Income Tax Due for Business Use of Employee Tax Withholding – Houston Tax Attorneys

Business owners facing cash flow challenges sometimes look to available funds to keep operations running. When those funds include employee tax withholdings that should be remitted to the IRS, the IRS has a number of tools at its disposal to recover the withheld but un-remitted funds.

For the most part this includes pursuing the business owner and those operating the business and imposing a trust fund recovery penalty. This makes the owner and operators personally liable for the missing payroll tax payments. The IRS can then collect against the owner and operators’ personal assets. This is usually all the IRS does to recover these un-remitted taxes.

But what about income taxes? When a business owner uses withheld taxes for business expenses instead of remitting them to the government, does this create a separate taxable event? The IRS Office of Chief Counsel memorandum (POSTS-117751-22) dated August 12, 2024, addresses whether diverted trust fund taxes constitute taxable income to the individual who diverts them. If this does create a personal income tax liability, it means the IRS may be entitled to recover the diverted amounts once through the trust fund recovery penalty mechanism, again through an income tax assessment on the same funds, and again on a criminal restitution order on the same funds.

Facts & Procedural History

To illustrate the issues addressed in the memorandum, let’s consider a hypothetical scenario.

Say John owns a single-member LLC with annual revenue of $500,000. The business has several employees with quarterly payroll of $100,000, from which $20,000 in federal income taxes, Social Security, and Medicare taxes are withheld. During a difficult quarter when a major client delays payment, John uses the $20,000 in withheld taxes to pay business rent, vendor invoices, and purchase needed equipment instead of remitting those funds to the IRS.

This seems to be a typical fact pattern that could have prompted the memorandum by the IRS. As noted above, the memorandum provides legal advice regarding the application of income taxes to diverted trust fund taxes.

Trust Fund Taxes Under Section 7501

With this in mind, we can consider the rules. Section 7501(a) of the tax code provides the legal framework for trust fund taxes. It states that whenever a person is required to collect or withhold any internal revenue tax from another person and pay it over to the United States, “the amount of tax so collected or withheld shall be held to be a special fund in trust for the United States.”

These so-called “trust fund taxes” include income taxes, Social Security taxes, and Medicare taxes that employers withhold from employee wages. These withheld amounts never belong to the business—they are effectively government property from the moment they’re withheld, with the employer merely acting as a custodian.

Why does this matter? The status of these funds as trust property forms the foundation for understanding the tax treatment of their diversion. When a business owner like John in our example diverts these funds, he’s not simply reallocating business assets but taking control of money that legally belongs to the government.

The Trust Fund Recovery Penalty

The primary enforcement mechanism for diverted trust fund taxes is the Trust Fund Recovery Penalty (“TFRP”) under I.R.C. § 6672. This section of the tax code provides that any person required to collect, truthfully account for, and pay over these taxes who willfully fails to do so is liable for a penalty equal to the total amount of the unpaid taxes.

The TFRP applies to “responsible persons” who willfully fail to remit withheld taxes. A responsible person generally includes officers, directors, owners, or anyone with significant control over a company’s finances. The “willfulness” requirement is satisfied when a responsible person knows the taxes are due but pays other creditors instead.

In John’s case, as the owner of the single-member LLC who deliberately used the $20,000 in withheld taxes for business expenses, he would likely qualify as a responsible person who acted willfully. The IRS would likely assess the full $20,000 as a TFRP against him personally. The IRS may also try to assess the penalty against anyone else at the business who could have saw to it that the taxes were paid–the business bookeeper, business manager, or even John’s absentee co-owner wife.

Unlike many penalties, the TFRP is not a percentage-based penalty but rather equal to 100% of the unpaid trust fund taxes. It’s also important to note that this is not technically a “tax” but a penalty, though the practical effect is the same—it creates personal liability for the business owner. The IRS can collect this penalty by levying bank accounts, seizing assets, and taking other collection actions against the responsible person’s personal property.

What Makes Diverted Trust Fund Taxes Income?

This brings us back to income taxes. Section 61(a) of the tax code defines gross income broadly as “all income from whatever source derived.” This sweeping definition has been interpreted by the Supreme Court to include “all accessions to wealth clearly realized, and over which the taxpayers have complete dominion.”

When looking at diverted trust fund taxes through this lens, the parallel to embezzlement becomes apparent. In both cases, an individual takes control of funds that legally belong to someone else. The memorandum explains that “when a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition,” the taxpayer has received income.

But if John in our example uses the diverted funds for business expenses rather than personal use, would this still create personal income? According to the memorandum, the answer is definitively yes.

The memorandum relies on James v. United States, a landmark 1961 Supreme Court case that established embezzled funds as taxable income. In James, a union official embezzled money from his employee union and an insurance company, then failed to report these amounts on his tax returns.

Embezzlement is defined as the “fraudulent appropriation of property by a person to whom such property has been entrusted.” The Court held that these embezzled funds constituted taxable income in the year of embezzlement, rejecting the argument that such unlawful gains should receive special tax treatment. There have been a number of court cases that address the income tax treatment of misappropriated funds.

How does this apply to John’s situation with the diverted payroll taxes? The memorandum draws a direct parallel between embezzlement and Trust Fund Recovery Penalty situations. In both scenarios, an individual takes control of property that legally belongs to another. When John diverts the $20,000 in trust fund taxes to pay business expenses, he’s exercising control over government funds, creating an “accession to wealth” under Section 61.

Does The Use Of Diverted Funds Matter?

A key question for taxpayers like John is whether using diverted funds for business purposes rather than personal expenses affects the tax treatment.

The memorandum addresses this directly by citing cases where courts have consistently held that the use of diverted funds is irrelevant to their characterization as income.

In Walters v. Commissioner, the taxpayer embezzled $9.7 million from clients’ employee benefit trusts and used most of the money to keep his business afloat. The Tax Court found that “embezzlement creates a taxable event, regardless of the income’s final destination.” The focus remained on the act of diversion, not how the funds were ultimately used.

Similarly, in Leighton v. Commissioner, the court didn’t distinguish between diverted funds used for personal expenses versus those reinvested in the business. The controlling factor was that the individual had taken control of funds that belonged to others.

For John in our example, this means that even though he used the $20,000 in withheld taxes exclusively for business purposes, he would still have $20,000 in personal taxable income from the diversion.

How Does This Affect Pass-Through Taxation?

For small business owners operating as sole proprietors or through pass-through entities like John’s single-member LLC, the tax implications can be quite complex.

Consider how this plays out on John’s income tax return:

The LLC reports $500,000 in gross revenue
The LLC deducts the $100,000 in gross wages paid to employees
After other business expenses, let’s say the LLC shows $150,000 in net profit
The $150,000 passes through to John’s personal return as business income
Additionally, John must report the $20,000 in diverted trust fund taxes as separate personal income

This creates a situation where John’s personal taxable income is $170,000, even though the business only generated $150,000 in actual profit. The additional $20,000 represents an “accession to wealth” from taking control of government funds, even though those funds were used for business operations.

The memorandum acknowledges that “depending upon the circumstances, if the individual repays the diverted trust fund taxes, they may be entitled to a deduction in the year of repayment.”

This follows the principle established in James, where the Supreme Court recognized that a taxpayer may be able to deduct embezzled funds in the years repayments are made. The memorandum cites several cases providing potential guidance:

Senyszyn v. Commissioner: Repayments to a victim of embezzlement should be credited against the perpetrator’s taxable income for the year.
Walters v. Commissioner: Some embezzler’s repayments were considered expenses of the illegal activity and ineligible for deduction because they helped to perpetuate the fraud.
Shipley v. Commissioner: Gift taxes paid on embezzled funds were not deductible against the embezzled funds.

If John later pays the $20,000 in trust fund taxes (perhaps after being assessed the Trust Fund Recovery Penalty), he might be able to claim a deduction in the year of repayment. However, the memorandum suggests this determination depends on specific circumstances, leaving uncertainty about when such deductions would be allowed.

What Are The Potential Enforcement Implications?

The memorandum clearly states that diverting trust fund taxes can trigger multiple enforcement actions:

Income tax liability and various civil penalties for failing to report the diverted taxes as income
The Trust Fund Recovery Penalty under I.R.C. § 6672 for responsible individuals
Potential criminal prosecution under I.R.C. § 7202 for willful failure to collect or pay over tax

For John, this means he could face three separate financial consequences: income tax on the $20,000 (plus penalties if he fails to report it), the original $20,000 trust fund recovery penalty, and potential criminal charges if the diversion was willful.

These multiple layers of liability significantly increase the stakes for clients facing cash flow problems. A business owner who views using withheld taxes as merely delaying payment to the government may not realize they’re creating a separate taxable event that compounds their overall liability.

With that said, as a practical matter, in nearly 20 years of tax practice, I have never seen the IRS even propose to assess income tax on un-remitted funds. The IRS does commonly impose trust fund recovery penalties. However, this is typically done by an IRS revenue officer in the collection function. The revenue officer would likely not be able to assess an income tax. They would, presumably, need to bring in an IRS agent from the examination function for this purpose. And even then, the statute for the income tax assessment may have already passed. Meaning, the IRS may have already missed the time period for assessing the income tax in many cases.

The Takeaway

The IRS’s position on diverted trust fund taxes creates a significant risk beyond the trust fund recovery penalty. Business owners who use withheld employee taxes to cover operating expenses aren’t just delaying payment of a tax obligation—they may be creating personal taxable income that has to be reported on their individual returns. This creates a compounding effect where the same diverted funds trigger multiple tax liabilities: the original trust fund recovery penalty, income tax on the diverted amount, and potential penalties for failing to report that income. While the memorandum acknowledges the possibility of deductions for repayments, the uncertainty surrounding when such deductions would be allowed further complicates an already perilous situation for business owners facing cash flow challenges.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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Can Judge-Made Doctrine Override Tax Deductions Allowed by Congress? – Houston Tax Attorneys

The tax code provides specific rules for when taxpayers can claim deductions for losses. These are rules enacted by Congress.

There are other so-called “judicial doctrines” that allow the courts to override the rules set by Congress. There are several of these that frequently come up in tax disputes, such as the economic substance doctrine (which was codified into law), the step transaction doctrine, etc. We have covered many of these doctrines in prior articles. We have not addressed the public policy doctrine.

The “public policy doctrine” allows courts to deny tax deductions that would otherwise be perfectly legal under the tax code when allowing such deductions would “frustrate” public policy.

The U.S. Tax Court recently applied this doctrine in Hampton v. Commissioner, T.C. Memo. 2025-32, to disallow a tax loss when the government seized assets of a business for the wrongdoing of the owner. This gets into issues of separation of powers, and how far the courts can go in overriding the rules set by Congress.

Facts & Procedural History

The taxpayer in this case was a stock broker. He operated as an S corporation, and was 100% owner of the S corporation.

In 2009, the taxpayer worked out an arrangement with his high school friend who had been appointed as the deputy treasurer of the State of Ohio. The arrangement involved the deputy treasurer directing trading business from the State of Ohio to the taxpayer, with the taxpayer sharing portions of his commissions with the deputy treasurer and two associates. The payments were aledged to have been disguised as legal fees or business loans. The taxpayer received approximately $3.2 million in commissions from these trades and paid about $524,000 to the conspirators.

In 2013, the taxpayer pleaded guilty to charges of bribery, fraud, and money laundering. In 2014, he was sentenced to 45 months in prison and ordered to forfeit approximately $2.2 million. In 2016, while he was incarcerated, the U.S. Marshals Service seized $1,182,543.71 in funds from seven bank accounts held in the name of either the taxpayer or his S corporation.

On its 2016 Form 1120S, the S corporation claimed a deduction of $855,882 for the forfeiture of its seized accounts. As the S corporation’s sole shareholder, the taxpayer reported this loss on his individual tax return. The IRS audited the tax return and disallowed the deduction for the tax loss. The taxpayer filed a petition with the tax court for review.

About the Public Policy Doctrine

The public policy doctrine is a judicial doctrine the courts have cited for denying tax deductions that would “frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof.” This principle was articulated by the Supreme Court in Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30, 33-34 (1958).

This is not a rule created by Congress through legislation. Instead, it was developed by judges who decided that some tax deductions, though technically allowed by the tax code, should nevertheless be denied on public policy grounds. This represents a significant judicial encroachment on what would normally be the legislative domain of determining which deductions are allowable.

The doctrine is particularly applicable to tax penalties imposed by the government–in addition to income tax due resulting from the denial of tax deductions. As the Supreme Court explained, the “[d]eduction of fines and penalties uniformly has been held to frustrate state policy in severe and direct fashion by reducing the ‘sting’ of the penalty prescribed by the state legislature.” The underlying rationale is that allowing a tax deduction for a government-imposed penalty would effectively reduce the financial impact of that penalty, thereby undermining its deterrent effect.

How Does the Public Policy Doctrine Override Section 165?

Section 165(a) of the tax code allows a deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” For individual taxpayers, the deduction is limited to losses incurred in a trade or business, in transactions entered into for profit, or in certain cases of casualty or theft. Notably, the text of Section 165 contains no exception for losses resulting from criminal forfeitures or other penalties.

In 1969, Congress partially codified the public policy doctrine by amending Section 162 of the tax code (which is the general provision that allows for business tax deductions) to explicitly disallow deductions for fines and penalties paid to a government for violation of law. However, Congress did not make similar amendments to Section 165 (which is the provision for deducting tax losses). This raises the question: Did Congress intend to limit the public policy doctrine to Section 162 deductions, leaving Section 165 free from such judicial restrictions?

The courts have not followed this distinction. The courts have applied the public policy doctrine to Section 165 deductions. For example, the Federal Circuit did so in Nacchio v. United States, 824 F.3d 1370, 1374 (Fed. Cir. 2016). In that case, the court explicitly stated that “§165 is subject to a ‘frustration of public policy’ doctrine.”

When Can Courts Override the Plain Language of the Tax Code?

How far courts are willing to go and should they be allowed to go in applying the public policy doctrine–even when doing so requires overriding the plain language of the tax code?

Under a strict reading of Section 165 and the S corporation flow-through rules under Section 1366, the taxpayer here would appear to be entitled to deduct his share of the S corporation’s loss from the asset forfeiture (there was an assignment issue for assigning income thath the court didn’t get to, which may also have been a problem had the court gotten to that issue–but that is beyond the scope of this article).

Section 165 allows deductions for “any loss” with certain limitations that don’t explicitly exclude criminal forfeitures. Section 1366(a) provides that an S corporation shareholder “shall take into account” his pro rata share of the corporation’s income or loss. Nothing in the text of either provision suggests an exception for losses resulting from criminal activity.

Yet the tax court determined that the public policy doctrine overrode these statutory provisions. The court held that even if the S corporation was entitled to claim a deduction (a question the court did not decide), the taxpayer as an individual was barred by the public policy doctrine from reporting his 100% passthrough share of the S corporation’s resulting loss on his individual return.

The court’s rationale was that allowing the taxpayer to deduct the loss would frustrate the sharply defined policy against conspiring to commit offenses against the United States. The taxpayer was the Purported wrongdoer, and the S corporation’s assets were somehow seized as part of a penalty for his wrongdoing. The court did not get into how the denial of a deduction is not a tax penalty, and the code already provides for tax penalties–no doubt which also applied. Thus, apparently the taxpayer should be double penalized–with a tax penalty (probably more than one) and then again by the loss of his tax deduction. According to the court, allowing the taxpayer a deduction would unquestionably reduce the “sting” of the penalty (which a forfeiture is not a penalty), regardless of what the tax code actually says about such tax deductions.

How Far Can Courts Extend the Public Policy Doctrine?

The tax court emphasized that the public policy doctrine is not constrained by formalistic distinctions between legal entities. This is similar to the rules that apply when a taxpayer transfers assets to a spouse to avoid IRS collections. The court cited Holmes Enterprises, Inc. v. Commissioner, 69 T.C. 114 (1977), where a corporation claimed a deduction for the criminal forfeiture of a car it owned after its sole owner and president was convicted on illegal drug charges.

In Holmes, the tax court concluded that although the corporation was a “separate, taxable entity, distinct from its employee,” the public policy doctrine forbade it from claiming a deduction because it was not a “wholly innocent bystander.” Due to the convicted person’s role as the corporation’s sole owner and president, the corporation “knew of and fully consented to the illegal use of its automobile.”

This reasoning shows how courts have expanded the public policy doctrine to deny deductions not just to convicted individuals, but also to closely related entities, even when those entities themselves haven’t been charged with any crime. This judicial expansion extends the doctrine well beyond what Congress explicitly codified in Section 162(f).

Can a Taxpayer Challenge Judicial Overreach Through a Tax Deduction?

The taxpayer in this case argued that the application of the public policy doctrine should be limited because the United States’ seizure of the S corp’s assets violated due process and was “over-zealous” given that the S corp was not the wrongdoer. However, the tax court found no legal impropriety in the seizure of the S corp’s assets to satisfy the taxpayer’s forfeiture liability.

The court relied on the Sixth Circuit’s decision in United States v. Parenteau, 647 F. App’x 593 (6th Cir. 2016), which held that a corporation wholly owned by an individual convicted of a criminal conspiracy was not a person “other than the defendant” for purposes of forfeiture proceedings. The Sixth Circuit cited relevant factors including that the defendant wholly owned and controlled the corporation, that the corporation did not follow corporate formalities, and that the defendant used the corporation’s property in his criminal scheme.

By analogy, the tax court concluded that the S corporation in this case was not separate from the taxpayer as an individual for purposes of the substitute forfeiture provisions. The taxpayer wholly owned and controlled the S corp, offered minimal evidence that corporate formalities were followed, and the S corp’s sole source of business income was the commissions generated by the taxpayer that were “assigned” to the S corp—the very commissions that led to the criminal indictment, plea, and forfeiture. This is consistent with the court’s prior rulings that apply various judicial doctrines to S corporations.

Is There Any Limit to Judicial Override of Tax Code Provisions?

The tax court also rejected the taxpayer’s argument that the public policy doctrine’s application should be affected by alleged illegality or over-zealousness on the government’s part in seizing the assets. Both the Fourth Circuit and the tax court have previously indicated that the alleged illegality of a criminal forfeiture need not prevent the public policy doctrine from disallowing a deduction for the forfeited property.

In Hackworth v. Commissioner, 155 F. App’x 627, 632 (4th Cir. 2005), the Fourth Circuit stated: “If the taxpayers believe that the forfeiture was invalid, the proper remedy is for them to sue the [relevant government unit] and seek return of the funds [rather than claim a tax deduction].” Similarly, in the tax court’s decision in Hackworth, the court stated: “This Court lacks jurisdiction over [the taxpayers’] collateral attack on the forfeiture.”

This principle further demonstrates the power of the public policy doctrine as a judicial override of tax code provisions. Even if a taxpayer believes that a forfeiture was illegal or improper, courts will not allow them to deduct the loss under Section 165. Instead, they must challenge the forfeiture directly in another forum—a requirement found nowhere in the text of the tax code itself.

The Takeaway

This case shows how the judge-made public policy doctrine can override explicit provisions of the tax code. Despite clear statutory language allowing deductions for business losses and requiring S corporation shareholders to report their share of corporate losses, the tax court denied the taxpayer’s deduction based on a doctrine created by judges, not legislators. The tax law as written by Congress can be trumped by judicial doctrines when courts determine that public policy would be frustrated by allowing certain deductions. Taxpayers facing criminal forfeitures should understand that the public policy doctrine enables courts to disallow deductions that would otherwise be permitted under a plain reading of the tax code, particularly when there is a direct connection between criminal activity and the forfeited assets.