Where Not to Look for Short-Term Cash Flow Needs

There is an urban legend in the Illinois nonprofit world about a Chicago-based nonprofit organization that was notified by the state department of revenue of a withholding tax delinquency. The executive director and board chair drove to the capitol city of Springfield to look into the matter. However, the interview did not go as they had expected. As the story goes, the state impounded the car they came in and they were forced to return home by train.

This sounds humorous, but it isn’t.

This is budget and cash flow crunch time in the human services field. Numerous providers that rely on state or federal payments for operating funds are wondering how they will make ends meet. Here in Illinois, it is widely reported that the state is six months in arrears.

When receivables swell and an organization taps out its available funds, where can it find quick cash when payroll comes due?

One place not to take money is from the account that holds employee withholding taxes.

Personal Responsibility for Employee Taxes

It may seem unlikely that any Alliance for Children and Families members would think of not paying these taxes as a way to meet short-term cash needs; however, I’ve recently heard several mentions of other organizations doing this as a method of survival when funds are tight. I’ve also had some client experiences with this issue (see the sidebar on the following page).

I cannot emphasize this too well: Employee withholding taxes are funds the organization holds in trust for employees; these funds are not the organization’s money!¹

In fact, corporate officers, executive leaders, and board directors are personally responsible for the payment of those taxes. Let me repeat that: Corporate officers, executive leaders, and board directors are personally responsible to the government for paying employee taxes.

Section 6672 of the Internal Revenue Code allows the Internal Revenue Service (IRS) to impose a trust fund recovery penalty against corporate officers who fail to remit employee taxes when due. Only two elements are required for a penalty to be assessed:

1. the person assessed is responsible for collecting or paying withheld income and employment taxes; and
    
2. the person willfully fails to collect or pay them.

What might make an officer a “responsible” person? He or she merely needs to be an officer of the organization or a corporate director who has the duty to perform and the power to direct the collecting, accounting, and paying of trust fund taxes.

As for “willfulness,” individuals merely need to be aware that, or should be aware that, taxes are due and he or she must either intentionally disregard the duty to pay or be indifferent to whether they were paid or not. As far as the federal or state governments are concerned, using these funds to pay other creditors is enough to prove the second part of the test.²

Moreover, the government does not need to show there was intent to never pay, nor must it prove evil intent or malicious motives. It only needs to show that taxes were due, that an individual could have exercised corporate authority to pay them, and that they were not paid.

Social Utility Helps—to a Point

The prevailing wisdom says that IRS-imposed penalties typically apply to the for-profit world, in which people might put personal self-interest above that of the government.³ While for-profit cases are legion, they are not unique.

To a certain degree, the fact that a nonprofit organization is engaged in socially useful activities will protect individuals to a certain degree.

For example, in a Pennsylvania case, the bankruptcy court relieved the board president of a nonprofit organization of responsibility for unpaid employee withholding taxes totaling $48,265. While the bylaws of the organization gave him financial authority, his position was an unpaid one, his control over the payment of bills was limited, and he had little involvement in the day-to-day operations.⁴

Another example is from Wisconsin, where a volunteer director of a day care center in Milwaukee’s inner city was held not liable for $8,770 of taxes because of “financial confusion and lack of funds in the waning days of the agency.” The center’s funding had been changed to a voucher system, whereby parents had to fill out lengthy forms in order for their children to be covered. Funding plunged and eventually the centers were closed.⁵

In these two cases and others that have relieved a nonprofit’s leaders of personal responsibility, the courts give heed to a 1983 case in which a judge berated the IRS for its insistence on imposing liability when the facts clearly showed that volunteers were doing their best under difficult circumstances. His oft-quoted rant says:

"This matter portrays the government at its heartless, rigid, and Orwellian bureaucratic worst. The plaintiffs in this action were engaged in selfless, dedicated charitable activity. They gave of their time and themselves to assist those in need. They received no personal gain other than the satisfaction derived from their charitable endeavors. The compassionate federal government, and particularly the well known, warmhearted Internal Revenue Service, has chosen to reward them with personal liability for the nonpayment of withholding taxes."⁶

However, the nonprofit sector is not entirely exempt. Organizations must be aware of complications that can change the outlook from friendly to unfriendly.

When a Texas hospital filed for bankruptcy protection in 2003, the Internal Revenue Service assessed a tax and penalty liability of more than $400,000 against Board Chair Stephen K. Verret. Verret paid the assessment in full but later requested a refund. The IRS refused, and a federal court upheld the denial, finding it inconceivable that Verret was unaware of the fact that the hospital was using employee trust funds to pay its bills.

What complicated this case was the fact that Verret was not a volunteer, but received $26,000 for serving as a corporate officer. Also, his wife was employed as the hospital’s COO.⁷

Another example arose from a routine IRS examination of a nonprofit women's shelter in Highland Park, Mich., when the examination ultimately morphed into a criminal prosecution.

Two of the shelter’s officers had used trust funds for operating expenses, but they also filed reports claiming that they paid the taxes. The two officers argued that the IRS was required to suspend its civil audit examination after becoming aware that the defendants were engaged in criminal activity. The court did not agree and allowed evidence to continue to be gathered. This evidence was used against the two officers, and the two eventually were sentenced to serve prison terms.

What complicated this case was that the audit originally began when a newspaper reported that the shelter had made political contributions of $50,000 to a local politician. In fact, the officer had created a dummy corporation to hide the fact that the money came from the shelter.⁸

Immediate Benefits Don’t Outweigh Risks

The simple rule is this: if your organization is so desperate for funds that dipping into employee taxes seems to be the only option, the board needs to seriously consider closing down operations. If the organization can’t afford to send in the taxes this quarter, it most likely won’t be able to send in a double payment next quarter.
Board directors shouldn’t put themselves at risk.

ENDNOTES

1. When net wages are paid to an employee, the taxes that were, or should have been, withheld are credited in full to the employee even if they are never remitted to the government. “Thus, unless the government can collect these taxes from the employer … the revenues are forever lost to the Government.” Verret v. United States, 542 F. Supp. 2d 526, 533 (E.D. Tex. 2008).

2. Section 6672 of the Internal Revenue Code, 26 U.S.C. 6672 provides: “Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over. …”

3. One of the most notorious examples of the tax penalty is Unger v. United States, a 1994 ruling. Nathan Unger was just out of school in 1978, when he took a job with an advertising company as an assistant controller earning $10,000 annually. Six years later, he was named controller. The firm’s owner had by that time become a cocaine addict. As the firm disintegrated, it failed to pay more than $1 million in employee withholding taxes. Unger eventually was found responsible for the entire debt. The court’s displeasure with the harshness of the outcome did not change that result. See Unger v. United States, 711 F2d 729 (So. Dist. NY 1994).

4. See In re E. Harry Lartz, Debtor (2003-1 USTC 50,339; U.S. Bankruptcy Court, Mid. Dist. Pa.). Here is what the decision said:

"The court acknowledged that "on paper" Debtor may have been a responsible person, but considering the totality of the circumstances, he was not responsible.

The club's bylaws do not allow the president to determine which bills should be paid. They only specify that the board of managers is responsible for the proper conduct of all business of the club. The bylaws expressly permit the president to co-sign checks with the treasurer but do not grant the president sole authority. Additionally, the club's payroll checks were issued by ADP Incorporated, an independent contractor, who used a facsimile signature of Debtor's predecessor on the checks.

As the bankruptcy court found, Debtor was only one of several officers, employees and members of the club who sometimes authorized the payment of creditors and the hiring and firing of employees. The evidence does not reveal that Debtor decided to pay the club's other creditors in lieu of the United States. Also, there is no evidence that Debtor signed the club's tax forms. Although Debtor did sign the club's bankruptcy petition, he did so after learning of its failure to pay the trust fund taxes.

Considering the Debtor's limited duties and involvements with the DCY while its president, we conclude that he was not a responsible person under section 6672."

5. See Holley v. United States, 89-1 U.S. Tax Cas. (CCH) P9196.

6. The case involved volunteers who operated a neighborhood health center, a community center, and a day care center in Newark, N.J. See Hildebrand v. United States, 563 F. Supp. 1259, 1260 (U.S. Dist. Ct. N.Jer. 1983).

7. See Verret v. U.S. 542 F. Supp. 2d 526 (E.D. Tex. 2008).

8. See U.S. V. Rutherford Case. 07-2312, 07-2313 (U.S. Ct. App. 6th Cir. 2009).

Kathryn Vanden Berk practiced law for nine years before serving as the president of two residential treatment centers for children. Now practicing in Chicago, she focuses on nonprofit start-ups, corporate and tax law, and employment issues. She serves as adjunct faculty at several Chicago universities, and is a member of the Advisory Board of the Axelson Center for Nonprofit Management at North Park University. She authored a handbook on starting nonprofits that is available from the Nonprofit Financial Center, Chicago, and a chapter in the Illinois attorney’s handbook Not-for-Profit Corporations, 2004 Ed., Illinois Institute of Continuing Legal Education. In 2004 she authored Retooling Employment Standards for the Future, a publication of the First Nonprofit Educational Foundation, Chicago. She can be reached by e-mail or at 312-558-1690.

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