TAX PITFALLS FOR THE ENTREPRENEUR
FIRST IN A SERIES
By Frederick J. Gawronski
Small business owners have many responsibilities. In addition to running their respective businesses, they have to be a part-time accountant, part-time bookkeeper, part-time negotiator, part-time boss and part-time employee. The last thing on their minds is that they may have personal responsibility and liability for debts incurred by the business. Nonetheless, both the Internal Revenue Service and New York State Department of Taxation and Finance rely on statutory and judicial authority to hold third parties such as shareholders, officers and commercial lenders responsible for the tax obligations of the business.
Over the next several weeks we will be examining these pitfalls for the unwary and presenting strategies to avoid them.
Trust Fund Recovery Penalty
Small businesses will commonly experience ups and downs associated with growth and success. Failing to turn over payroll taxes to the IRS is an easy mistake to make when money is tight and bills need to be paid. That mistake can quickly turn into an expensive problem for the company and could turn into a nasty surprise for those responsible to pay the taxes.
In brief, Internal Revenue Code §6672 allows the IRS to collect from the person(s) responsible to collect, account for and pay over trust funds that should have been collected, accounted for and turned over to the IRS from an employee’s pay but were willfully not collected, accounted for and turned over to the IRS. The liability is considered joint and several among all those persons deemed responsible. Before we go any further, we need to define a couple of key phrases.
Trust Funds. Typical trust funds are the portion of the Social Security and Medicare tax withheld from employees pay (7.65%) and income tax withheld from the employee’s pay. They may also include railroad retirement taxes and excise taxes.
Responsible Person. Responsible person can really be anyone. Typical examples include corporate officers, sole proprietors, partners, employees, bookkeepers and accounting firms. For this provision, responsible person is not just derived from a title in the business but from other indicators as well such as hiring and firing authority, check signing authority and the authority to sign and file payroll tax returns.
Willfulness. The willfulness test determines if a person knew the taxes were not paid and willfully and intentionally did not remit the funds to the IRS after knowing that such funds were due. Responsible persons act willfully if they know taxes are due and use funds to pay other debts, such as other business liabilities. Responsible persons do not act willfully if they do not know of a tax liability but, upon learning of the liability, use funds to pay current taxes.
Joint and Several. Each person or entity determined to be responsible is liable for the entire tax. The IRS is under no obligation to collect from each party equally.
The determination and assessment of a trust fund penalty on a responsible person is a two step process. First, a company must be assessed a liability for unpaid payroll taxes. The assessment can include the unpaid trust funds as well as federal unemployment taxes, the employers matching 7.65% for Social Security and Medicare taxes or the interest and penalties assessed to the employer for failing to remit these trust funds. The interest and penalties alone can more than double the liability for the employer.
Once the assessment on the employer has taken place, the IRS can move to assess the responsible person(s) when it believes the government’s ability to collect the assessed taxes is in jeopardy. Typically, this happens if the company hasn’t filed appropriate tax returns or the IRS determines it will be difficult to collect from the company. The assessment against the responsible person(s) is not for the same amount as the assessment against the company. It is only for the trust fund portion of the assessment.
The best way for an employer to address this potential issue is to take steps to make sure your payroll taxes are timely paid. This can be done by hiring a payroll company to handle all your payroll filings. In the event a payroll company is not a possibility and payroll will be handled in-house, then the employer needs to make payment of payroll taxes a priority above all other debts of the company.
In the event a company is assessed for unpaid payroll taxes, it is best to seek professional help. Tax issues of this kind are often symptoms of other problems with the business and an accomplished professional will be necessary to help navigate these troubled waters.