Payroll Tax Fraud and Form 941

Payroll Tax Fraud and Form 941 – When Your Business Tax Problem Becomes a Criminal Case

Here’s a truth that destroys business owners every year: the money you withheld from your employees’ paychecks isn’t yours. It was never yours. The moment it came out of their wages, it became the property of the United States Treasury. You were just holding it temporarily.

When you spend that money on rent, on suppliers, on keeping your business alive – you’re not borrowing from yourself. You’re stealing from the federal government. And the IRS treats payroll tax theft as one of the most serious crimes in the entire tax code.

Welcome to Spodek Law Group. Our goal is to explain how payroll tax problems become criminal cases, who can be held personally liable, and what you can do if your already behind on your 941 filings. Todd Spodek has represented business owners at every stage of payroll tax enforcement – from civil collection to criminal prosecution. Understanding where the lines are is the first step to avoiding prison.

If you’re behind on payroll taxes or think you might be under investigation, call us at 212-300-5196 immediately. Every quarter you wait makes the criminal case against you stronger.

What Are Trust Fund Taxes (And Why the IRS Takes Them So Seriously)

When you withhold taxes from an employee’s paycheck – federal income tax, Social Security, Medicare – those funds are called “trust fund taxes.” The name isnt accidental. Your holding that money in trust for the government. It was never your money to spend.

Heres the paradox that catches business owners. The money sits in YOUR bank account. It looks like YOUR cash flow. It feels like YOUR money when your scrambling to make payroll or pay rent. But legally, its already been transferred to the government. You’re just the temporary custodian.

Employment tax withholding represents 70% of all revenue collected by the IRS. Seventy percent. Thats why the IRS takes these cases so seriously. When businesses fail to remit payroll taxes, they’re not just avoiding their own obligations – they’re diverting the largest single source of federal revenue.

As of 2016, there was over $59.4 billion in unpaid payroll taxes outstanding. The IRS has made employment tax enforcement one of its highest priorities because the numbers are so massive. When they catch someone who hasn’t been paying, they make an example of them.

The Priority Order the IRS Expects

Heres an uncomfortable truth that most business owners dont realize. The IRS considers itself the FIRST creditor, not the last. When your business has limited cash, the IRS expects you to pay trust fund taxes BEFORE you pay rent. BEFORE you pay suppliers. BEFORE you pay anything else.

From the IRS perspective, paying your landlord while payroll taxes are outstanding is evidence of criminal intent. You had money. You made a choice about who to pay. And you chose someone else over the federal government. Thats willfulness.

Every check you wrote to someone else while trust fund taxes were due becomes evidence in a potential criminal case. Every vendor payment, every utility bill, every lease payment – all of it proves you had funds available and directed them elsewhere.

How Payroll Tax Problems Become Criminal Cases

Most payroll tax crimes dont start with criminal intent. They start with a bad quarter. Cash flow got tight. Payroll taxes got deferred. The business owner thought they’d catch up next quarter when things improved.

But things didnt improve. The next quarter came, and now they owed double. With penalties and interest, the number kept growing. Catching up became impossible. So another quarter went by. And another.

Heres the irony. The business owner was trying to SAVE the business. They were paying employees to keep operating. They were paying suppliers to maintain inventory. They thought they were being responsible by keeping the lights on. Instead, they were building a criminal case against themselves.

When you miss more than one quarter of payroll tax deposits, the IRS stops viewing you as someone who made a mistake and starts viewing you as someone who made a pattern of choices. A single missed quarter might be negligence. Multiple missed quarters demonstrates willfulness.

The pyramid effect is devastating. Miss one quarter, owe $50,000. Miss two quarters, owe $100,000 plus penalties. Miss three quarters, and now a Revenue Officer is assigned to your case. Miss four quarters, and Criminal Investigation is evaluating wheather to prosecute.

The IRS calls this pattern “pyramiding” – accumulating trust fund tax debt quarter after quarter with no realistic plan to catch up. Pyramiding is one of the clearest indicators of willfulness. You knew you owed from the first quarter. You continued operating and withholding taxes from new employees. You continued not paying them over. The pattern proves intent.

Heres what the pyramid collapse looks like in real cases. A business owner falls behind in Q1. Instead of stopping operations or cutting staff to get current, they continue operating normally. Q2 passes – now they owe double. Q3 – triple. By Q4, they owe more than the business could pay even if it had a perfect quarter.

At this point, the business owner faces an impossible choice. Stop operations and definitely lose the business. Or continue operating, hoping for a miracle, while creating more criminal exposure every week. Most choose to keep going. Most end up in prison.

The Criminal Referral Triggers

Several things accelerate the transition from civil collection to criminal investigation:

• Repeated non-compliance: Missing multiple quarters shows pattern, not accident
• False statements: Lying to Revenue Officers about why you havent paid
• Asset concealment: Moving money to hide it from collection
• Continued withholding without paying over: Taking from employees and keeping it
• Prior history: If you’ve had payroll tax problems before, you’re a target

The IRS also matches your Form 941 quarterly filings against other records. They compare your reported wages to the W-2s you file at year end. They compare your reported deposits to what actually appears in the Treasury system. Discrepancies trigger closer examination.

The “Responsible Person” Trap

One of the most terrifying aspects of payroll tax enforcement is the “responsible person” liability under 26 USC 6672. This provision lets the IRS collect the full amount of unpaid trust fund taxes from any individual who was responsible for paying them and willfully failed to do so.

Heres the paradox. You dont have to be an owner to be a responsible person. You dont even have to be an officer. The IRS looks at who had the DUTY and POWER to collect, account for, and pay trust fund taxes. If you had check-signing authority, you might be a responsible person. If you made decisions about which bills to pay, you might be a responsible person. If you had any significant control over financial decisions, the IRS can come after you personally.

Who Can Be Held Responsible:

• Business owners and officers (obviously)
• Directors and shareholders with financial control
• Bookkeepers and accountants with check-signing authority
• Employees who directed financial decisions
• Outside consultants with control over funds
• Even lenders and sureties in some cases

The court in one case emphasized that the term extends beyond “mere mechanical functions” to anyone “in fact responsible for controlling corporate disbursements” or who has “the final word as to what bills should or should not be paid, and when.”

The Multiple Responsible Persons Inversion

Heres something else that terrifies business owners. When multiple people qualify as responsible persons, the IRS can collect the FULL amount from EACH of them. They dont split the bill. They send 100% bills to everyone.

You and your business partner each had check-signing authority? The IRS can pursue you for the entire $500,000. They can pursue your partner for the entire $500,000. They might collect it from both of you and later figure out the allocation. Or they might collect it all from whichever person has assets.

This isnt a penalty – its how the statute works. The IRS just wants to collect what they’re owed. They’ll pursue whoever can pay.

What “Willfulness” Actually Means

For the IRS to assess the Trust Fund Recovery Penalty or pursue criminal charges, they need to prove “willfulness.” Most business owners think this means evil intent – that the IRS has to prove you were trying to defraud the government.

That’s not what willfulness means in this context.

Willfulness means a “voluntary, conscious and intentional act to prefer other creditors over the United States.” No evil intent or bad motive is required. You just have to know the taxes were due and choose to pay someone else instead.

Every time you wrote a check for rent while payroll taxes were outstanding, you demonstrated willfulness. Every supplier payment. Every utility bill. Every payroll check to employees (using NEW withholding that you also didnt pay over). All of it shows conscious choices.

The Reckless Disregard Standard

It gets worse. Willfulness includes “reckless disregard” – ignoring obvious warning signs that taxes arent being paid. If your bookkeeper tells you the 941 payments are behind and you dont investigate, thats willfulness. If you see IRS notices piling up and ignore them, thats willfulness.

The IRS doesnt need to prove you personally knew every detail. They need to prove you knew enough to know something was wrong and didnt fix it. Business owners who say “I trusted my bookkeeper” find that excuse doesnt work when they also received delinquency notices they ignored.

The Numbers That Should Terrify You

Let me give you the penalty and criminal exposure for payroll tax violations:

Civil Penalties:

• Trust Fund Recovery Penalty: 100% of unpaid trust fund taxes
• Failure to file penalty: 5% per month, up to 25%
• Failure to pay penalty: 0.5% per month
• Interest: Compounds until paid

Criminal Penalties:

• 26 USC 7201 (Tax Evasion): Up to 5 years prison, $250,000 fine
• 26 USC 7202 (Willful Failure to Pay Over): Up to 5 years prison PER COUNT
• Each quarter can be a separate count

Heres what “per count” means. If you failed to pay over employment taxes for 8 quarters, thats potentially 8 separate counts under 26 USC 7202. Each count carries up to 5 years. Theoretically, thats 40 years of potential prison exposure.

In practice, sentences are shorter – but still devastating. The iProcess Online case resulted in just over a year in prison for $2.6 million in unpaid taxes. The Dallas business owner case resulted in over 8 years for failing to pay over withheld taxes.

Recent Cases That Show What Happens

In November 2024, Lorena Padilla of Orange County was arrested on federal charges for an alleged $90 million payroll tax fraud scheme. She operated multiple staffing companies – Platinum Staffing, Payroll Staffing Solutions, Three Star Global, Next Level Staffing. The companies collected payroll taxes from client businesses but didnt remit them to the IRS. She faces up to 20 years for wire fraud conspiracy and 5 years for each employment tax count.

In August 2024, the owner of iProcess Online, a Maryland payroll company, was sentenced to one year and one day in prison. From 2016 to 2021, she withheld taxes from employee wages but didnt pay them to the IRS. The tax loss was $2,663,264. She also embezzled from employee 401(k) plans.

These arent unusual cases. The DOJ Tax Division maintains a database of employment tax enforcement actions. Business owners across the country are prosecuted regularly for failing to pay over trust fund taxes. The IRS has a 90%+ conviction rate when they bring cases.

Employment Leasing Fraud

Theres another scheme the IRS aggressively prosecutes: employment leasing fraud. This happens when a business outsources payroll responsibilities to a company that then pockets the employment taxes, closes up shop, and disappears when the IRS comes looking.

The original business owner thinks they paid the taxes – they gave the money to the payroll company. But if the payroll company stole it, the original employer is still on the hook. The IRS doesnt care that you were a victim of fraud. They want their money. And if you were negligent in selecting the payroll provider, that negligence might create personal liability.

The 100% “Penalty” Inversion

The Trust Fund Recovery Penalty is called a “penalty,” but its really just the amount you already owed. The IRS can collect 100% of the unpaid trust fund taxes from responsible persons. This isnt a fine on top of the taxes – its just the taxes themselves, transferred from the corporation to you personally.

The “penalty” is that corporate protection disappears. You cant hide behind the corporate structure. You cant dissolve the company and walk away. The debt follows YOU, personally, until its paid or you die.

How the IRS Catches Payroll Tax Fraud

The IRS has multiple systems for detecting payroll tax non-compliance. Most business owners dont realize how transparent their fraud actually is.

The W-2/941 Match

At the end of every year, you file W-2s showing wages paid to each employee. Those W-2s contain total wages, withholding amounts, and Social Security/Medicare information. The IRS compares those totals against your quarterly 941 filings.

If the W-2s show you paid $2 million in wages but your 941s only reported $1.5 million, the IRS knows instantly. The numbers audit themselves. No investigation required – the discrepancy is automatic.

The Deposit Match

When you make a federal tax deposit, it goes into the Treasury system. The IRS compares your actual deposits against what your 941 says you owe. If your 941 shows $75,000 in trust fund taxes but you only deposited $40,000, thats flagged.

Bank Record Analysis

The IRS can also match your bank deposits against your reported wages. If your bank shows $5 million in deposits but you only reported $2 million in wages on your 941, thats a problem. Either your lying about revenue (income tax fraud) or your lying about wages (employment tax fraud).

Employee Discoveries

Sometimes investigations start from unexpected sources. An employee files for unemployment and it turns out they were classified as a contractor. The state notifies the IRS. Now the IRS is examining your employment tax returns and discovers you’ve been paying people off the books.

Or an employee reports you directly to the IRS because they noticed their W-2 dosent match their paystubs. Whistleblower tips are a common trigger for employment tax investigations.

Former employees are particularly dangerous. They know your payroll practices. They know if cash payments were made. They know if their tax withholding was actually sent to the IRS. And if you terminated them badly, they have motivation to report you. The IRS Whistleblower Program even pays rewards for information that leads to collected taxes.

What To Do If You’re Behind on Payroll Taxes

If your reading this because your already behind on payroll taxes, heres what you need to understand:

Stop the bleeding first. Do not miss another quarter. Current compliance is the single most important factor in how the IRS treats you. If your still digging the hole deeper, they will not negotiate.

Do NOT lie to the IRS. When the Revenue Officer contacts you – and they will – do not make false statements about your situation. Lying to a federal officer is a separate crime that transforms a civil collection matter into a criminal case.

Understand your options before making decisions. Depending on your situation, you might be able to negotiate an installment agreement. You might qualify for an offer in compromise. You might have defenses to personal liability. But you cant evaluate options without understanding your exposure.

Get a criminal tax attorney involved immediately. This is not a situation for your regular accountant or business lawyer. You need someone who understands both the civil and criminal aspects of employment tax enforcement. The wrong move can trigger prosecution.

Spodek Law Group is located in the Woolworth Building at 233 Broadway in Manhattan. We handle payroll tax matters nationwide. If your behind on your 941 filings, if a Revenue Officer has contacted you, or if you have any reason to believe the IRS is investigating your employment taxes – call us at 212-300-5196.

Todd Spodek has represented business owners facing Trust Fund Recovery Penalty assessments and criminal prosecution for employment tax fraud. Some clients came to us early enough that we could negotiate civil resolutions. Some came to us after referral to Criminal Investigation, and we fought to minimize prison exposure. The earlier you act, the more options you have.

The worst thing you can do is keep operating the same way and hope things get better. Every quarter you miss makes the pattern clearer. Every payment you make to someone other then the IRS strengthens the willfulness evidence. Every month that passes moves you closer to criminal prosecution.

Call us today. The consultation is free. The cost of waiting could be your freedom.