Dealing With the IRS:
Understanding the Payroll Tax
usinesses must stay compliant with their taxes or the consequences can be astounding. As business people we all know that we must file our business income tax returns. Most small businesses operate under the protection of an LLC or S-Corporation, but C-Corporations and Partnerships still have their place. Regardless of your choice of entity, filing on time and paying what is owed on time is more important than most people realize. Yes, there are penalties for filing late, even on flow-through entities that otherwise would owe no tax at all. But the biggest pitfall businesses face is falling behind on payroll tax.
Let’s understand what payroll tax is. Payroll tax is money withheld from employee’s paychecks to pay their income tax withheld, Social Security, and Medicare. Most business owners see this as a liability, which it is, and part of their cash flows. But you need to realize—are you ready for this? IT’S NOT YOUR MONEY!
I realize you must match the Social Security and Medicare so that part is yours, but the part that is withheld from the employee’s paycheck is not. So what happens when cash flows are a little short and the 15th rolls around and it is time to make that Federal Tax Deposit for last month, and doing so will mean other bills don’t get paid? Well, most business owners make a business decision to keep the lights on and pay the taxes later. After all, things will get better and receivables will be collected soon so paying a little late isn’t a problem—right? Wrong. There is a staggered penalty for late deposits, but just assume you will be penalized 10% for a late deposit– which is where most of the penalties fall.
Besides the late deposit penalties, what other problems can you get into by paying late or not paying the payroll tax? Well, most people plan to pay a little late, but the pitfall is, whatever the problem is that caused you to not have the money on the due date may still be a problem. Now the problem begins to snowball. One month late becomes two, then three. Then if you have a little money you are not sure where you should pay it, so you likely will put it on the oldest period in an attempt to get caught up. Wrong again. That oldest period already has the maximum penalty assessed to it. The most important thing you can do with the money is to make a current Federal Tax Deposit and NOT pay the tax from months ago.
Another pitfall many business owners find themselves in when they are behind on their payroll taxes is to not file the Form 941 at all. They figure if they don’t have the money to pay the tax, they may as well wait to file the return. This is another HUGE mistake. Few people realize that in the minefield of IRS penalties, the Failure to File Penalty (filing late), is 10 times higher than the Failure to Pay Penalty. That’s right. In our tax system, the IRS doesn’t tell you how much tax you owe. You tell them. So when you fail to tell them, they hit you with a huge penalty of % per month for up to five months. Not paying on time is only 0.005% per month. So, file those returns, even if you can’t pay.
OK, so you’ve filed all of your returns and you are behind on your payroll tax. What is going to happen to you? Well, this is the $64 dollar question, isn’t it? You must realize that even though you considered your decision to pay your payroll and suppliers and other bills instead of the payroll tax that was due to a business decision to keep your doors open until things turned around, the IRS looks at it very differently. They consider you to be a THIEF. You spent money that was not yours in your business without permission. If an IRS Revenue Officer shows up they will tell you that what you really did was dip your hand into the US Treasury to pay your light bill and that is a crime. And, hey have two choices on how to handle it.
They can handle it criminally, which will entail prosecuting you and seeking federal prison time. This is a real option. When I was a Revenue Officer, I pursued this option on egregious cases. Or the IRS can treat it as a civil matter. In reality, the IRS is short staffed, as are the courts, and they cannot prosecute every one that fails to pay their payroll tax. Therefore they pick and choose which ones to prosecute that will generate the biggest bang for their buck. They want cases that will hit the news and cause other business people to get scared and jump back into compliance. That is a good thing. Even when they handle it civilly, it can still be a painful lesson to the business owner and others.
The Trust Fund Recovery Penalty (TFRP) is what is coming your way if a Revenue Officer shows up and you are behind on your payroll tax. You may be thinking that you are protected by the shield your LLC or Corporation provided you, but a Revenue Officer will pierce that shield and assess a penalty to EVERYONE they find was responsible to pay the tax and willfully did not.
So what is the TFRP? It is the amount actually withheld from employee paychecks. Not the matching Social Security and Medicare. Not the penalties or interest. Just what you actually held in trust and failed to pay the IRS. This number can snowball and get huge really fast.
Personally, I have seen TFRP penalties in the millions of dollars. They can pierce that veil and assess that penalty without ever even talking to a judge. Once the penalty is assessed, your home and your vehicles and your boat and your retirement accounts are all fair game. The Revenue Officer will also cast a wide net and usually assess the penalty to others as well. Your bookkeeper who can sign checks, your spouse or sibling who can sign checks just in case you are in the hospital. They can hit anyone who could have paid the tax and didn’t. Now everyone involved will get a Notice of Federal Tax Lien and be in collection personally. It can turn into a nightmare.
So, what do you do? First of all. Don’t get behind on your payroll tax. And if you do, get current NOW. You can always deal with the back taxes you owe but if you are adding more unpaid tax to that pile, it will get ugly. The IRS calls that PYRAMIDING. Stop pyramiding and get current quickly. If you cannot get current, then you need to discuss your business viability with your financial advisors. It may be better to stop the bleeding quickly and close the doors than to keep using employee tax money to keep the doors open. Your CPA or other advisor might be able to make a plan to restructure your business to save it. I’ve seen many plans work and yours might also.
What should you do if you are behind and can’t get caught up, or a Revenue Officer shows up? If this happens, then truthfully, you need help. You can represent yourself in court if you like, but smart people will hire a lawyer to help them. Same thing applies to payroll (and other) tax problems. You should engage an expert to help you. Your CPA or tax attorney is allowed to represent you before the IRS and might be a good choice. If someone from the Government shows up, say nothing. Tell them you want representation and ask them to leave. Then hire a competent representative quickly. You can do more damage than you would think by talking to them yourself. Believe me, I know!
by Ken Mullinax