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Diversion of Trust Fund Taxes Results in Taxable Income to Individual Diverting the Taxes

(Parker Tax Publishing October 2024)

The Office of Chief Counsel advised that, when an individual diverts trust fund taxes for whatever reason, including to pay personal or business expenses, the diverted taxes are taxable income to the individual and must be reported on the individual's return for the tax year in which the diversion occurs. According to the Chief Counsel's Office, this rule is not limited to responsible officers under Code Sec. 6672 and, where the individual fails to report the diverted taxes, the individual is liable for additional taxes and various civil tax penalties. PMTA 2024-6.

Background

Under Code Sec. 61(a), gross income is defined as all income from whatever source derived and includes accessions to wealth clearly realized, and over which a taxpayer has complete dominion. Code Sec. 7501(a) provides that if a person is required to collect or withhold any internal revenue tax from any other person and to pay over such tax to the United States, such taxes must be held in a special trust fund. These "trust fund taxes" include social security and Medicare taxes (i.e., FICA taxes) and income taxes required to be withheld from the wages of employees.

Employers are primarily liable for withholding trust fund taxes from their employees' wages. However, where the employer fails to meet its withholding obligations, Code Sec. 6672 provides an alternative means for the IRS to collect these trust fund taxes. Under the trust fund recovery penalty in Code Sec. 6672, any "responsible person" - i.e., any person who has the duty to account for, collect, and pay over trust fund taxes to the government - who willfully fails to carry out those duties may be held personally liable for a penalty equal to the total amount of the tax not paid over.

In PMTA 2024-6, the IRS Office of Chief Counsel was asked to provide non-taxpayer specific legal advice regarding the application of Code Sec. 61 to diverted trust fund taxes. Specifically, the question was whether an individual who diverts trust fund taxes, for whatever purpose, has taxable income in the amount of the diverted taxes for the tax year in which the individual diverted such taxes.

Analysis

The Office of Chief Counsel advised that when an individual diverts trust fund taxes for whatever reason, including to pay personal or business expenses, the diverted taxes are taxable income to the individual and must be reported on the individual's income tax return for the tax year in which the diversion occurs. If the individual fails to report the diverted taxes, he or she is liable for additional taxes and various income tax civil penalties. This conclusion, the Chief Counsel's Office said, is not limited to responsible persons under Code Sec. 6672. Thus, anyone who diverts the trust fund taxes will have taxable income for the tax year of the diversion. According to the Chief Counsel's Office, if the individual who diverts the trust fund taxes is a responsible individual, such individual is also liable for the trust fund recovery penalty under Code Sec. 6672 and may also be subject to criminal prosecution under Code Sec. 7202 for willful failure to collect or pay over the tax. Depending upon the circumstances, if the individual repays the diverted trust fund taxes, the Chief Counsel's Office advised that such individual may be entitled to a deduction in the year of repayment.

In reaching these conclusions, the Chief Counsel's Office cited the Supreme Court's decision in James v. U.S., 366 U.S. 213 (1961), in which the Court (quoting Comm'r v. Glenshaw Glass Co., 348 U.S. 426 (1955)) concluded that when a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition, the taxpayer has received income even though repayment may be required. The taxpayer in James embezzled money from his employee union and an insurance company with which it was doing business, then failed to report those funds on his tax return in the embezzlement years. Before the James decision, it was well-established that other types of illegal gains were taxable, making it illogical to exclude embezzled funds as taxable income. The Supreme Court in James deemed it unlikely that Congress intended unlawful gains to receive special treatment when compared to lawful gains and held that the embezzled funds (the same as lawfully obtained funds) are included in income in the years of the embezzlement. Therefore, the Chief Counsel's Office concluded, under James, when an individual diverts trust fund taxes for whatever reason, such individual has taxable income in the amount of the diverted funds in the year of diversion.

For a discussion of the general rule for including amounts in gross income, see Parker Tax ¶70,101. For a discussion of the trust fund recovery penalty under Code Sec. 6672, see Parker Tax ¶210,108.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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