Nonprofit Payroll Tax Alert

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A recent federal government report shows that thousands of nonprofits are not meeting their payroll tax obligations.  Though it may be tempting for nonprofits to avoid payroll tax responsibilities, especially when facing cash flow challenges, such avoidance is extremely risky. 

Payroll Tax Primer

All organizations with employees owe taxes to the government, in substantial part to pass along tax dollars owed by the employees.  Payroll taxes cover both employees’ income tax obligations, and their employees’ 7.65% portion of FICA taxes for social security and Medicare taxes.   In addition, employers are separately responsible for paying the employers’ other 7.65% portion of FICA taxes.  Essentially, employers hold  employees’ tax obligations in trust and must remit them to the government taxing authorities, as well as pay the employers’ share. 

The financial cost of each employee thus includes all tax-related costs, not just the net compensation each employee receives.  Even the most worthy charitable causes are responsible for withholding and paying their employment taxes – no excuses, no exception.   What’s the key lesson here?  Pay your taxes!

The TIGTA Report

The U.S. Treasury Inspector General for Tax Administration (“TIGTA”) recently released a report showing that a shockingly high number of tax-exempt organizations have not been paying employment taxes.   Specifically, the TIGTA report found that 64,200 tax-exempt organizations owed almost $875 million in unpaid taxes.  According to the report, 1,200 of these organizations owed more than $100,000 each, and five owed more than $10 million each.  The rest owed varying amounts. 

The TIGTA report recommended that the IRS more seriously address nonprofits’ delinquent payroll taxes practices.   In particular, TIGTA recommended that the IRS’s Exempt Organizations (“EO”) unit coordinate with the IRS’s payroll tax collection division to identify nonprofit organizations that may not be complying with other legal requirements regarding tax-exempt status.  In other words, payroll tax problems may indicate other tax-related malfeasance.

The IRS’s EO unit rejected this recommendation, stating that data from collections is not useful in indicating other tax-related compliance issues such as private inurement or operation for a non-exempt purpose.  Of course, the EO unit has the flexibility to later decide that unpaid payroll taxes may point to other issues warranting IRS examination.  Notably, failure to pay payroll taxes – by itself – at this point would not constitute legal grounds for revocation of tax-exempt status.

The IRS’s EO unit indicated that it will act upon one recommendation in the TIGTA report – that the EO unit “work with the Department of Treasury to evaluate whether a legislative proposal is warranted to strengthen the IRS’s ability to enforce payroll tax non-compliance by tax-exempt organizations.”  As such, we may see the IRS pushing for legislative action to allow the agency to address nonpayment of payroll taxes more aggressively.

What Could Go Wrong?

            1.         Penalties.  If payroll taxes are paid late, significant penalties may be owed to the organization.  While penalties may be decreased when the organization had “reasonable cause” for the late payments, this standard is extremely high.  The organization must show that the lateness was due to circumstances outside the control of the directors, rather than due to any oversight by the board.  It is also important to show that the organization has taken corrective measures to ensure that payroll taxes will be timely paid in the future.  Obtaining an abatement (i.e., reduction or elimination) of penalties based on a reasonable cause determination may be very challenging. Organizations should instead establish payment procedures early on to help avoid late payments and the associated penalties.

            2.         Frozen/Taken Assets.  IRS has the power to freeze and levy (i.e., take from) organizational assets like bank accounts.  In that way, the IRS can ensure that the employer makes payroll taxes a high priority, albeit involuntarily.

            3.         Personal Liability for Leaders.  Unpaid payroll taxes may result in personal liability for the organization’s leaders who are responsible for overseeing timely payment.  The board of directors has a general responsibility to make sure payments are made.  Other individuals may have a more specific responsibility to ensure timely payment, and may be more likely to be held personally liable for such payments and late penalties.  This often includes the Treasurer, the Executive Director, or a director or officer who is aware that the payments are not being timely made.   Because of serious responsibility associated with payroll tax liability, both civil and criminal liability may be imposed.  Serious business indeed!

            With the recent spotlight on payroll tax noncompliance by nonprofits as shown by the TIGTA report, we may see the IRS increase penalties, more aggressively attempt to collect from officers and directors, or even press for legislative action allowing revocation of income tax exemption for organizations that have unpaid payroll taxes.  Nonprofits should thus be aware of their employment tax liability and extremely diligent in paying taxes as they are due.