Businesses collect trust fund taxes as required by law, and they are held in trust until the taxes are paid to a government entity. State sales taxes and federal payroll taxes are the most common examples of these taxes. It's important to know how these taxes work and the penalties a business and its owner face if they don't pay the full amount by the due date.
How Trust Fund Taxes Work
Trust fund taxes (not to be confused with taxes on trust funds) are taxes collected by a business dealing as required by a government agency and being held in the business's accounting system until they are paid to the government agency.
The two most common types of trust fund taxes are
- Employment taxes withheld from employee pay and paid to the IRS
- State sales taxes collected from customers and paid to state tax agencies
The government entity sets up requirements for amounts to be collected, when to report the amounts, and when to make payments.
Employment Taxes as Trust Fund Taxes
If your business has employees, you must collect employment taxes, which must be paid by both employees and employers. Federal income taxes and the employee part of FICA taxes (Social Security and Medicare taxes), for example, are trust fund taxes. You must pay these taxes to the IRS at least monthly, along with your employer portion of FICA taxes, and you must file quarterly reports.
Sales Taxes as Trust Fund Taxes
Your business is collecting money from customers for the products or services you sell. They are trusting that you are (a) collecting the correct amount, and (b) paying these taxes to the state revenue department. At each step along the way, you have certain responsibilities to:
- Know if you must collect sales tax in a specific state because you have a tax nexus (sales tax presence) in that state
- Find out if what you're selling is taxable in your state
- Make sure you are collecting the correct amount of tax
- Set aside the taxes you collect
- Report what you owe to your state
- Pay the required amount of sales taxes
What Happens If You Don't Pay Trust Fund Taxes?
One of the most common ways businesses get into trouble with the IRS and state tax departments is to use these accumulated liabilities for their own businesses instead of paying them when they are due.
Federal Laws and Penalties for Employment Taxes
Federal law covers penalties for non-payment of federal income and FICA taxes. Failing to turn over employment taxes to the U.S. Treasury can result in large penalties, and the longer it takes to pay, the greater the penalty.
A failure-to-deposit penalty is charged for businesses not complying with the deposit rules and deadlines, including using electronic funds transfer (EFT) to make deposits.
A failure-to-file penalty is applied for each whole or part of a month that a return isn't filed when it should have been. The maximum penalty is generally 25% of the tax due, The IRS also charges interest on balances due.
Trust Fund Recovery Penalty (TFRP)
The IRS can also impose a Trust Fund Recovery Penalty (TFRP) against an individual who is responsible for collecting or paying payroll taxes and who willfully (intentionally) fails to collect or pay them. Willfulness means the person was aware or should have been aware of the requirement to pay the taxes and who intentionally disregarded or was "plainly indifferent to the requirements."
The IRS identifies one or more responsible person(s) who have the duty to pay these taxes. A responsible party can be an employee, board member, corporate officer, payroll service, or a third-party payer.
The amount of the penalty is 100% of the unpaid tax based on the total unpaid income taxes withheld, plus the employee's portion of withheld FICA taxes.
Businesses are responsible for paying trust fund taxes, but the responsible person at the business can be personally liable for willful non-payment. If the taxes aren't paid, the IRS can seize the person's assets or file a tax lien against their personal property.
State Laws and Penalties on Sales Taxes
Each state has its own laws and penalties for unreported and uncollected sales taxes. California, for example, charges interest and penalties on businesses for:
- Not filing a sales tax return, or filing it late
- Not paying the sales tax collected or filing it late
- Not reporting taxable transactions
- Not getting the required permits or licenses
California also has a collection cost recovery fee to cover costs of getting payment of past due amounts.
New York, meanwhile, also imposes criminal penalties, including fines and a jail sentence, for willfully failing to file tax reports and collect and pay sales taxes.
Florida also has similar penalties and includes a 100% penalty for willful failure to collect sales taxes. The third offense becomes a felony, with the level of felony depending on the amount of uncollected tax.
Accounting for Trust Fund Taxes
The taxes must be held in a separate account (usually a payables account) so that it's clear that the tax is an accrued (accumulated) liability for accounting purposes. For sales taxes, it's "sales tax payable," and for employment taxes, it's "employment tax payable."
When you record a sale, for example, you must record the sales tax separately from the income, If you sold something for $10 and the sales tax was 7%, you would collect $10.70. The $10 is recorded as income and the 70 cents as "sales tax payable." By the date required by your state (usually quarterly), add up all of the sales taxes payable from all transactions and send the total to your state tax agency.
Many businesses have a separate bank account for payroll, partly to keep these trust fund taxes separate so the money isn't spent by mistake.
Frequently Asked Questions (FAQs)
Who pays taxes on a trust fund?
Paying taxes on a trust fund isn't the same as paying trust fund taxes. Taxes on trust fund income depend on whether the trust is revocable or irrevocable. In general, taxable income from a trust is passed to beneficiaries, who must pay the tax on their personal tax returns. Income not distributed to beneficiaries is taxable to the trust.
What are trust fund taxes?
Trust fund taxes are taxes collected by a business. They are not that are the property of the business, but are held in trust and must be paid to a federal or state agency. The most common types of trust fund taxes are
- Employment taxes withheld from employees' pay for federal income taxes and Social Security and Medicare taxes
- State and local sales taxes collected from customers
Businesses must set aside these taxes and pay them as required by federal and state laws, or pay penalties for non-payment.
What's included in employment trust fund taxes?
The employment trust fund taxes include:
- Federal income tax withheld from the employee's pay, based on the directions of the employee of Form W-4 and the tax tables
- Social Security and Medicare taxes (FICA taxes) withheld from the employee's pay, based on their earnings for the pay period
Employers must also pay federal unemployment taxes and the employer part of Social Security and Medicare taxes by law, but they are not trust fund taxes because employees don't have to pay them.
What is a TFRP (Trust Fund Recovery Penalty)?
A trust fund recovery penalty (TFRP) is a penalty is collected from businesses that don't pay their employment taxes on time. The penalty is equal to the unpaid balance of the trust fund tax based on the amount withheld plus the employee's portion.
Although the business owes the tax, the tax is assessed against the person in the business who is responsible for collecting or paying these taxes and who willfully fails to collect them. The responsible person can be an officer, owner, or employee of a business.