Anticipating Tax Litigators…And the IRS (Part 2 of 2): Tax Strategy Tips

Since the COVID-19 pandemic, the Internal Revenue Service (IRS) has had a long backlog that, due in part to funding received in the Inflation Reduction Act of 2022, it only began to catch up on in mid-2023. In the meantime, the IRS’s backlogs and delays might have lulled taxpayers into a false sense of security. Some taxpayers have put off paying tax bills, thinking that the IRS was too busy to crack down on delayed payments, but the IRS is most certainly making its way back to full operations. Indeed, the IRS has indicated that it will resume issuing Notices CP14 and other collection notices that were paused or suspended in 2022.

Tax professionals, especially those who work on compliance and tax planning, can help their clients avoid costly enforcement measures. If they are prepared, tax professionals and their clients can even anticipate what tax litigators and defense attorneys could ask for when preparing a case with the IRS. This article, which is part two of two in a series, offers some tips on how businesses can strategically manage payment of outstanding tax liabilities. It offers advice on how to direct payments to higher priority liabilities, managing Federal Unemployment Tax Act (FUTA) and Federal Insurance Contributions Act (FICA) taxes, and avoiding IRS levies of assets.

IRS Payment Strategy

The IRS is swift to assess penalties and interest for unpaid tax liabilities. For that reason alone, aside from the underlying legal obligations, taxpayers should pay their outstanding liabilities when they are assessed, or as quickly as possible thereafter. In the real world, when some businesses and other taxpayers have limited funds, paying assessed tax liabilities can be a challenge. In that situation, a taxpayer can make a voluntary payment to the IRS, specifying to which liability it should be applied. Without such specification, the IRS will apply the payment to whichever liability it chooses. Often, as one might expect, the IRS applies payments to favor itself, not the taxpayer.

If a taxpayer has a personal liability for their business, such as when their business has unpaid employment taxes, they can use payment designations to strategically resolve their outstanding liabilities. Payroll tax is comprised of 1) the FUTA tax, plus the employer’s portion of the FICA tax, and 2) the employer’s withholding of its employees’ income tax plus their share of the FICA tax. In the case of FICA taxes, employers take money from their employees’ wages and hold it in trust to be paid to the IRS on the employees’ behalf. As such, the FICA tax is sometimes called the “trust fund” tax. If an employer fails to pay their trust fund taxes, the IRS does not consider it as simply a failure to pay tax, but the taking of the employees’ funds for the employer’s own use. It is serious and usually requires serious solutions.

The IRS’s tactics for pursuing unpaid trust fund taxes can be drastic. The IRS can pursue the trust fund taxes from the business itself, from the business owners, as well as from any persons responsible for withholding the funds and paying amounts due to the IRS. Additionally, under Internal Revenue Code (IRC) § 6672, the IRS can assess a penalty equal to the amount of tax owed. In other words, the IRS can assess a 100% penalty to collect unpaid trust fund taxes against the people who failed to pay. IRC § 7202 allows the IRS to prosecute such persons for failure to pay. Given such severe steps that the IRS can take, if a business falls behind on its payroll taxes, it should prioritize all voluntary payments to the trust fund portion of their outstanding liabilities for each unpaid quarter. It is important to note that, maintaining current compliance should remain any operating business’s top priority with back payments only being made provided compliance is met.

Another example of a taxpayer’s strategy for payments to the IRS involves bankruptcy. Bankruptcy can introduce its own challenges, but also new possibilities in terms of payment. The Bankruptcy Code contains lookback rules, for example, that generally bar the discharge of delinquent income tax obligations when no return was filed or when one was filed within 2 years prior to filing the petition. See 11 USC § 523 (a)(1)(B)(i) and § 523 (a)(1)(B)(ii). Given such rules, and others like them, in certain circumstances it may be prudent to use any available funds to satisfy a tax debt that will survive a bankruptcy filing, if bankruptcy is a possibility, rather than resolving other ordinary expenses. That being said, the relationship between the tax code and bankruptcy code is very complicated and taxpayers should seek guidance from experienced counsel before proceeding.

Finally, there are Offers in Compromise (Offers) to resolve outstanding tax debts for less than the full amount owed. In considering an Offer, the IRS looks at things like the financial hardship of paying total outstanding tax debt, as well as a taxpayer’s income and expenses, and the total value of the equity in their assets. In order to qualify for an Offer, a taxpayer must have filed all required returns. At the same time, they must also remain current on all required tax payments. For an employer, remaining current includes the previous 2 quarters prior to application for an Offer. If a taxpayer submits an Offer but fails to remain compliant, the IRS will reject the Offer or an Installment Agreement on an older tax obligation. Failure to remain current and compliant, including for 5 years after an Offer is accepted, can cause a default on the collection alternative. The taxpayer is then liable for the original tax debt, less payments made, and all accrued interest and penalties. For this reason, remaining current and compliant is a key part of a successful Offer.

The IRS has only recently begun to flex its muscles like it did prior to the COVID-19 pandemic. Its backlogs and delays, while not resolved in every area, have been reduced. As a result, the IRS can respond more quickly and with greater urgency. Taxpayers should act accordingly. If a business falls behind on its FUTA or FICA taxes, one strategy they can pursue is to direct voluntary payments to the trust fund portion of their outstanding liabilities for each unpaid quarter. Remaining current and compliant, especially after an Offer has been approved, may reduce the overall amount of debt they pay.