For people who give their time and money to serve on non-profit boards, a recent ruling of the United States District Court should serve as a flashing yellow light. In Roy Don Bunch v. Commissioner of Revenue (No. 2:10-CV-122), the Court for the Eastern District of Tennessee held a volunteer philanthropist personally liable for nearly $200,000 in penalties because his organization failed to pay “trust taxes” – the federal income and payroll taxes that are withheld from employees’ paychecks.

Nearly everyone knows that the directors of any organization – even if unpaid volunteers – are responsible to run the organization lawfully and to try to correct known violations. The Bunch case takes this notion to a new extreme and reveals that directors on non-profit boards have a particular responsibility to ensure that taxes are paid. This responsibility can arise even though the director has only minimal involvement with the day-to-day operations of the organization, even though he might not actually know of the tax shortfall, and even though he is an unpaid volunteer. The Bunch case makes it clear that even if a volunteer might never see a financial report, might never sign a check, and might never direct that any particular payment be made by the organization, he still must make sure that the organization pays its trust taxes.

The fact pattern of Bunch reflects a classic story: a good-hearted philanthropist whose passion for his charitable mission overwhelmed his prudence. Bunch’s organization provided supportive services for developmentally disabled clients and provided treatment for alcohol addiction. The organization was chiefly funded by grants from the State of Tennessee. Mr. Bunch helped start the foundation and was named as Chairman of its governing Board. In that role (according to the organizational documents), Mr. Bunch supervised the chief executive officer and had “full control over the corporate affairs” of the entity. At first, Mr. Bunch’s involvement was mostly financial: he made cash gifts and substantial loans to the foundation, which helped to cover its operations while awaiting payments from the state (his advances at times exceeded $600,000). His operational role was initially very minimal. He never saw, or asked for, a financial report; never hired or fired employees; never directed payments or wrote checks. However, when the organization got behind on its bills, Bunch stepped in and took control: he assumed check-writing authority, and once he did, he wrote checks paying the foundation’s creditors (including himself) at a time when the organization still owed significant trust taxes to the government. That was enough for the court to find that Bunch was personally liable for the unpaid taxes – not only for the period when he wrote checks, but for the early period when his involvement was clearly nominal.

It is, unfortunately, a somewhat common practice for businesses to bridge their cash-strapped quarters by delaying the payment of taxes. An executive may believe that once a large customer payment comes in, or when business picks up, money will be available to pay the tax; conversely, the executive may know that failing to pay employees or key creditors first can mean shutting the company down. The temptation to use trust tax funds for operations can therefore be great, and it arises for non-profit foundations just as it does for profit-seeking businesses. It is, nevertheless, a serious violation of the tax laws. Both the Internal Revenue Code and case law make clear that taxes withheld from employees’ paychecks are held in trust by the employer for the benefit of the government – these funds are never the employer’s to use.

The Code imposes severe penalties for failure to pay over to the government, trust taxes that are withheld from employees’ payroll checks. Specifically, Internal Revenue Code Section 6672 makes any “responsible person” personally liable for trust taxes that any organization (non-profit or for-profit) has willfully failed to properly pay over to the government. Under that Section, an individual is personally liable if both (a) he is responsible for paying the tax, and (b) he willfully fails to turn over the tax money to the government. The “responsible” designation turns on the degree of financial authority and control that the person has over the organization. The “willful” requirement is not as rigorous as it may seem. No malice, fraud, or “bad intent” is necessary; a failure to pay is “willful” if the responsible person pays other debts while knowing that taxes are unpaid. Although there is no liability if the organization simply has no funds to pay, liability surely does ensue where funds exist and are used to pay creditors who do not have priority over the tax authority. In the Bunch case, the foundation received enough grant money from the state of Tennessee to pay the taxes, but it first paid other creditors – and repaid some of the money it had borrowed from Mr. Bunch himself.

The statute provides an exception for certain volunteers, but it has limited application. Code Section 6672(e) provides relief from “responsible person” liability for volunteer board members who are serving “solely in an honorary capacity.” To avoid liability, the director must not be involved in day-to-day activities and must not actually be aware of the unpaid tax. Moreover, the exception is not available if it would result in no one being liable for the unpaid taxes. Mr. Bunch was not able to come within the exception.

In court, Mr. Bunch admitted that he was “responsible” for the later periods in dispute, after he took over check-writing authority, but he denied that he was responsible for paying taxes during the earlier periods when he was not involved in the foundation’s daily operations. The court however found that he was “responsible” for taxes during all periods. The court also determined that Mr. Bunch’s failure to direct the payment of taxes was “willful.” He knew that there were unpaid taxes and knew that the entity was suffering financial difficulties. Given that knowledge, the Court concluded, Mr. Bunch should have asked more questions; he either knew or “should have known” that trust taxes were unpaid. He had the authority to access financial records (even though he never asked) and had the power to direct that tax payments be made (even though he never exercised that power).

What makes the court’s ruling significant for us, is that Don Ray Bunch became personally liable for the organization’s trust taxes even before he actually exercised his financial authority as a director, when he was acting simply as a generous donor. The court found that Mr. Bunch could have exercised his financial authority at any time, and held that this was the equivalent, for purposes of Code Section 6672, as actually exercising that authority.

The Bunch case means that volunteers with minimal actual involvement now have a duty of diligence (as regards taxes, at least) that might surprise them. If you sit on a board and have financial authority that you could exercise, then you have an affirmative duty to study the foundation’s financial reports, to ask questions, to find out who is being paid, and to direct that the tax authorities be paid first.

Volunteers must also be cognizant of the reality that organizations in financial trouble, whether they are for-profit or not-for-profit, have a way of flooding all nearby boats when they go down. Volunteers should be especially cautious in joining the governing boards of organizations that are delinquent on their financial obligations. A director’s knowledge that an organization is in trouble increases, rather than decreases, the diligence required of them. Knowing about financial problems puts a volunteer on notice that there may be problems with paying taxes, and imposes an affirmative duty to find out more.

One might hope that “good intentions” would relieve volunteers of this responsibility, but they will not, and perhaps they should not. It is easy to boo the stone-hearted Internal Revenue Service and to cheer the well-meaning volunteer doing good works. The truth, however, is that many non-profit organizations are poorly managed, and misuse of trust taxes is a widespread problem. Volunteers should heed the warning message from the federal District Court: anyone fortunate enough, and generous enough, to hold a position of responsibility with a non-profit organization must take seriously their duty to ensure that taxes are paid.

IRS CIRCULAR 230 DISCLOSURE: To comply with IRS regulations, we advise you that any discussion of Federal tax issues in this communication is not intended or written to be used, and cannot be used by you, (i) to avoid any penalties imposed under the Internal Revenue Code, or (ii) to promote, market or recommend to another party any transaction or matter addressed herein.