In general, the creditors of a corporation cannot recover the corporation’s debts from its shareholders—the shareholders enjoy the benefit of limited liability protection as a matter of state law. Among the corporate liabilities from which shareholders are usually shielded is the Federal income tax imposed on a corporation’s taxable income.
There are a number of exceptions to this general rule, however – some of which are better known than others – including the ones described below.
Piercing the Veil
A creditor, including the IRS, may be able to “pierce the corporate veil” or “sham” the corporation, in appropriate circumstances, as where the corporation does not have a bona fide business purpose, or where its shareholders do not respect it as a separate entity, or where their withdrawal of funds from the corporation renders it insolvent.
In the right circumstances, the IRS may pursue a corporation’s shareholders as transferees of a corporation’s assets in order to satisfy a corporate tax liability. While the Code does not create the substantive tax liability as to a transferee-shareholder of a transferor-corporation’s property – which is determined as a matter of state law – it does provide the IRS with a remedy for collecting from the transferee-shareholder, the transferor-corporation’s existing tax liability.
In certain circumstances, the Code imposes a duty on a taxpayer to withhold and remit income taxes from certain payments made by the taxpayer. These withheld funds are often referred to as “trust fund taxes” because the Code characterizes them as a special fund that is held in trust for the IRS. When these taxes are not collected or are not remitted by the taxpayer, the IRS is generally authorized to “collect the tax” from any “responsible person” who was required to collect, truthfully account for, or pay over any tax withheld but failed to do so. In the case of a corporate taxpayer, this may include an officer or employee of the corporation who, as such, is under a duty to collect, account for, or pay over the withheld tax.
Federal Priority Statute
One of the most powerful tools available to the IRS for the collection of income tax is not found in the Code and, in fact, is sometimes overlooked by tax advisers.
According to the Federal Priority Statute, a person (for example, a corporation) that (i) is indebted to the U.S. government, (ii) is not in bankruptcy, (iii) is insolvent, and (iv) does not have enough property to pay all of its debts, must satisfy its indebtedness to the U.S. government before satisfying any other debts that do not have priority over the government’s claim; the U.S. has the right to be paid first, and all other creditors are subordinate.
If that person, instead, pays any part of a debt owing to a non-priority creditor at a time when the debtor was insolvent, before paying a claim of the Federal government, that creditor is necessarily favored at the expense of the government. In the case of such a preferential transfer, the Federal Priority Statute authorizes the government to hold that person’s “representative” liable for the unpaid claims of the government up to the amount of the payment made to the non-priority creditor.
For purposes of the statute, the term “claim” or “debt” means any amount of funds that has been determined by the Federal government to be owed to the U.S. by any individual or entity. This includes taxes, as well as any interest and penalties imposed with respect to such taxes.
Representatives of the Taxpayer
If it is determined that a violation of the Federal Priority Statute has occurred – there has been a preferential transfer – a court must decide whether anyone other than the taxpayer should incur liability for that violation. As the courts have noted, the purpose of the statute “is to make those into whose hands control and possession of the debtor’s assets are placed, responsible for seeing that the Government’s priority is paid.”
In the case of a corporation, the courts have interpreted the reach of the Federal Priority Statute as extending to those individuals who, responsible for the conduct of a corporation’s affairs, allow the corporation to make payments that defeat the government’s tax claims. Thus, a director, an officer or a shareholder of the corporation, who was in control of the corporation’s affairs, who was (or should have been) aware of the outstanding claims against the corporation, and who either (i) directed or controlled the wrongful payments, or (ii) knew of such payments and failed to prevent them, may be held personally liable for the corporation’s taxes.
The exact nature of the duties and control exercised by an individual, and his status as a “representative” of the debtor, is a matter of proof, and must be determined by examining all the relevant facts and circumstances. The individual may be found to be a “representative” of a corporation and thus liable, to the extent of the payment, for unpaid claims of the government, where such individual is the sole officer, director and/or shareholder of the corporation. An individual may also be treated as a corporation’s representative where he oversees the corporation’s finances, and executes most of its checks.
Notice of Tax Claim
Once it is determined that an individual is a representative of a corporation within the meaning of the Federal Priority Statute, it must still be established that the individual knew about or was put on notice of the government’s outstanding tax claim before liability for such claim may imposed upon him. In general, the officers and directors of a corporation are deemed to be in control of its affairs, and the courts have often assumed that, being responsive to their duties, these individuals were aware of all the outstanding claims against the corporation.
Based on the foregoing, the lack of knowledge may be asserted as a defense against the application of the statute. However, the courts have found the requisite notice of a claim where the representative lacks actual notice of the liability, but possesses notice of such facts as would lead a reasonable person to inquire as to the existence of any unpaid claims.
The foregoing highlights the fact that the privilege of stock ownership in a close corporation may also entail a number of burdens.
In the case of a closely held corporation that is struggling, its directors, officers and shareholders have to be diligent in monitoring its financial vital signs, and they need to be as objective as possible in ascertaining its prospects.
Many times, they will forego the payment of certain taxes, using these funds, instead, to satisfy the corporation’s business creditors in the hope of keeping the business alive until it can “turn the financial corner,” and then pay off its tax liabilities.
Too often, however, the corporation will fail, notwithstanding the efforts of its “insiders,” at which point its shareholders may be left holding the proverbial “bag” for the corporation’s taxes.
What, then, is a shareholder to do?
The IRS’s response would be to shut down the business, liquidate its assets, and satisfy the unpaid taxes. This course of action may be difficult for a shareholder to accept, but it will often be the best choice.