When a parent hires a child in the family business, makes them an officer in that business, or grants them an equity interest in the business, the parent’s goal in doing so is to help the child. Unfortunately, those same acts may place the child in harm’s way. Similarly, when a child seeks to assist a parent in the family business, the child may be exposing him- or herself to significant financial risk.

 A recent U.S. District Court opinion highlights a common scenario. In Webb-Smith v. U.S., the IRS assessed civil penalties against Daughter based on her involvement in Dad’s business, which had failed to account for employment taxes withheld from its employees’ wages. Daughter paid the penalties, filed a claim for refund, and, once the refund claim was rejected, then commenced a refund action against the IRS in federal district court. The IRS subsequently filed a motion for summary judgment, which the Court denied.

The Court’s opinion provides a good summary of the factors that are considered in determining whether someone possesses the requisite authority to be treated as a “responsible person.” More importantly, it illustrates how easily personal liability may attach to an employee-family member in respect of so-called “trust fund taxes.”

The Issue:  Was Daughter Liable for Business’s Unpaid Taxes?

Pursuant to federal law, employers must withhold income and social security taxes from employee wages, and hold these amounts in trust for the IRS. These taxes are commonly referred to as “trust fund taxes.” The Code imposes personal liability for failure to remit trust fund taxes to the IRS.

An individual will be personally liable for unpaid taxes if (1) the individual was “responsible” for collection and payment of trust fund taxes; and (2) the “responsible person” acted “willfully” in his or her failure to comply with the statute.

In determining “responsible person” status, the critical question is “whether the person had the ‘effective power’ to pay the taxes—that is, whether he had the actual authority or ability, in view of his status within the corporation, to pay the taxes owed.” More than one person in a corporation may be deemed a “responsible party,” and a person’s title alone is insufficient to establish him or her as such a party.   Rather, courts focus on the substance of that person’s duties.

Courts have developed a non-exhaustive list of factors that assist in determining whether a person possessed the requisite authority to be considered a “responsible person.” Factors to consider include whether the employee:

(1) served as an officer of the company;

(2) controlled the company’s payroll;

(3) determined which creditors to pay and when to pay them;

(4) participated in the day-to-day management of the corporation;

(5) possessed the power to write checks; and

(6) had the ability to hire and fire employees.

No one factor is determinative, and the court will consider the totality of the circumstances.

Daughter was a founding officer of Dad’s business (“Business”) and, at Dad’s request, acted as Treasurer beginning in March 2003. Dad was the sole shareholder of Business.  In December of 2004, Daughter resigned as Treasurer because she had a separate, full-time job that required substantial out-of-state travel. After her resignation, however, she continued to assist Business by calculating payroll, preparing and signing tax returns, and writing checks to creditors at Dad’s direction.

The government argued that Daughter’s title as Treasurer “speaks powerfully to her role within the business.” She disputed this contention, stating that “[her] duties never included those of a corporate treasurer,” despite her title. She characterized her role as more akin to a bookkeeper than a corporate treasurer.

Although Daughter possessed the title of Treasurer of the Business between March, 2003 and December, 2004, she pointed to evidence that gave rise to a genuine dispute as to whether she actually carried out the duties and possessed the authority of a corporate treasurer. All of her actions – calculating the Business’s payroll, preparing and signing tax returns, and writing checks to pay the bills – were taken at the direction of Dad who, according to Daughter, controlled access to the company checkbook. She did not write checks or file tax returns on behalf of Business without Dad’s permission. Additionally, she had no office at Business and was away from Business for substantial periods of time during the time frame in question.   Thus, while the government argued that Daughter was “given responsibility for calculating the company’s payroll, issuing payroll checks, and preparing and signing payroll tax returns,” Daughter countered that performing payroll calculations at Dad’s direction and acting as bookkeeper were insufficient facts to establish that she had control of the Business’s payroll.

Again, while Daughter prepared the company’s payroll and signed payroll checks, these actions were taken at Dad’s request and direction, often while Daughter was working full-time out-of-state. Employee salary was determined by Dad, and he was in charge of making sure payroll taxes were paid. Daughter’s lack of control over the payroll was supported by her testimony that she did not learn that Business had failed to remit trust fund taxes until 2006.

The government argued that Daughter “had the ability to determine which creditors to pay because she had access to the company’s checkbook and had full check-signing authority on the company’s account.” She contended that because she “was only allowed to write checks for bills that were [pre-authorized] by her father,” she had no authority to determine which creditors to pay.

Though Daughter possessed full check-signing authority, as no co-signor was required, and thus her signature alone would be sufficient for the bank to cash a check, whether she had access to the checkbook was in dispute. Nevertheless, even assuming Daughter had access to the checkbook, that fact combined with her full check-signing authority was insufficient to show there was no dispute as to whether she determined which creditors to pay and when to pay them. Her actual authority was circumscribed by Dad’s control over the process; she was only allowed to write company checks with the permission and at the direction of Dad. She testified that Dad would tell her what specific bills to pay and that she never questioned his decision or offered advice on the issue. Daughter testified that Dad “was the only person that could authorize anything at [the Business].”

While the power to sign checks is an important factor in the “responsible person” inquiry, the Court said, the power “can exist in circumstances where the individual in reality does not possess significant control over corporate finances.”  The Court here found that Dad exerted such control over the process as to divest Daughter of any meaningful authority.

The government also argued that, based on Mom’s testimony, there was no dispute that Daughter had authority to hire and fire employees. (Mom?!) Daughter maintained that she had no such authority. In outlining Dad’s duties, Daughter testified that “[h]e hired all of the employees . . . [and] fired any employees.” She stated that she had no role in hiring and firing at Business at any point.   Although Daughter did not testify explicitly that she lacked ability to make hiring and firing decisions, her testimony gave rise to a reasonable inference that she lacked such ability.

The government did not contend that Daughter participated in the daily management of Business. She testified that she was working full-time out-of-state during most of the time period in question. She never had an office or even a designated workspace at Business. While Daughter performed several tasks for Business between 2004 and 2008, the record showed no evidence that she was involved in the company’s day-to-day management, and therefore, this factor favored a finding that she was not a responsible person.

Based on the foregoing, the Court found that the record presented genuine questions as to the amount of actual, substantive authority that Daughter possessed over the control of Business finances and the scope of her decision-making authority, and thus, whether she was a responsible person.

Escaping Liability

Daughter was fortunate. She had a full-time job that kept her away from Business and she had no office at Business.  Had these facts differed even slightly, the Court may have not have assigned as much weight to Daughter’s testimony regarding Dad’s control over check-writing and hiring. In other words, the result could have been very different.

The lesson: although a child’s involvement in the family business can be a starting point for succeeding to control over, and ownership of, the business, the economic benefits and opportunities bestowed upon a child come with a great deal of responsibility, much of which– as in the case of trust fund taxes– may not be readily apparent to many. It will behoove a child who finds him- or herself in a position of authority in the family business to understand the attendant legal responsibilities and to ensure that the business remains compliant with its own.