 988 F.2d 1449 (5th Cir. 1993), which held that a vice president was the responsible person, because he could have influenced the withholding decisions had he wished to exert his authority, even though the former president was likely “more” responsible.

The penalty under ' 6672 is not dischargeable in bankruptcy and is not deductible as a business expense or bad debt, although a person who has paid the penalty will have a right of contribution from other responsible persons in his firm. He also may have a separate contribution right under his firm's partnership agreement.

Other Tax Obligations

In addition to potential penalties under ' 6672, partners of a firm also may be personally liable for failure to perform certain other tax responsibilities, with respect to worker compensation, if they are under a duty to perform them under other provisions of the Internal Revenue Code. For example:

• Section 6674 imposes a penalty for willful failure to furnish or willful furnishing of a fraudulent written statement to employees required by ' 6051, such as Form W-2 for employee compensation.
• Section 6721 imposes a penalty for failure to file information returns, such as Forms W-2, with the IRS.
• Section 6722 imposes a penalty for failure to furnish correct payee statements.
• Section 7202, which imposes a penalty of up to $10,000 and/or up to five years in prison for willful failure to truthfully account or pay over any tax.

ERISA Liability

As a general matter, partners of a firm cannot be held personally liable under ERISA in their capacities as partners of the firm. They may be sued in an action under ERISA for plan benefits, however, if they have discretionary authority or responsibility for the administration of the plan.

As an example, failure to transmit employee contributions to an employee plan, such as a 401(k) plan, as soon as the contributions reasonably may be segregated from the firm's general assets can be a problem. This subjects those contributions to treatment as “plan assets” and, therefore, subjects any partner having responsibility for the management of the assets to treatment as a fiduciary for purposes of ERISA. As such, the partner may be personally liable for losses to the plan participants resulting from his failure to use plan assets exclusively for the purpose of providing benefits to plan participants.

Also, where plan documents specify that title to all money paid or due and owing to the plan is vested in the plan trustees, officers of a corporation responsible for the day-to-day decisions regarding the allocation of the employer's funds have been held personally liable for unpaid pension and welfare plan contributions under ERISA ' 409(a). In Connors v. Paybra Mining Co., 807 F. Supp. 1242 (S.D. W.Va. 1992), with later proceedings reported at 817 F. Supp. 34 (S.D. W.Va. 1993), this “due and owing” language was held by the court to cause the unpaid contributions to be plan assets, making the officers fiduciaries of the plans who committed a breach of their fiduciary duties. The same may apply to a partner with such responsibilities.

The lesson of these provisions is that, regardless of a firm's form of organization or size, formal procedures, with appropriate checks and balances, should be put in place within the firm to assure that the firm is meeting its obligations to employees with respect to compensation and benefits. The good news is that liability can be avoided through diligent monitoring of the firm's obligations and of those responsible to fulfill them.

Michael E. Mooney, a member of this newsletter's Editorial Board, is the managing partner of Nutter McClennen & Fish, LLP, in Boston. His firm maintains an active tax and business practice, representing and advising domestic and international corporations in a broad range of tax issues, reorganizations, business combinations and divestitures. He can be reached at [email protected]. Special thanks to Mooney's ERISA partner Robert D. Webb for his valuable input for this article.

Like most businesses, law firms have payroll and other tax obligations with respect to amounts paid to their employees. Although many firms operate in corporate, LLC or even LLP form in order to protect partners individually from liabilities, their partners may be surprised to learn that they may be personally liable if the firm fails to fulfill its obligations associated with employee compensation and benefits payable by the firm. It is important that firms be aware of this potential personal liability and the ways to avoid it.

There are four major areas where personal liability may arise.

Failure to Timely Pay Wages

Many states have wage payment statutes that require employers to pay wages on a weekly or biweekly basis (or sometimes semi-monthly or monthly to certain salaried employees). In addition to regular salary, wages may include accrued but unused vacation time and sick pay. In some states, employees who are involuntarily terminated also must be paid all earned wages on the day of discharge, and employees who separate from service for any other reason must be paid wages on the first regular payday on or following their separation date.

Penalties for failure to comply with these requirements can be significant. They include in some cases criminal liability, even in cases where a violation of the applicable statute is without willful intent. More onerous statutes may impose not only fines that may reach as high as $25,000 for each violation, but possibly imprisonment. Some also allow a state agency to pursue private causes of action on behalf of the affected employee, or allow the employee to apply to a court to issue a summons to the employer to appear and show cause why a warrant should not issue against the employer for violation of the wage payment statute.

Perhaps most important, some statutes provide that each officer and agent managing an employer will be deemed to be the “employer” for purposes of the statute. In Massachusetts, for example, which has such a statute, courts have held that both local and nonresident officers of a Massachusetts employer could be sued individually in a class action under its weekly payment of wage statute, and that even outside investors could be sued individually where their responsibilities were functionally equivalent to those performed by a corporate president or treasurer. Narrowing the scope of the statute a bit, a later decision held that the “deemed employer” rule could be applied only to corporations and not to LLCs due to the language in the statute.

Employment Tax

As law firm administrators know, an employer is required to withhold federal income and FICA taxes from employee compensation and to pay those amounts, as well as FUTA taxes and the employer's share of FICA taxes, to the IRS. If the employer fails to deposit these employment taxes, it will be subject to a penalty of up to 15% of the underpayment. Of more consequence to certain partners, however, may be the provisions of ' 6672 of the Internal Revenue Code, which provides that, if the person “responsible” for the collection and payment of these taxes willfully fails to pay over the withheld taxes to the IRS, he will be personally liable for a penalty equal to 100% of the delinquent taxes.

The person responsible for these “trust fund” taxes may include a firm partner if the partner has the authority to avoid the default or direct the payment of taxes. Moreover, responsible person status does not require exclusive authority or control over the employer's financial affairs. See, for example, Barnett v. IRS , 988 F.2d 1449 (5th Cir. 1993), which held that a vice president was the responsible person, because he could have influenced the withholding decisions had he wished to exert his authority, even though the former president was likely “more” responsible.

The penalty under ' 6672 is not dischargeable in bankruptcy and is not deductible as a business expense or bad debt, although a person who has paid the penalty will have a right of contribution from other responsible persons in his firm. He also may have a separate contribution right under his firm's partnership agreement.

Other Tax Obligations

In addition to potential penalties under ' 6672, partners of a firm also may be personally liable for failure to perform certain other tax responsibilities, with respect to worker compensation, if they are under a duty to perform them under other provisions of the Internal Revenue Code. For example:

• Section 6674 imposes a penalty for willful failure to furnish or willful furnishing of a fraudulent written statement to employees required by ' 6051, such as Form W-2 for employee compensation.
• Section 6721 imposes a penalty for failure to file information returns, such as Forms W-2, with the IRS.
• Section 6722 imposes a penalty for failure to furnish correct payee statements.
• Section 7202, which imposes a penalty of up to $10,000 and/or up to five years in prison for willful failure to truthfully account or pay over any tax.

ERISA Liability

As a general matter, partners of a firm cannot be held personally liable under ERISA in their capacities as partners of the firm. They may be sued in an action under ERISA for plan benefits, however, if they have discretionary authority or responsibility for the administration of the plan.

As an example, failure to transmit employee contributions to an employee plan, such as a 401(k) plan, as soon as the contributions reasonably may be segregated from the firm's general assets can be a problem. This subjects those contributions to treatment as “plan assets” and, therefore, subjects any partner having responsibility for the management of the assets to treatment as a fiduciary for purposes of ERISA. As such, the partner may be personally liable for losses to the plan participants resulting from his failure to use plan assets exclusively for the purpose of providing benefits to plan participants.

Also, where plan documents specify that title to all money paid or due and owing to the plan is vested in the plan trustees, officers of a corporation responsible for the day-to-day decisions regarding the allocation of the employer's funds have been held personally liable for unpaid pension and welfare plan contributions under ERISA ' 409(a). In Connors v. Paybra Mining Co. , 807 F. Supp. 1242 (S.D. W.Va. 1992), with later proceedings reported at 817 F. Supp. 34 (S.D. W.Va. 1993), this “due and owing” language was held by the court to cause the unpaid contributions to be plan assets, making the officers fiduciaries of the plans who committed a breach of their fiduciary duties. The same may apply to a partner with such responsibilities.

The lesson of these provisions is that, regardless of a firm's form of organization or size, formal procedures, with appropriate checks and balances, should be put in place within the firm to assure that the firm is meeting its obligations to employees with respect to compensation and benefits. The good news is that liability can be avoided through diligent monitoring of the firm's obligations and of those responsible to fulfill them.

Michael E. Mooney, a member of this newsletter's Editorial Board, is the managing partner of Nutter McClennen & Fish, LLP, in Boston. His firm maintains an active tax and business practice, representing and advising domestic and international corporations in a broad range of tax issues, reorganizations, business combinations and divestitures. He can be reached at [email protected]. Special thanks to Mooney's ERISA partner Robert D. Webb for his valuable input for this article.