Failure to Deposit Payroll Taxes

IRC Sec. 6656(a) imposes a civil penalty when the taxpayer fails to make a required tax deposit with an authorized government depository (or, as explained later, by electronic funds transfer). This failure to deposit (FTD) penalty uses a four-tier rate (from 2% to 15%) that increases the amount of the penalty the longer the required amount remains undeposited. It can apply when the taxpayer sends a deposit to an unauthorized depository (such as the IRS), and extends to any employment tax form where the filer is required to deposit the reported taxes. As with the failure to file and failure to pay penalties, the FTD penalty is waived if the failure is due to reasonable cause and not willful neglect [IRC Sec. 6656(a)].

Note: There appears to be no statutory or regulatory prohibition against the IRS assessing both the FTD and the Section 6651 failure to pay penalties when both apply.

Waiver of Penalty for First-time Depositors
The Secretary of the Treasury has the authority to abate the FTD penalty for first-time depositors who inadvertently send the deposit to the IRS rather than the proper depository [IRC Sec. 6656(d)]. The Secretary can also waive the FTD penalty based on an inadvertent failure to deposit any employment tax if [IRC Sec. 6656(c)]:

1. the depositing entity meets the maximum net worth requirements applicable to the award of attorney's fees under Reg. 301.7430-5(f) [i.e., the taxpayers net worth does not exceed $2 million for an individual and $7 million for a sole proprietor, partnership, corporation, association, unit of local government, or organization (other than Section 501(c)(3) charitable organizations and certain cooperatives), provided the business has 500 or fewer employees];
2. the failure occurs during the first quarter the entity was required to make a deposit, or if the entity is required to change the frequency of deposits, the failure relates to the first deposit to which the change applies; and
3. the related employment tax return was filed on or before the due date.

Computation of the Penalty
The amount of the FTD penalty is equal to the applicable percentage of the underpayment. For FTD penalty computation purposes, an underpayment is the excess of the amount of tax that must be deposited over the amount, if any, that was deposited on or before the due date [IRC Sec. 6656(b)(2)]. The applicable percentage [IRC Sec. 6656(b)(1)] is:

1. 2% if the underpayment is deposited not more than five days after the due date,
2. 5% if the underpayment is deposited more than five days but not more than 15 days after the due date,
3. 10% if the underpayment is deposited more than 15 days after the due date, or
4. 15% if tax is not deposited by the earlier of the 10th day after the IRS issues its first notice and demand for payment, or the date that notice and demand for immediate payment is given under the jeopardy assessment rules.

Example 1: Avoiding the 15% Penalty Rate
A monthly depositor fails to make a required deposit of employment taxes for the month of June but files the second quarter employment tax return (Form 941) on July 31. If the IRS makes an assessment on August 15, and then sends out a notice and demand for payment on September 5, the employer will not be subject to the 15% penalty (but will be subject to a 10% penalty) if the FTD is corrected on or before September 15.

When the Penalty Applies
The FTD penalty applies when tax reported on one of the following forms is not timely deposited: (1) Form 940 [Employer's Annual Federal Unemployment (FUTA) Tax Return], (2) Form 941 (Employer's Quarterly Federal Tax Return), (3) Form 943 (Employer's Annual Federal Tax Return for Agricultural Employees), (4) Form 944 (Employer's Annual Federal Tax Return), or (5) Form 945 (Annual Return of Withheld Federal Income Tax).

The FTD penalty can apply when the taxpayer mails a payment directly to the IRS, or mails a payment to an unauthorized depository (IRS Ann. 83-171). However, the FTD penalty does not apply when the failure to deposit income tax and/or FICA tax results from the failure to withhold such amounts from compensation paid to the employee. In such case, the employer is subject to the FTD penalty only on the underpayment of its share of FICA taxes not deposited or not timely deposited (unless, of course, the failure to deposit was due to reasonable cause). Conversely, if the employer withholds income and FICA taxes from wages paid to the employee but does not make the required deposit or is late in doing so, the employer is liable for the FTD penalty on the combined employer/employee tax, unless the failure is due to reasonable cause (Rev. Rul. 75-191).

How Deposits Are Credited
Every employer deposit is applied to the most recent deposit period, unless the employer requests otherwise [IRC Sec. 6656(e)(1)]. (See Rev. Proc. 2001-58 for detailed information.)

Example 2: Order in which Deposits are Applied
An employer is required to deposit $1,000 on February 15 and $1,500 on March 15 but fails to make the February 15 deposit. On March 15, the employer deposits $1,700. Unless the employer specifies otherwise, this deposit satisfies its March liability of $1,500 in full and $200 of the unpaid February liability, thereby eliminating the FTD penalty for March.

Note: Taxpayers may contact the IRS within 90 days after receiving a penalty notice and designate how deposits are to be applied (Rev. Proc. 2001-58). The ability to make such a designation, particularly in hindsight, may lead to penalty savings opportunities. For example, if a deposit exceeds the amount due for the deposit period, Rev. Proc. 2001-58 would default the excess to the next latest underpaid deposit period. If the 10% penalty already applies to that period, the taxpayer might find it desirable to designate a different deposit period where penalty reduction is possible. As another example, if a deposit otherwise satisfies the 98% safe haven (see discussion of tax deposit safe harbor rules later) but the employer fails to deposit the shortfall by the make-up date, the employer might, upon receiving a penalty notice from the IRS, designate subsequent deposits made on or before the shortfall make-up date as make-up payments for purposes of the shortfall, thereby meeting the 98% safe haven.

Effect of the Tax Deposit Safe Harbor Rules
Two safe harbors (the de minimis safe harbor and the 98% rule) are available to an employer who has experienced a deposit shortfall, which is defined as the excess of the amount of employment taxes (FICA taxes and withheld income taxes) required to be deposited for a period over the amount actually deposited [Reg. 31.6302-1(f)(2)]. The de minimis safe harbor applies if the total amount of accumulated employment taxes due for a quarterly or annual return period (e.g., the current quarter's Form 941 or the current year's Form 944) is less than $2,500 and the amount is fully deposited or remitted with a timely filed return, the amount deposited or remitted will be deemed to have been timely deposited [Reg. 31.6302-1(f)(4)]. The IRS issued temporary regulations effective for quarterly return periods beginning on or after January 1, 2010 that expand the de minimis safe harbor for quarterly returns (i.e. Forms 941) to include the return for the prior quarter. Therefore, the de minimis safe harbor will apply if the total amount of accumulated employment taxes for the current quarter or for the prior quarter is less than $2,500 [Temp. Reg. 31.6302-1T(f)(4)(i)and (ii)].

For employers who file Form 944 annually instead of Form 941 quarterly, temporary regulations modify the safe harbor deposit rules by mirroring the treatment employers would get if they continued to file Form 941 quarterly instead of Form 944 annually [Temp. Reg. 31.6302-1T(f)(4)(iii)]. Thus, Form 944 filers are allowed to deposit employment taxes of less than $2,500 that accumulate during a quarter by the last day of the month following the close of that quarter. In addition, employers who filed Form 944 in the prior year that are not eligible to file Form 944 in the current year because their prior year annual employment tax liability exceeded the threshold amount may avoid a failure-to-deposit penalty if they fully pay their current year January Form 941 employment taxes, which normally would be due February 15, by March 15 [Temp. Reg. 31.6302-1T(c)(6)]. (See NACPB's Payroll Tax Guide for more information on the Form 944 temporary regulations.)

The 98% rule applies if the amount of the shortfall does not exceed the greater of $100 or 2% of the amount of employment taxes required to be deposited, and the employer deposits the shortfall on or before the shortfall makeup date [Reg. 31.6302-1(f)(1)]. The shortfall makeup date for monthly depositors is the due date for the return for the period in which the shortfall occurs. The shortfall makeup date for semiweekly depositors and employers subject to the one-day deposit rule is the earlier of (1) the first Wednesday or Friday, whichever comes first, falling on or after the 15th day of the month after the month in which the deposit was required to be made; or (2) the due date for the return for that period [Reg. 31.6302-1(f)(3)].

Example 3: Failure to Comply with the 98% Safe Harbor Rule
On a Monday, a semiweekly depositor pays wages and accumulates $3,500 of employment taxes and, as required, deposits the taxes by the following Friday. Subsequently, the employer discovers it was actually required to deposit $4,090, resulting in a $590 shortfall. The shortfall exceeds the greater of $100 or 2% of the amount required to be deposited ($81.80). The 98% safe harbor rule does not apply, and absent reasonable cause, the employer is subject to the FTD penalty. [See Reg. 31.6302-1(f)(5), Example 2.]

Reasonable Cause for Failure to Deposit
The FTD penalty does not apply if the failure is due to reasonable cause and not willful neglect [IRC Sec. 6656(a)]. The Section 6656 regulations state that reasonable cause must be shown in a written statement made under penalties of perjury that sets forth the relevant facts. The statement should be submitted to the IRS office where the return is filed. See NACPB's Payroll Tax Guide for examples of reasonable cause.

Note: A taxpayer that has not had any penalties in the preceding three consecutive years (or 12 consecutive quarters) can request to have a penalty abated without providing any additional information (IRM 20.1.1.3.5.1). The IRS will abate the penalty due to the good compliance history. Even if the taxpayer has had a penalty in the prior three years, a request will be considered, but additional information must be submitted.

Deposits by Electronic Funds Transfers
Businesses must make electronic deposits of all depository taxes (employment taxes, corporate income tax, back-up withholding, etc.) using the Electronic Federal Tax Payment System (EFTPS) when the total deposits of such taxes were more than $200,000 during the year two years prior to the current year. Once a taxpayer is required to make electronic tax deposits, it must continue to do so even if its tax deposits later drop below $200,000 a year. Therefore, a business must use EFTPS in 2008 if (1) its total depository taxes in 2006 were more than $200,000 or (2) the business was required to use EFTPS in 2007 or any prior year.

Taxpayers who are required to deposit federal taxes by EFT will be assessed the Section 6656 failure-to-deposit penalty if the taxes are deposited by paper, even if the deposit is made on time (Rev. Rul. 95-68; F.E. Schumacher Co.; Fallu Productions).

Example 4: Failure to Deposit by Electronic Funds Transfer
Abel Corp. has been making electronic tax deposits since January 1, 2008, the date it first became subject to the EFTPS requirement under the $200,000 threshold. (Abel's tax deposits exceeded $200,000 in 2006 and, thus, Abel was required to make electronic tax deposits beginning January 1, 2008.)

Abel was required to deposit $10,000 by EFT on Wednesday, October 1, 2008, but instead made the deposit using a paper coupon. Abel is subject to a FTD penalty because of its failure to deposit using EFTPS.

Example 5: Taxpayer Voluntarily Using EFTPS is Not Subject to FTD Penalty for Deposit Made Using Paper Coupon
TC Corporation has been making electronic tax deposits since January 1, 1999. TC's total federal tax deposits have never been more than $150,000 in any one year. Therefore, TC is entitled to use paper coupons since its tax deposits do not exceed $200,000 for any tax year. However, the company has voluntarily chosen to use EFTPS because of the convenience of this deposit method.

TC was required to deposit $12,000 of employment taxes. A new payroll clerk timely made the deposit using a paper coupon rather than electronically. However, TC will not be subject to a FTD penalty because the deposit was timely made using a paper coupon and the company's use of the EFTPS is voluntary. TC may switch back to paper coupons without penalty provided that deposits are timely made.

For more discussion on this and other payroll tax issues, order NACPB's comprehensive Payroll Tax Guide.