Cash flow is in the toilet, and you are past due on prior quarters’ payroll tax liabilities. You can barely cover the next payroll check run. What to do? My number one rule for having a better life is “Don’t go broke while owing the IRS for payroll taxes”. The reason is simple. They will make your life even more miserable by assessing the Trust Fund portion of the taxes on you personally. You will not be able to discharge this penalty in bankruptcy which means that the IRS will be after you for the next 10 years.
Must Do Steps
Step Number One is you need a new business plan, and you need it fast. Moreover, it must be a real plan that shows a clear path to cash flow and profitability. If you can’t produce this plan, it’s time to shut the business down. Either go back to being a sole proprietor without employees or move on to something better. Digging the hole deeper is a bad bet.
Step Number Two is to reduce the liability for the Trust Funds portion of the payroll tax liabilities. Assuming the business is being taxed as a corporation, transfer whatever cash is available to the owner and let them make a voluntary payment to the IRS for the payroll taxes. The owner needs to pay the IRS by check along with a letter that designates that the payment is to be applied to the “Trust Funds Only” for each outstanding liability period under Rev. Proc. 2002-26. Eliminating the trust fund portion of the tax debt eliminates the possibility of the Trust Fund Recovery Penalty being assessed on the owner individually.
Staying in Business
Here are a couple of ideas if the business is going to continue:
- The business should immediately set up a payment plan to cover the balance of the payroll taxes owed. Do not wait for the IRS to contact you. Things will not get better with a Revenue Officer assigned to your case.
- Make future payroll tax deposits on the same day that you pay the employees. Your payment plan will automatically be in default if you do not make all tax deposits timely. It is critical that you don’t let this get away from you.
The great thing about the American Economic System is that you are allowed to fail and go on to other things. However, a payroll tax liability that is perhaps in the hundreds of thousands is going to make that recovery ever so much harder.
Companies that fail to make their payroll tax deposits will eventually be faced with dealing with IRS Collections. One of the tools that the IRS has in its arsenal is the Trust Fund Recovery Penalty which is assessed on the people responsible for not making the payments. Defending against this assessment starts with understanding who the IRS will consider to be a responsible person.
The IRS considers a responsible person to be anybody who is accountable for collecting OR paying the payroll taxes and who then willfully fails to do so. “Willful” sounds like a possible out if your cash flow is in the toilet, but it’s not. Paying other bills before the IRS is considered evidence of willfulness.
Typically, the IRS will assess people in the following positions:
- The owner/operator – There is no out for anybody in this position. Even if you did not know the taxes were not being paid, the courts have held that you should have.
- Other officers of the corporation if they had signature authority on bank accounts and knew that the payroll taxes were not being paid.
- Accountants that had signature authority on bank accounts and signed the payroll tax returns.
- Lenders who have funded payrolls in the amount that only covers the employees’ net paycheck. The theory here is that they knew the company owed the funds and could have required them to borrow enough to pay the taxes.
The best defense for anybody in these positions, other than the owner, is to not have signature authority on any business bank accounts. The ultimate responsible person is always the top guy or gal. Business owners and CEOs cannot delegate this responsibility away.
My next post will cover some strategies for dealing with a potential Trust Fund Recovery Penalty.
The IRS recently released their Data Book for 10/1/19 – 9/30/20. This publication is a compilation of various statistics for the fiscal year ended 9/30/20. You can find some interesting information that might be useful in dealing with the IRS.
For example, ever wonder which penalties are the easiest to abate? Table 26 shows penalties assessed vs. penalties abated. I did a little spreadsheet work and compiled the following table for individual penalties:
|Type of tax and type of penalty
||Civil penalties assessed
||Civil penalties abated
||% of #
||% of $ abated
|Civil penalties, total
|Failure to pay
The failure-to-file penalty is the most likely penalty to be abated. The accuracy penalty is the one that causes taxpayers the most angst and is one of the hardest to get relief.
The bad check penalty is interesting. It’s one of the easiest penalties to have abated since it requires someone to knowingly issue an insufficient funds check. Most of the corporate bad check penalties are abated, but only 5% of the assessments on individuals get removed presumably because the amounts are too small to bother with.
One of the hardest and most irritating problems to work with the IRS is when someone has issued a W-2 or 1099 with an incorrect social security number on it. Generally, what happens is that you receive an IRS notice of proposed changes to your tax return for unreported income. The notice includes a list of 3rd party 1099s and W-2s issued to your social security number. One of those 1099’s, for say $20,000, is from some company that is not even in your part of the country.
Calling up the IRS and complaining about this does nothing. The IRS’s position is that it is up to you to prove that the 1099 is in error. Several people I have known over the years have given up at this point and just paid the additional taxes.
However, there are better options:
- Call the company on the form and try to get them to amend it.
- Fill out IRS Form 2624 giving the IRS permission to contact the payor. The IRS will race at a snail’s pace to contact them, but this is usually enough of a prompt to get it fixed.
- If this does not work, it’s possible that you are a victim of identity theft. You should call the IRS and request an IP PIN.
- The next step is to file a Form 911 with the Taxpayer Advocate Service. One of their primary purposes is to get the bureaucracy to correct errors when its processes fail.
- Finally, if it’s enough money, consider an Offer-in-Compromise due to Doubt as to Liability. Make an offer of $150 to cover the processing costs and hopefully, the IRS will let it go at that.
What is so irritating about this issue is its unfairness and the IRS response that this is your problem, not theirs. Luckily, most of the millions of 1099s and W-2s are issued with correct id numbers.
The most effective IRS tool for getting paid is the Federal Tax Lien Notice. Should you sell your real estate, they are virtually guaranteed to get your share of the proceeds to cover your tax debt. Most payment plans on the other hand end up in default. As a result, they will not remove the lien notice simply because you start making monthly payments.
There are some options open to you when it comes to Federal Tax Lien Notices:
- They will usually issue a Subordination of Federal Tax Lien to allow a bank refinancing of a mortgage provided they get a significant chunk of any cash coming out of the deal.
- They will also remove a particular property from their lien provided they get some cash. This is called a Certificate of Discharge from a Federal Tax Lien.
- You can get a Lien Withdrawal if you are on a Direct Debit Installment Agreement and your debt balance is $25,000 or less. The catch on this one is that the agreement must lead to full payment in less than 60 months or before the Statute of Limitations runs.
Of course, the option the IRS likes the best is for the taxpayer to just pay off the debt balance. Should that happy day happen, the Lien Withdrawal will be automatically issued within 30 days.
Lien Notices are usually not very disruptive to your life like a levy of your wages or bank account. They do affect your credit score and will result in you getting umpteen letters from people offering to get you out of your problem for “pennies on the dollar.” However, most closing agents have experience in dealing with these when it comes to selling real estate making them a minor complexity in the deal.
The IRS issues millions of liens on tax debtor property every year. Unlike other creditors, IRS liens are “self-releasing”. There is a highlighted box on each Notice of Federal Tax Lien that states that this notice will also operate as a lien release one day after the Last Date for Refiling. The problem is that most people, including financial professionals, do not read this and keep looking for a formal release that is not coming.
The easiest way I have found to handle the problem with bankers and closing agents expecting a formal withdrawal is to send them a copy of the lien notice and highlight in red the already highlighted box. You can also send them IRS Publication 1468 which explains the self-releasing nature on page 4.
The IRS will formally withdraw the lien notice if the debt is cleared prior to the Statute of Limitations. This is usually done automatically within 30 days after the debt has been paid off with money or an Offer-in-Compromise. There are also other reasons they will issue a withdrawal if the government can be convinced it is in their best interest.
Non-Filers have a particular problem when they decide to come in from the cold and rejoin the tax system. That is nonexistent records. Non-Filers are most likely to be people with small businesses that can dodge the 1099/W2 reporting systems. Coming clean with the IRS requires them to report their net income for any returns missing in the last 6 years. What should they do if those records do not exist?
First, you must realize that records do exist. They are just not in the possession of the taxpayer. Here is a list of places to start to rebuild those resources:
- The IRS transcripts are the first place to start. You can download these from the irs.gov website. Life is a lot easier if late filed returns agree to the 1099s in IRS possession.
- Bank statements are still on file at the various banks. There may be some cost to get them depending upon their age.
- Credit card statements are also available from the various banks that issue them.
- Vendors have records of their billings and collections from their customers. This is particularly important if the transactions were primarily in cash.
Finally, there is the Cohen Rule. Cohen was a 1930 case in which the Court allowed the use of estimates if there is a reasonable basis to assume that the expenses had occurred. This won’t work with travel and entertainment expenses but is still better than nothing when it comes to other costs.
Yes, the fees for cobbling all this stuff together are going to be higher than they would have if you had never gone out of compliance. Think of it as a motivation to avoid this situation in the future.
One of the more confusing issues in reporting taxable income is what to do when there is a 1099-A or 1099-C involved. Sometimes both the A and the C refer to the same property, other times not. Here is a simple way to think about the issue.
- The 1099-A is required from any creditor when a borrower abandons real or personal property. This is not a taxable event. The purpose of the form seems to be only to alert the IRS that a taxable event is likely coming.
- The 1099-C on the hand is issued by a financial institution whenever it cancels debts of more than $600. This usually means that the finance company has given up on collecting the debt and written it off.
The 1099-C is what the IRS is going to attempt to match to the related tax return. The problem is that just because there is an amount on a 1099-C, it is not necessarily all taxable. There are several exceptions that the taxability of debt cancellation including:
- Cancellation of debt in a title 11 bankruptcy case. Use Form 982 to report the reduction in tax attributes for canceled debt.
- The amount that the taxpayer is insolvent immediately after the discharge. See Pub 4681 for their nifty worksheet to calculate solvency.
- A discharge that is characterized as a gift.
- A discharge that would produce an offsetting deduction.
- A purchase price reduction that reduces the asset basis.
- Certain student debts.
All 1099-Cs should be reported to avoid problems with the IRS matching program. Use a disclosure note to explain your reductions when one of the exceptions applies.
The IRS has been building a list of millions of nonfilers who have significant income. The names on this list have been prioritized and their people are starting to work on those cases. One of the options for someone who thinks their time is running out is the Voluntary Disclosure Practice.
The idea here is that by making disclosures before the IRS catches up with you, you demonstrate your goodwill by coming clean. This saves the government investigation time and money. There are two steps to the process. First, you need to make sure that an investigation is not already underway. This is called ‘Preclearance’ and takes 4 to 8 months before you receive an IRS letter welcoming you to the program or not. Once you have your preclearance letter in hand the next step is the actual disclosure followed by making arrangements to pay the taxes and penalties due.
The Pros of joining the program:
- Acceptance means jail time is most likely out.
- Penalties can be negotiated down.
There are some Cons to think about also:
- You must tell them everything and cooperate fully. Messing this up will result in you having provided evidence to the IRS to be used against you in a likely criminal case.
- Nonfilers with illegal income, even if legal under state law, are not eligible to participate.
The common scenario is somebody who has not filed for years but finds themselves wishing they had. Perhaps they have seen articles about the IRS’s claim to have identified millions of non-filers with significant income. Or maybe they realize that in this world of interconnected databases there is simply no place to hide.
Whatever their reasoning, the next question is “how do I get back into the tax system without invoking a criminal investigation?” There are three approaches to consider:
- Simply start filing and hope enough time goes by that the non-filing periods drop off the IRS radar.
- Then there is the “Quiet Disclosure” technique. Basically, you prepare returns for the last three years and mail them in separately every week or two, hopefully with a check. The idea here is that no one return processor will connect the dots that something significant is happening.
- Finally, there is Voluntary Disclosure. You file a letter with the IRS requesting preclearance for voluntary disclosure. The preclearance process is so that the IRS can check their records to determine if you are already under investigation and not eligible for the “Voluntary Disclosure” process. Once you are cleared to proceed, you confess all and begin negotiating the penalties without fear of criminal actions.
Which is the right approach? Depends upon the situation and money owed. Acceptance into the Voluntary Disclosure Program is the safest approach if you owe lots and a criminal investigation is likely. Run-of-the-mill cases are usually safe with the Quiet Disclosure approach.