We have not written about designation of payment in a long time. Early in the life of the blog we had two posts on the topic which you can find here and here. Designation of payment for any type of tax could have important consequences for the taxpayer and save lots of money. For taxpayers who owe employment taxes, or any trust fund tax, or for responsible persons regarding those trust fund taxes, the issue of designation becomes more critical to a successful plan to limit liability.
Why does it matter which taxes get paid and what happens if a taxpayer makes a payment and does not designate?
It matters because sometimes a taxpayer owes different types of taxes and sometimes the taxpayer owes for several periods.
Different taxes – Payroll taxes provide a good example of different types of taxes. While you might lump payroll taxes together as one tax, it has different components. Some of the payroll tax is owed because of the trust relationship created by the taxpayer when it withheld taxes from a third party for purposes of paying that tax over to the IRS. Another part of the payroll tax is the taxpayer’s liability as a party making payroll to pay for the employer’s portion of payroll taxes. Generally speaking, a payroll tax return (Form 941) will have three separate bases for liability. Two are based on the trust relationship and stem from the money withheld from the employee to pay 1) income taxes and 2) Social Security and Medicare taxes. The third portion of the payroll tax liability stems from the direct liability of the taxpayer to pay the employer’s portion of Social Security and Medicare taxes.
Different tax years – A taxpayer might owe income taxes for 2020, 2018, 2016 and 2014. Attached to each of the income tax liabilities will also likely be interest and penalties.
If the taxpayer owing payroll taxes is Acme, Inc. and Acme’s owner is John, John faces a trust fund recovery penalty for which he has personal liability with respect to the unpaid trust fund portion of Acme’s payroll tax liability. John cares deeply that Acme satisfy the trust fund portion so that he does not face a personal assessment of that liability. He may also care about the employer portion of the payroll tax liability if he wants to keep Acme going, but his main concern derives from fear of personal liability. If Acme has limited funds with which to pay the taxes or John has limited funds to contribute to Acme to pay the payroll taxes, John wants to ensure that the payments apply to the unpaid trust fund portion for which he has personal liability. Only after the taxpayer penalties and interest of that portion of Acme’s liability is satisfied can he breathe easy regarding his personal liability.
If Acme or John, on behalf of Acme, makes a payment on the payroll tax liability and says nothing, the IRS will apply the payment to the non-trust fund portion of Acme’s liability first until it satisfies that portion. By doing so, the IRS preserves the greatest possibility for it to collect additional dollars since it can go after either Acme or John on the trust fund portion but can only go after Acme on the non-trust fund portion. The failure to make the designation could have significant negative consequences for John.
If Bob is the taxpayer owing income taxes for different years, he too might care about which of the four years to which the IRS applies his payment. In most situations, the IRS will have assessed the earlier tax periods first, which means the statute of limitations on those periods will run first. If the taxes for these four years were reported on timely filed tax returns, Bob’s 10-year statute of collection would run from about April 15, 2015 for the 2014 liability to April 15, 2021 for the 2020 liability. The 2014 has less than four years to run before it expires while the 2020 liability has almost 10 years left. Additionally, should Bob go into bankruptcy, the 2014 and 2016 liabilities would be classified as general unsecured claims which might be dischargeable with no payments made while the 2018 and 2020 would be excepted from discharge if a bankruptcy petition were filed at this time. So, Bob has an incentive to designate his payments to the more recent periods, allowing the older periods to disappear more quickly due to the statute of limitations on collection or due to the bankruptcy discharge. If Bob sends money to the IRS and says nothing, the IRS will almost always apply the money to the oldest period, first to taxes, then to penalties and then to interest. Once the oldest period is paid, the IRS will almost always move to the next oldest period and again apply the payment to taxes, then penalties and then interest and so on until the liability is paid in full. By applying the payment to the oldest periods first the IRS generally preserves the longest period of collection on the remaining liabilities and reduces the liabilities susceptible to discharge in bankruptcy.
In CCA 2019110508593544, IRS Chief Counsel gives brief advice on the issue of designation. It states:
[A] question was raised about whether a taxpayer can designate the payment allocation when the taxpayer makes a quarterly federal tax deposit, attributable to a specific payroll, or whether the payment must be applied in the best interests of the government. Please share the response below with your staff.
A taxpayer is permitted to designate a voluntary payment, but in order for such designation to be proper the request or designation for the application of the payment must be specific, in writing, and made at the time of the payment. A taxpayer has no right of designation of payments resulting from enforced collection measures.
If a taxpayer submits a voluntary partial payment when there are assessments for more than one taxable period, and does not provide specific written instructions as to the application of the partial payment, then the payments will be applied in a manner serving the best interests of the government. The payment will generally be applied to satisfy the liability for successive periods in descending order of priority until the payment is absorbed and is applied to non-trust fund taxes first.
Pursuant to Policy Statement 5-14 (found at IRM 188.8.131.52.3), to the extent partial payments exceed the non-trust fund portion of the tax liability, they are deemed to be applied against the trust fund portion of the tax liability (e.g., withheld income tax, employee’s share of FICA, collected excise taxes). Once the non-trust fund and trust fund taxes are paid, the remaining payments will be considered to be applied to assessed fees and collection costs, assessed penalty and interest, and accrued penalty and interest to the date of payment.
For more information, see the following resources:
Rev. Proc. 2002-26, 2002-1 C.B. 746
Salazar v. Comm’r, 338 Fed. Appx. 75, 79 (2d Cir. 2009) (and cases quoted therein)
If you represent a taxpayer in a situation in which paying one tax period or one type of tax provides an advantage over letting the IRS choose the application of payment that most benefits it, you should make a clear designation with your payment. In addition to describing the designation in the cover letter forwarding the check, you might also consider making note of the designation on the check itself in the notes section.
Taxpayers can only make a designation when they make a voluntary payment. Involuntary payments such as payments pursuant to a levy, pursuant to a sale, pursuant to a bankruptcy distribution, or other similar situations in which the money comes to the IRS from a source other than the taxpayer do not offer the benefit of the opportunity to designate. This can provide a good reason for the taxpayer to make a payment rather than to wait for the IRS to take the money through some form of collection action.