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Payroll Taxes – When the IRS Doesn’t Mess Around!

Houston Tax Attorney

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Trust Fund Recovery Penalty

The IRS may be kinder and gentler after the 1998 IRS Restructuring and Reform Act, but that certainly doesn’t seem to be the case with payroll taxes. When a business is doing poorly, a small business needs to make a decision – to reduce staff or not pay the bills. Oftentimes, a struggling business owner, for emotional or other reasons, may not want to lay off employees. At the same time business expenses need to be paid to keep the business running. A tempting solution can be to dip into their employees’ payroll tax funds to pay off business expenses. This ends up being a recipe for disaster. The struggling business gets behind on payroll taxes, continues to incur new payroll taxes and business expenses, and is unable to catch up. Eventually when the business shuts down, the owner will be personally liable for some of the payroll taxes. The IRS will prioritize collection of these taxes from the owner and other responsible parties. I’ve seen clients with excess of $300,000 in income tax debt who were not contacted by a revenue officer for years. In most of my payroll tax cases, however, the case was picked up by a revenue officer for enforced collection action within a year of the assessment.

Payroll Taxes vs. Trust Fund Taxes

Employers must withhold federal income taxes, social security, and Medicare tax from their employees’ pay. All of the federal income tax and ½ of the social security and Medicare taxes are paid by the employee, while the employer pays the other ½. The employees’ portion is referred to as trust fund taxes. Payroll tax is comprised of trust fund and non-trust fund taxes.

Failure to Pay Trust Fund Taxes

The IRS considers it a theft of government money when employers dip into the trust fund portion and fail to pay these taxes to the government. And it’s easy to see why – the employees are still able to deduct their payroll taxes on their tax returns, while the government is left holding an empty bag.

When an employer fails to pay the trust fund portion, the IRS has the authority to assert a trust fund recovery penalty (TFRP). A TFRP may be asserted against those determined to have been responsible and willful in failing to pay over the tax. The persons responsible could include:

  • an officer or an employee of a corporation,
  • a member or employee of a partnership,
  • a corporate director or shareholder,
  • a member of a board of trustees of a nonprofit organization,
  • another person with authority and control over funds to direct their disbursement,
  • another corporation or third-party payor,
  • payroll service providers (PSP) or responsible parties within a PSP,
  • professional employer organizations (PEO) or responsible parties within a PEO, or
  • responsible parties within the common law employer (client of PSP/PEO).

Whereas when an employer fails to pay the non-trust portion (i.e., the employer’s share of payroll tax), the IRS may only hold the company responsible, and the liability generally does not extend to the owners or partners.

Trust Fund Recovery Penalty Process

TFRP cases begin when the employer files a Form 941 with a balance due or an IRS FTD (Federal Tax Deposit) alert is created. FTD alerts identify employers that have not made current deposits or made them in substantially reduced amounts.

The alerts are then routed to a Revenue Officer (RO) and a pre-contact analysis is performed. If the analysis shows that the funds have been paid after the alert was created, the RO will close the case. Otherwise, the revenue officer is required to make initial contact with the taxpayer within 15 calendar days. During the initial contact, the RO is required to explain the TFRP and provide a copy of the TFRP calculation. The IRS will then conduct an interview and record their notes on Form 4180. This is the RO’s time to begin asking questions and gathering documents for purposes of asserting the penalty.

Taxpayers are encouraged to retain a representative to complete the interview on their behalf. The IRS cannot force a taxpayer to attend absent the issuance of a summons.

The RO will then assemble the core evidence necessary to assess a TFRP, such as the interview notes on Form 4180, business operating agreement and certificate of formation, bank signature authority cards, and a sampling of cancelled checks showing payments to other creditors instead of the government.

After all responsible persons are interviewed and documents are reviewed, the RO will submit a recommendation of assertion or non-assertion of TFRP on Form 4183. If the RO group manager confirms, a Letter 1153 and Form 2751 will be issued, notifying each responsible person of the proposed assessment.

If you are the recipient of a Letter 1153 and Form 2751, you should not sign the form without talking to an attorney! Form 2751 waives the restriction on notice and demand. You waive your right to a 60-day notice and give the IRS the authority to assess the TFRP immediately and initiate collections action.

Relief from Trust Fund Recovery Penalties

A Trust Fund Recovery Penalty asserted against you can be overwhelming. While there may be multiple responsible parties, the IRS has the authority to collect all the tax from any responsible individual (joint and several liability). That individual would then have a right to bring suit against the other responsible parties to pay their portion in civil court.

Statutory prerequisites. The first step if you’ve been asserted a TFRP is to determine whether you meet the statutory prerequisites – responsibility and willfulness. There are a multitude of TFRP cases where the tax court has found that the IRS overreached in asserting these penalties against parties who were not responsible.

Statute of limitations. Absent fraud, or failure to file, the TFRP must be assessed within 3 years of the date the Form 941s were filed.

Payment strategies. Often a company will owe both trust fund penalties as well as income taxes (non-payroll). Since TFRPs are asserted on the individual members and pursued aggressively, it would be advantageous to pay the trust fund portion first before paying the income tax.

Criminal Liability

While criminal prosecution by the IRS is rare, criminal cases involving TFRP are on the uptick. This is especially the case where the taxpayer has a history of unpaid payroll tax. Recently a trucking firm owner was sentenced to 18 months in prison for failing to pay $300,000 of payroll taxes between 2007 and 2012. See IRS Press Release 3/4/16.

A Simple Solution for Reducing your Chances of an Audit

Houston Tax Attorney

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The IRS Tells You how to Reduce your Chances of an Audit

If you’re an independent contractor (aka self-employed or sole proprietor), or in a general partnership, here’s another reason why you should form a separate legal entity.

In its annual Data Book, the IRS has released the percentages of tax returns that were audited in 2015. One of the most heavily audited returns were Schedule C business returns, which are filed by unincorporated businesses (i.e., those that have not formed a business entity). The stats reveal that your chances of audit are at least 4 times higher if your business is not incorporated.

And if you’re not already aware, incorporating your business also offers limited liability protection and lowers taxes by eliminating your self-employment tax.

Read more about the different options for incorporating your small business or sole proprietorship

IRS Installment Agreement

Houston Tax Attorney

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IRS Installment Agreements

This section only applies to taxpayers with total tax debt greater than $50,000. For debt less than $50,000, the process is different.

Example: Bob has $100,000 of total tax debt. He has gross monthly wages of $150,000. He has $25,000 equity in his home and $75,000 in his company 401(k). After his attorney reviews his options, they decide that an installment agreement will be his only option.

IRS’ goal: Receive full payment of the debt in the shortest period of time possible.

Bob’s goal: Minimize his monthly payment and protect assets from seizure.

Will the IRS Enter into an Installment Agreement?

The IRS will consider an installment agreement only if the taxpayer is current on his tax liabilities, which means that:

  • Bob must have filed all of his tax returns
  • Bob must be in compliance with his current year tax obligations. He needs to be current on his withholdings and estimated tax payments for this year. If in 2016 Bob files his 2015 return and owes on the return and is unable to pay, the IRS will not enter into an installment agreement. He will have to wait until 2017. He should adjust his withholdings so that he isn’t in the same tax owed position in 2017. Bob may not have the option to wait until 2017, in which case he should take out a loan to pay off his 2015 return liability before applying for an installment agreement

How will the IRS Determine the Monthly Payment Amount?

The IRS will look at the taxpayer’s monthly income, assets, and expenses to determine the amount of disposable monthly income available.

Income

  • Bob has $12,500 gross monthly income ($150,000 wages/12)

Expenses

  • Bob lives in an upscale apartment and pays $2,500/mo. He drives a luxury car with a $1,500/mo payment. He dines at expensive restaurants and has a shopping addiction. At the end of the month, he saves on average $100. Bob thinks his discretionary income is $100.
  • The IRS cares very little about how much Bob actually spends. The IRS has federal and local standard tables based on the taxpayer’s family size and location. For example, based on Bob’s location and family size (1 individual), the IRS applies the following federal standards:
    • Food – $307
    • Housekeeping supplies – $30
    • Apparel & Services – $80
    • Personal care products and services – $34
    • Miscellaneous $119
    • Vehicle ownership (lease or monthly payment) – $471
  • Local standards:
    • Housing – $1,457
    • Vehicle operating cost – $281
  • Additionally, the IRS allows actual expenses for the following expenses:
    • Health insurance
    • Court ordered payments (e.g., child support)
    • Child/dependent care
    • Term life insurance
    • Tax withholdings (Federal, FICA)
    • Secured debts
    • Certain expenses (e.g., required continuing education for job)
  • After applying the above standard and actual expenses, the IRS determines that Bob actually has $6,200 discretionary income, not $100.

The IRS will expect you to adjust your living standards in order to make the monthly payment based on the calculated discretionary income. You can elect for the IRS to allow 1 year of actual expenses for car payments, private school/university education, and housing in order to give you time to modify your current spending.

While the IRS standard expenses are not cast in stone and there is some flexibility, you should not expect much deviation unless you meet the 6 year rule* or have a very good argument why a particular expense should exceed the federal or local standards. The amount of flexibility will be determined by your attorney’s knowledge of procedure and negotiation skills, the personality of the IRS representative, and your particular situation.

Assets

  • Bob has $25,000 equity in his home, some of which is available to be borrowed against through a home equity loan
  • Bob has $75,000 in his 401(k). His 401(k) plan allows Bob to take a loan up to 50% of the value
  • If the installment payments will not result in full payment of debt before the expiration of the collections statute, the IRS will likely require Bob to tap into the equity of his home and/or take a 401(k) loan to make additional payments to cover the shortfall.

If the monthly payments will not result in full payment of debt before the collections statute expires, the IRS will determine if you have any equity available in your assets to borrow against or if you have any assets that can be sold (e.g., jewelry, collectibles, etc)

Alternatives to Installment Agreements

While taxpayers with little income and future earning potential are able to negotiate a lump sum deal with the IRS through an Offer in Compromise, Bob has a good, steady source of income. He does not qualify.

His only other option is bankruptcy. Taxes can be discharged in bankruptcy subject to certain requirements. The main requirements are that 240 days have passed since the taxes were assessed and at least 3 years have passed since the due date for the tax return. It is possible to have part of the debt discharged in bankruptcy if 3 years have passed for some of the tax years but not others. It is also possible to enter into an installment agreement for 3 years and then file for bankruptcy. We will go over all of your options with you. While we do not currently represent clients for bankruptcy, we can refer you to a reputable bankruptcy attorney.

The Doing Nothing AKA “Sticking your head in the sand” Method

If you do absolutely nothing and ignore the collections notices, the IRS will start levying, which can involve garnishing your wages, levying your bank accounts, seizing your vehicle, and sending levy notices to anyone that has issued you a 1099 in the past instructing them to send any payments owed to you directly to the IRS. In extreme cases, the IRS will seize your home and keep the equity up to the amount of your debt. The IRS will be more aggressive where there are multiple tax years, a large amount of debt, and/or a short collections statute.

Sometimes the doing nothing method works out if you don’t have a large balance (over $50,000) and the IRS is not able to identify any assets or sources of income (i.e., you don’t receive W-2s or 1099s, and have no reported assets and bank accounts). I still would never recommend this method to a client.

Some clients have asked, “if the IRS will require monthly payments anyway, why not do nothing and let the IRS garnish my salary.” Because the IRS will leave you with as little as $400 after garnishment on your biweekly pay. Additionally, your employer will now know about your IRS debt, which may be embarrassing or damaging to your reputation.

The longer you wait to resolve your tax debt, the more you limit your options.