The IRS really hates businesses that fail to pay their payroll taxes for good reason. The government ends up paying for these failures twice. First, they never get the money. Second, they end up having to credit the employees with the withholding and potentially pay refunds on the money they never received. The resulting IRS policy is to put you out of business as soon as possible to avoid the run-up of these tax debts.
What should you do if your cash flow just can’t hack it?
Step 1 is to stop digging the hole. Immediately, start paying your payroll taxes for each payroll at the same time you pay the employees. If your cash situation is so bad that paying your payroll taxes and employees is not feasible, start laying them off until you get it down to what you can pay. In my experience, the idea that your business is going to magically improve next week never happens.
Step 2, you need a new business plan yesterday. The planning process needs to consider all the standard cash flow options such as collecting on receivables, stringing out suppliers, and improving inventory turns. Cash flow is one thing, but profitability is the only thing that works in the long term. Unless you can find a clear path to profitability, the company is not going to survive. Recognize it. Close it. Go on to something new.
Step 3 is to minimize the impact on you the business owner. The IRS will eventually show up and assess a penalty on you personally for the monies withheld from the employees’ paychecks. You can minimize this impact by paying those trust funds personally and designating that payment to be applied to the “trust funds only”. This will reduce the unpaid trust funds portion that the IRS could eventually assess upon you. This only works if you make the payment voluntarily. The company cannot do this.
Unpaid payroll taxes are the worst tax debt you can have. The IRS will eventually shut you down, but they usually don’t show up until the debt is large. You then file for bankruptcy, but the IRS will assess the Trust Funds Penalty on you personally. Now you’re out of business and an employee again. But you owe $100k or more with the IRS threatening levies against your wages for the next 10 years. The time for action is now.
If you owe the IRS money, you might be considering an Offer-in-Compromise (OIC) as a way to settle your tax debt for less than the full amount you owe. This is the so-called “pennies on the dollar” approach you hear in ads.
While an OIC can be an excellent way to resolve your tax debt, it’s essential to understand that the IRS does not accept every Offer-in-Compromise that is submitted. In fact, the IRS rejects the majority of OICs that are submitted.
The most common reasons for these rejections include:
- Compliance Problem – All of the returns due for the last 6 years have not been filed or the current year’s estimated tax payments are not being made. This results in an immediate rejection of the offer.
- Ability to Full-Pay – The IRS has a methodology for analyzing a taxpayer’s financial situation. If the offer amount is below what they determine the taxpayer could pay, they will reject the offer.
- Dissipated Assets – The IRS finds that the taxpayer has sold assets to friends, relatives, or lenders sometime in the last 3 years. The IRS’s position is that the cash from these transactions should have been used to pay down the tax debt.
Nobody can guarantee that an OIC will be accepted. However, avoiding these 3 common problems should put you in the 95% chance of success range.
Darren Guillot, Deputy Commissioner, Collections and Operations Support announced on January 20th that the trial policy of allowing installment plans without requiring financial information for tax debts up to $250,000 is now permanent.
Why is this a Big Deal?
The requirement to provide financial information is no easy task. Most people need professional help with preparing Form 433. Answering a question wrong, such as do you or have had any cryptocurrency transactions, could get you a visit from the Criminal Investigations Division. The ability to simply go to the IRS website and start a payment plan without financial analysis is a big time and money saver for tax debtors.
What’s the Catch?
There are a few caveats:
- This debit limit only applies to individuals and out-of-business sole proprietors.
- This option goes away if your case has been assigned to a Revenue Officer. The old limits of $50,000 and $25,000 still apply if you are dealing with an RO.
- Your payment amounts must be adequate to fully pay the debt before the Statute of Limitations runs.
Should you consider this without professional help?
Certainly, seems like a good idea to go give it a try. If the IRS calculator comes back with a monthly payment that you can’t live with, then go talk to someone. There are other options such as a Partial-Pay or an Offer-in-Compromise that will probably make more sense in these cases. Setting yourself up for a future default will make your problems worse
The CP11 letter arrives in the mail. You open it up and see the words “We made changes to your return because we believe there is a miscalculation. You owe money on your taxes as a result of these changes.” Yep, this is going to be a great day.
Usually, these notices are vague. They typically list various reasons which might be the cause of the change. Perhaps it’s an invalid social security number, or maybe it was a limit based on AGI. You get to take your best guess as to which of these reasons applies to you. This can lead some people to put off responding and that is a very big mistake.
CP11 notices are considered to be a “Math Error” procedure by the IRS and not an audit. This is an important distinction. In an audit, you have the opportunity to contest a tax assessment. A Math Error, on the other hand, will get you an immediate assessment if you do not contest it within the 60-day time period. This means IRS Collections will begin immediately.
You can contest the change by calling the IRS. Lots of luck with that approach given that you will be on hold for hours. The better way is to write up your response as to why the original return is correct and mail it certified to the IRS. Do not expect a quick response from the IRS. You will have plenty of time to gather documents to support your position.
For more information, here is a link to a Taxpayer Advocate Service blog
It’s a natural tendency to want to avoid dealing with an unpleasant task such as an IRS debt problem. After all, the IRS is not particularly speedy in most of the things they do, so ignoring them, in the beginning, is easy. But this is probably going to cost you. Waiting for that levy notice to come in the mail is going to reduce the time available for you to arrange your finances so that your payments to the government are minimized.
Why is this? Unless you qualify for a streamlined payment plan, the IRS is going to perform a financial analysis of your situation to determine how much money they should be able to collect. Basically, they are going to relate your income to what they consider to be the “reasonable” costs of living. If that cash flow projection is positive, they are going to want a deal that gives them that amount as a minimum.
Here is where the time problem comes in. Given enough time in advance of that levy notice, you can use the IRS financial analysis approach in advance to figure out what changes you can make to minimize the amount that the IRS might think of as collectible. For example, say you do not have life insurance. The IRS allowable expenses include term life insurance premiums. But, you need at least 3 months of payments to the insurance company before the IRS will include this money in their calculations. So, signing up for life insurance tomorrow is not going to work. Given enough time in advance of negotiating with the IRS could result in you having life insurance with zero difference to your cash flow.
Performing the financial analysis early allows you to develop a strategy to minimize the IRS’s impact on your life. Waiting for the levy notice is a mistake
Economic Hardship is a kind of get-out-of-jail-free card when it comes to dealing with IRS Collections Division. It can be used to get a levy released or an Offer-in-Compromise accepted if the financial analysis showed the result would place the taxpayer in an economic hardship
So, just what is an Economic Hardship? Economic hardship occurs when a taxpayer is unable to pay reasonable basic living expenses. The IRS considers the taxpayer’s equity in assets and expected cash flow to determine how much money should be available to pay their tax debts. This information is brought together with a formula that is called the Reasonable Collection Potential or RCP. Much of the “reasonableness” in the formula comes from various tables of allowed or allowable living costs.
Plug all the numbers into the RCP and if the result is positive, the IRS figures you can make payments. If the number comes out negative, then you are in an Economic Hardship situation.
This leads us to one of the major reasons for Offers-in-Compromise to fail. Nobody did the RCP analysis and instead made an offer that was unacceptable on the face of it.
A retired couple decides to liquidate some of their stock investments because they are no longer able to handle the ups and downs of the market. This action puts them into a strong and safe cash position but also produces a large tax bill. Paying that bill significantly reduces the savings they have built and depend upon for their retirement years.
They decide to make an Offer-in-Compromise with the IRS instead. The offer is rejected by the IRS because the analysis of their financial position shows that they could full-pay the debt. Is it a lost cause for this couple?
Not necessarily. The IRS can accept the Offer under Special Circumstances where the collection of the debt in full would create an “Economic Hardship”. This would be the case for the retired couple depending upon their savings for the rest of their lives.
The big factor for taxpayers hoping to have an Offer with Special Circumstances accepted is a history of compliance. Investing in dubious tax shelter schemes, repeated non-filing penalties, or failure to pay on a regular basis are all factors that will work against the offer. Most of these offers are in fact initially rejected by the IRS, so you can expect that a trip to Appeals is going to be part of the process.
I will discuss the meaning of “Economic Hardship” in more detail in my next post.
The IRS does have the power to have the State Department revoke your passport for owing back taxes is YES. Recently the Fifth Circuit upheld the constitutionality of the government restricting international travel for James Franklin due to back tax debts of $55,000. Mr. Franklin had claimed that revoking his passport had violated his 5th Amendment rights to due process. Luckily, the US is a big country, so you can still have some places to go while all those IRS notices are building up in your mailbox.
Revoking your passport is not the only tool in the IRS toolkit that goes beyond liens and levies. In 2014 Congress passed the Consolidated and Further Continuing Appropriations Act that prohibited federal agencies from awarding contracts or grants to contractors with any amount of delinquency in federal taxes. This law does not get used consistently, but it is another good reason to avoid getting in the hole with the IRS.
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.