Overview of "Trust Fund" Taxes
If you search for the term "trust fund taxes" on the internet, you will see two different kinds of taxes:
Taxes on trust funds. A trust fund is a special kind of legal entity that holds money on behalf of a person, group or organization. While trust funds are often set up to shield money from taxes, taxes on trust fund distributions have unfavorable tax rates.
Trust fund taxes. These are taxes that are collected by a business as a result of its activity and then held in trust until the taxes must be paid to a government entity. The two most common types of trust fund taxes are employment taxes and sales taxes.
This article will deal with the requirements of trust fund taxes for businesses.
How Trust Fund Taxes Work
In general, the purpose of a trust fund tax is for a business dealing with a government agency in collecting taxes and holding them in the business's accounting system until the taxes are paid to the government agency.
If you are collecting money from employees, you are collecting their income taxes and their retirement benefits. The employees trust that you will make these payments. In the same way, customers are trusting your business to make the sales tax payments to the state. That's why they are called trust fund taxes.
If you are collecting money from customers you have the responsibility to pay those taxes to your state.
Accounting for Trust Fund Taxes
The taxes must be held in a separate account (usually an account called a payables account) so that it's clear that the tax is an accrued (accumulated) liability for accounting purpose and should not be used for any other purpose by the business.
Let's use the example of sales tax. When you record a sale, you must record the sales tax separately from the income in the category of "sales tax payable;" it's not income to you. If you sold something for $10 and the sales tax was 7 percent, you would collect $10.70. The $10 is recorded as income and the 70 cents as "sales tax payable." At the time required by your state (usually quarterly), you would add up all of the sales taxes payable and send them in one lump sum to the state.
It's important to put these taxes in a separate checking account or in some other way to segregate them from your day-to-day business financial activities, so they don't get spent. It's easy to forget that these amounts are not the property of your business.
One of the most common ways businesses get into trouble with the IRS and state tax departments s to use these accumulated liabilities instead of paying them when they are due. The IRS says,
Congress has established large penalties for delays in turning over your employment taxes to the Treasury. The longer it takes to pay that money, the more it will cost you.
The same caution applies to states in which you are responsible for collecting and paying state income taxes.
Employment Taxes as Trust Fund Taxes
Your business as an employer is required to collect employment taxes, taxes that must be paid by both employees and employers. Employment taxes include federal income taxes, state income taxes (if applicable), FICA taxes (Social Security and Medicare taxes), federal unemployment taxes, and self-employment taxes.
The amount of taxes is determined for each type of employment tax is calculated based on the employee gross pay and by the specific amounts that must be withheld for each employee.
All employment taxes except self-employment tax are trust fund taxes. Here's a quick run-down on these taxes:
Federal and state income taxes:
- Withheld from employee pay; the employer doesn't pay
- Reported quarterly on IRS Form 941
- Paid to IRS, state revenue department, with timing based on the amount due
Federal unemployment taxes:
- Paid by the employer based on the gross pay of employees
- Reported on IRS Form 940
- Paid to IRS, with timing based on the amount due
Self-employment tax isn't specifically a trust fund tax because no amounts are required to be paid to the IRS during the year. But self-employment tax is calculated based on your business net income and it must be paid as part of your personal income tax payment. It's easy to forget about this tax during the year, so be sure to include it in your calculation of estimated taxes.
Sales Taxes as Trust Fund Taxes
As described above, sales taxes also work as trust fund taxes. Your business is collecting money from customers. They are trusting that you are (a) collecting the correct amount, and (b) that you are paying these taxes to the state revenue department in your state.
Set aside the sales tax amounts you collect in a liability account called "Sales Taxes Payable" and report and pay to your state's taxing authority.