In our last post, we described the concept of the “responsible person” under NY’s sales tax law, and how such an individual may become personally liable for the unpaid sales tax of a business. Today we will explore the factors that are considered in determining one’s status as a responsible person, as well as some planning options.

Personal Liability

It is important to note that the personal liability of a responsible person (like a corporate officer) for sales taxes is separate and distinct from that of the business – it extends beyond the business.   For example, a corporate bankruptcy does not affect the officer’s liability for the tax, since the latter involves a separate claim than one that is asserted in the corporate bankruptcy proceeding.  

Because the responsible person’s liability is distinct from that of the corporation, it has its own statute of limitations for assessment purposes. Thus, the extension of the corporation’s limitation period does not automatically extend the limitation period for assessing tax against the responsible person. 

Decisions, Decisions

Before reviewing the factors that the State and the courts have found relevant in the past in considering individuals’ status as responsible persons, it will be helpful if the taxpayer places them in the proper context. In order to “set the scene,” the taxpayer has to weigh his desire to have some control over his investment against the tax exposure that such involvement may bring. If a person wants to be involved and have a say in the business, he or she must be prepared to act responsibly, including looking at records, inquiring about taxes, etc.

It is not acceptable to say that you want to have the title of an officer, or that you want to receive a salary from the business, but that you are not responsible for the sales tax.

Determining Factors

            Once a sales tax liability has been asserted, it is important to appreciate that the notice of determination issued by the Tax Department is presumed to be correct. The burden of proof, therefore, rests on the taxpayer to present enough support regarding the taxpayer’s position as to the extent of his or her responsibilities and authority. This can be especially challenging where the owners of the business are at odds with one another (as will often be the case) and, thus, it may be difficult to obtain copies of documents and records that support one’s position.

As was mentioned earlier, the determination of one’s status as a responsible person is fact-specific.  However, a review of the case law highlights the factors that are routinely considered important, and many of the rulings reflect consistent themes that may be useful for planning purposes.

Among the questions that are asked in evaluating one’s status as a responsible person are the following:  Did the person receive a salary? What was his ownership (and percentage)?  Did he enjoy a return on his investment?  Did he have authority to hire or fire employees?  Did he have knowledge, control or discretion over business/financial affairs?  Did he participate in daily operation of the business or in shareholder/director meetings?  Were there prior tax assessments against him or the business?  Was he involved in the preparation of sales tax returns or the payment of sales taxes?  Did he sign sales tax returns?  Did he have authority to operate the business, review its books and records, and determine and authorize the payment of creditors?  Did someone else have complete control of daily operations, financial affairs and management of the business?  Did he have knowledge of the business’s industry?  Did he have check-signing authority?  Did he sign only in the absence of, and at the direction of, another person?  Was he listed as an officer or director of the business?  Did he and the business use the same CPA to prepare their returns?

An officer – shareholder may not be held responsible where his role was essentially that of a minority investor who was precluded from taking action with regard to the financial and management activities of the corporation. 

Look at the Federal Returns

In considering the nature and extent of the taxpayer’s involvement with a business, one must consider several factors including both the taxpayer’s federal income tax returns as well as the business entity’s returns.  The following factors, if present, can indicate that the taxpayer has significant involvement in the business.

  • Has the taxpayer described his participation in any business as active or passive?
  • Did the taxpayer claim an exemption from the 3.8% surtax on net investment with respect to his share of S corporation or partnership income, on the basis of having materially participated in the business?
  • How can he reconcile the exemption with his claim that he is not active in the business for purposes of determining his status as a responsible person?
  • Did he receive a W-2 from the business, reflecting significant compensation, which may also point to active participation in the business?

The same may be said as to “guaranteed payments” made to a taxpayer for services rendered by the taxpayer to a partnership or LLC, as reflected on a Schedule K-1 issued to the taxpayer.

  • Does the Schedule K-1 identify the taxpayer as a general partner or managing member?
  • Did the taxpayer complete Schedule SE, Self-Employment Tax, to Form 1040, with respect to any of the allocations made or any of the payments received from the business?
  •  Did the taxpayer execute these business entity returns and, if so, in what capacity?

These inquiries are directed at determining the taxpayer’s level of involvement in a business, as reflected on the taxpayer’s federal income tax returns, and whether it is consistent with the taxpayer’s assertion that he is not a responsible person.

Planning for the Penalty

The best way to protect someone from personal liability for sales taxes would be to have the business pay the taxes when due. It is amazing how quickly and how significantly these liabilities can grow if left unattended. If a business is unsure of the proper tax treatment of a transaction, it should immediately consult with an experienced tax adviser to ensure that the taxes are being properly collected, remitted and reported.   Unpaid sales taxes rarely occur in a vacuum.  Rather, they are only one of many signs that a business is in dire economic straits. They are often accompanied by unpaid employment taxes. Together, these can turn into an expensive proposition.

The next best way to avoid surprises is to plan. Taxpayers should review the assignment of duties, responsibilities and decision-making authority within the business. These may be reflected in the by-laws or shareholder agreements. In the case of a partnership or LLC, the partnership or operating agreement should similarly allocate responsibilities among the members. This should be done at the inception of the business, or at least before one enters an existing business.

Additionally, passive shareholders should consider an indemnity or contribution agreement to protect themselves from the expense of responsible person liability. They may also want to consider corporate resolutions confirming their lack of authority.   It is also critical that each shareholder report consistently for all tax purposes. If he is not active in the business, his federal return should not report his activity in, or his losses from, the business as nonpassive.

Spotting the Issue

Before engaging in any transaction, the sale tax consequences of which are unclear to them, the owners of a business should consult with their tax advisers so as to avoid or satisfy the tax liability in the first place.  Once they have engaged in a transaction, they need to ensure that the business can properly substantiate its tax treatment of the transaction. 

Once a sales tax problem is discovered, the taxpayer should act quickly to address it. One must take immediate and extensive steps to rectify the problem. With any luck, the corporation has sufficient assets with which to satisfy the tax, penalty and interest.

I learned early on that a tax practitioner should do his or her best to help clients to avoid surprises. Few tax events can be as surprising as the imposition of personal liability for sales taxes as a responsible person for a business. The foregoing advice should help to mitigate the likelihood of such a surprise.