Employers are generally required to withhold income, Social Security, and Medicare taxes from their employees' paychecks. Employers hold these taxes "in trust" until they are deposited or otherwise paid over to the government. Since one of the most common problems faced by owners and managers of businesses is the lack of adequate cash to satisfy their numerous immediate obligations, this system creates a temptation for the employer to use the withheld funds to cover its costs. Short-term bank loans are often either unavailable or unaffordable, and the employer's own debtors may be unable to pay or not yet obligated to pay. Certain creditors, such as landlords, suppliers, shipping agents, and employees, must be paid on time or the business would cease to operate. When confronted with this dilemma, the employer may turn to the one source of cash immediately available: the taxes withheld from employee paychecks.
This decision is usually seen as a short-term fix to a temporary cash flow problem; the employer believes it will be able to meet its tax obligations when due. If the employer manages to replenish its cash before the withheld taxes are due, the employer satisfies its obligation and avoids sanction. If the payment is late, the employer may be liable for penalties. On the other hand, if cash flow problems are permanent, the employer may be entirely unable to fulfill its obligation to pay over the withheld taxes. If the company fails to pay the taxes when required, a full range of tax collection devices are available to the Internal Revenue Service (IRS).
Withheld taxes are referred to as "trust fund taxes," in reference to Internal Revenue Code (Code) section 7501, which states, "the amount of tax so collected or withheld shall be held to be a special fund in trust for the United States." Under general trust principles, the employers' use of funds held in trust, as are "trust fund taxes," constitutes a misappropriation of those funds. However, general common law trust principles cannot be applied wholesale to this context. For example, despite the creation of a trust, there is no requirement that the trust fund taxes be segregated from the employer's general operating funds as soon as the trust taxes are incurred. While the IRS has the right to demand segregation, and even criminalize the failure to do so, segregation does not help the government collect trust fund taxes that have already been misappropriated. Generally, the withholding system only requires that the employer deposit the withheld taxes, pay the taxes with the quarterly employment tax return, or both.
P. Prestin Weidner,
The Misappropriation of Trust Fund Taxes Under the Guise of Reasonable Cause,
57 Vanderbilt Law Review
Available at: https://scholarship.law.vanderbilt.edu/vlr/vol57/iss1/7