IRS Disagrees With Tax Court on Ability to Designate Employment Tax Payments as Income Tax Withholding

By Deborah Spyker, CPA, CPP, Washington

Editor: Michael Dell, CPA

Employment Taxes

The IRS announced in Action on Decision (AOD) 2014-001 that it will not follow the Tax Court's holding in Dixon, 141 T.C. 173 (2013), that an employer may designate payments of its employment taxes to the income taxes of specific employees. The IRS stated in the AOD that it did not appeal the Tax Court's ruling because the case has limited precedential effect.


James Dixon and Sharon Dixon owned Tryco Corp., which failed to file employment tax returns and pay its employment taxes from 1992 through 1995. The Dixons also failed to file their individual income tax returns and pay their taxes during that same period.

The government criminally prosecuted the Dixons for failing to file their income tax returns. During plea negotiations, the Dixons attempted to pay their taxes in full; however, instead of paying the taxes, they transferred the funds to Tryco and directed Tryco to use the funds to pay some of its delinquent employment taxes. Tryco also designated that the payments be applied to the Dixons' withheld income taxes. Because of Tryco's payments, the plea agreements and sentencing in the criminal proceeding indicated that the Dixons' income taxes "were mostly satisfied" (AOD 2014-001).

The IRS, however, applied Tryco's payments to the unpaid employment tax liabilities, not to the Dixons' income tax liabilities, and sent a notice of intent to levy and right to a hearing to the Dixons. The Dixons requested a collection due process hearing, and the Office of Appeals sustained the levy, concluding that the Dixons were not entitled to a credit under Sec. 31(a) because the payments represented tax "not withheld at the source." Appeals also determined that Tryco could not designate payments that were not withheld at the source to the income taxes the Dixons owed.

The Dixons filed a petition with the Tax Court, which disagreed with Appeals and held that the Dixons were entitled to a credit under Sec. 31(a) because most of Tryco's payments "represent[ed] tax actually withheld at the source within the meaning of sections 3402 and 3403." However, the Tax Court determined that the Dixons were not entitled to a credit for the payments that represented tax not withheld at the source.

Additionally, the court held that the IRS had to honor Tryco's designations of the payments and credit the Dixons' income tax liabilities. The court observed that designation of its payments to the income tax liabilities of specific employees is consistent with IRS policy and federal case law that permits a taxpayer's designation of voluntary payments of tax. The court also pointed out that disregarding the designations "would be . . . inconsistent with the premises of the plea agreement and sentencing."


The IRS disagreed with the Tax Court's holding that employment tax payments not withheld at the source may be designated by an employer to a specific employee's income tax liability. The IRS noted in AOD 2014-001 that, under Secs. 3402 and 31(a), "an employee may only get a credit for income taxes withheld at the source. If the income tax is not withheld at the source, a later payment by the employer of its liability for the tax it should have withheld will not result in a credit to the employee."

The IRS believes that the Dixons cannot rely on the rule that allows the designation of partial voluntary payments under Rev. Proc. 2002-26 because the designation rule allows a taxpayer to designate a payment only toward its own tax liabilities. In this case, Tryco could not designate its payments to the Dixons' income taxes because the Dixons owed the taxes, not Tryco.

Therefore, the IRS will not follow Dixon's holding that an employer may designate payments of its employment taxes to income taxes of specific employees. However, the IRS also explained that it did not appeal the Tax Court's ruling because, due to the unique facts of the case, it has limited precedential effect.

Form 4669

If an employer discovers that it has failed to withhold income tax after the close of the calendar year, the employer may not remit the income tax and credit the tax to the prior calendar year Form W-2, Wage and Tax Statement, as federal income tax withheld at the source. However, the employer remains jointly and severally liable for the tax.

The employer may consider procuring a Form 4669, Statement of Payments Received, from an affected employee after the employee has filed his or her income tax return on which the employee certifies under penalties of perjury that he or she reported the income and paid the corresponding income tax. Form 4669 abates the income tax assessed against the employer in an examination but does not abate penalties that the IRS may assess for failure to withhold tax.


Michael Dell is a partner at Ernst & Young LLP in Washington.

For additional information about these items, contact Mr. Dell at 202-327-8788 or

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

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