Small business owners can be very creative when it comes to making bad business decisions for their companies. Some business owners negate their liability protection by failing to respect their various legal entities and intermingling personal expenses in their business. Others overspend at year-end on equipment and supplies that they do not need just to reduce their income tax bill for the year. And many fail to plan for business continuity upon their death or disability.
However, you do not have to be too creative to make perhaps the worst mistake any business owner can make – the willful decision to not submit timely payroll tax deposits.
The one bill that has to be paid. Every. Single. Time.
Ever had one of those weeks where you were barely able to pay your employees, much less make minimum payments to your suppliers? Many small business owners have. Because sometimes cash doesn’t flow the way it is supposed to. Collections may be down, seasonal employees may be needed, unexpected and unbudgeted expenses may need to be paid.
In times like these, it is tempting to pay your suppliers and employees before paying your payroll taxes. After all, you need your suppliers to continue to provide goods and your employees to continue to provide services. And you will always get immediate feedback from your suppliers and employees if you do not pay them while the IRS will not send you notices for at least a few months. But foregoing the payment of your payroll taxes in order to pay your other bills can have dire, long-term consequences on your business and on you as the business owner.
Harsh penalties for delinquent payroll tax deposits
There are three components to federal payroll taxes: employee federal income taxes withheld, employee Social Security and Medicare taxes withheld, and employer Social Security and Medicare matching. The IRS defines these payroll taxes as trust fund taxes. You withhold these taxes from your employees’ paychecks and hold them in trust until submitted to the government. In other words, the money is never yours to spend.
The IRS views unpaid payroll taxes as a type of theft. Therefore, they take a very strong stand on these taxes and are very quick to react to unfiled payroll tax returns and delinquent payroll tax deposits. Many payroll tax returns are due quarterly which allows the IRS to identify delinquent taxpayers quickly.
Once a delinquent business owner has been identified, the IRS is usually quick to initiate collections proceedings. Penalties for failure to file payroll tax returns and failure to timely deposit payroll taxes will be assessed and interest will be accrued. These penalties and the related interest can quickly increase the total amount owed. I often tell clients that it is much cheaper to pay off a credit card than to pay off delinquent payroll taxes. But assessing penalties and interest is not the IRS’s most powerful weapon.
The IRS will often assess the trust fund recovery penalty in addition to the failure to pay and failure to file penalties. The trust fund recovery penalty is equal to 100% of the unpaid trust fund taxes. This is a very harsh penalty that can be assessed on the business and any “responsible person”. A responsible person is anyone who has the duty to account for, collect, and pay the taxes to the government. This can be you as the business owner as well as an employee responsible for making payroll tax payments.
Protect yourself and your employees by making your tax deposits timely.
A sign of bigger problems?
Having unpaid payroll taxes is a good indication that your business is underperforming. As the business owner, it is your job to find out why. Here are a few areas to check for issues:
Living beyond your means. Unfortunately, in many circumstances, having unpaid payroll taxes is an indication of poor lifestyle choices by the business owner. If you are having trouble paying your payroll taxes, this is the place to look first.
Business owners fund their lifestyle by either paying too many personal expenses out of the business, making too many distributions from the business, or paying themselves too high of a salary. For instance, I have seen situations where a small business owner paid themselves a $100,000 salary, and over the course of one year became delinquent on $100,000 of payroll taxes. It’s not too difficult to see that the owner funded their salary out of the trust fund payroll taxes that should have been remitted to the government.
You cannot operate your business with the blind belief that all of the money in the checking account is yours at any given time.
Failure to manage your receivables. Don’t like making collection calls? Hate cutting off services to customers and clients who have gotten a little behind? You are not alone. But these tasks must be done. Your business needs to timely collect its receivables to survive.
Every business has an operating cycle. Your operating cycle is the time it takes to convert purchases of inventory from vendors into collections of cash from customers. The longer your operating cycle is, the longer your business has to fund the purchases of inventory, payments of accounts payable, and payments to employees. Proper accounts receivable management is one crucial step towards decreasing your operating cycle.
Lack of adequate financing. You have heard it said, “It takes money to make money.” One of the biggest mistakes entrepreneurs make is underestimating how much money it takes to start a business or survive an economic downturn.
Having unpaid payroll taxes is basically using the government’s money to fund your operations. Instead, try to fund your business with a business operating line or line of credit. If you do not have an operating line or a line of credit for your business, apply for one before you need it.
The best solution is to stay out of trouble
So how do you avoid this problem? One simple solution is to separate your payroll and accounts payable functions by having separate checking accounts. Even with a separate payroll checking account, you will need to be dedicated to adequately funding your payroll expense, not just funding your net pay checks.
To do this, you will need to transfer enough cash at every payday to cover the gross payroll plus your employer taxes – Social Security and Medicare matching, and federal and state unemployment taxes. And always remember that the money left over in your payroll account is not yours.
So remember to always pay your payroll taxes on time. Your success depends on it.