The name "Trust Fund Penalty" is somewhat misleading because it is not really a penalty added to tax owed. The Trust Fund Penalty refers to a portion of the payroll taxes owed by a corporation. Note that the Trust Fund Penalty only applies in the corporate setting, not to sole proprietorships or partnerships. In legal terms, a corporation is a legal "person" and acts as such until it goes out of business or dissolves. Normally when a corporation owes money and then goes out of business, the creditors cannot look to the employees or stockholders for repayment, because the legal "person" owing the money is now gone. This is one of the protections in doing business as a corporation.

However, this protection does not absolve certain persons from liability for a portion of the payroll taxes the corporation owes. When the corporation withholds taxes from an employee's payroll, the corporation is holding that money in trust for the employee and it is to be paid to the US Government on the employee's behalf. Instead of the employee paying the IRS directly the taxes he owes out of his check, the corporation withholds it and pays it to the IRS. The corporation also pays an additional amount equal to the FICA amount the employee owes. The trust fund portion of the taxes is simply the amount withheld from the employee. If a corporation owes payroll taxes and does not pay them, the IRS will, of course, first look to the corporation to pay the total amount due. If the corporation cannot pay the taxes, then the IRS will look to anyone in the corporation who had the authority to direct where and how money was spent. That person (or persons) is liable for the trust fund portion of the taxes, but not the matching FICA portion. This is the "penalty" owed by the individual for authorizing the employee's money to be paid to someone else other than the IRS. The responsible individual(s) will also owe the interest and penalties associated with the trust fund portion of the taxes.

The trust fund penalty does not apply to sole proprietorships because in that instance the individual owner is naturally responsible for all the taxes due, both those withheld from the employees and the matching part he has to pay.

As in other types of delinquent tax situations, the taxpayer may be able to compromise these taxes through an Offer In Compromise of other types of deals.