Legal Definitions - Trust fund recovery penalty (TFRP)

The Trust Fund Recovery Penalty (TFRP) is a serious financial penalty imposed by the Internal Revenue Service (IRS) when an employer fails to pay certain taxes withheld from employee paychecks.

When you receive a paycheck, your employer typically withholds amounts for federal income tax, Social Security, and Medicare (collectively known as FICA taxes). These withheld amounts are not the employer's money; they are considered "trust fund taxes" because the employer holds them in trust on behalf of the employees, to be paid directly to the IRS. Employers are legally obligated to remit these funds to the IRS on a regular schedule.

If an employer knowingly or willfully fails to pay these trust fund taxes to the IRS, or uses them for other business expenses instead, the IRS can assess a TFRP. This penalty is equal to the full amount of the unpaid trust fund taxes. Importantly, the TFRP can be applied not only to the business entity itself but also to individuals within the business (such as owners, officers, or managers) who had the authority and responsibility to ensure these taxes were paid and who willfully failed to do so.

Here are a few examples illustrating how the Trust Fund Recovery Penalty might apply:

• Example 1: Small Business Cash Flow Crisis

  Scenario: "Bistro Bites," a local restaurant, experiences unexpected financial difficulties due to a sudden drop in customers. To keep the business afloat and pay urgent suppliers for food ingredients, the owner decides to temporarily use the employee income and FICA taxes withheld from paychecks for the last two quarters, intending to pay the IRS back when business improves. Unfortunately, the situation worsens, and the restaurant cannot remit the withheld taxes.

  Explanation: The owner of Bistro Bites made a deliberate decision to use the trust fund taxes for other business expenses, even with the intention of repaying them later. This willful failure to remit the withheld taxes to the IRS makes the owner, as a responsible person, liable for the TFRP, which would be equal to the total amount of unpaid withheld taxes.

• Example 2: Corporate Officer's Strategic Misdirection

  Scenario: The Chief Financial Officer (CFO) of "InnovateTech Inc.," a growing software company, is aware that the company is facing significant cash flow challenges while trying to fund a major new product launch. The CFO instructs the payroll department to delay payments of employee withholding taxes to the IRS for several months, prioritizing payments to key investors and development teams, believing this strategy will ensure the company's long-term success. The company eventually fails to meet its tax obligations.

  Explanation: The CFO, as a responsible corporate officer with authority over financial decisions, willfully directed the company to use trust fund taxes for other purposes, despite knowing the obligation to pay the IRS. This action makes the CFO personally liable for the TFRP, in addition to the company's liability, for the full amount of the unremitted employee withholding taxes.

• Example 3: Negligent Oversight by a Board Member

  Scenario: A non-executive board member of "GreenThumb Landscaping," a large regional company, is primarily responsible for overseeing financial compliance and has the authority to approve major expenditures and tax filings. Despite receiving regular reports indicating that the company was consistently behind on its payroll tax remittances to the IRS, this board member failed to take any corrective action or ensure the taxes were paid, allowing the problem to persist for over a year.

  Explanation: Even though the board member might not have personally diverted funds, their willful disregard and failure to act on known tax delinquencies, given their position of authority and responsibility, could lead to them being considered a "responsible person" liable for the TFRP. Their inaction, despite knowledge, constitutes a willful failure to ensure the trust fund taxes were paid.