So Far, So Good!
Posted on | August 21, 2009 | No Comments
So Far, So Good!
Have you heard the one about a man who jumped out off the 20th floor of a building? As he was falling past the 10th floor, someone yelled out to him, “How’s it going?” He replied “so far, so good.”
A few days ago I just had a conversation with a new client. By the way, I’m an Enrolled Agent, which means I am a tax professional and, in addition to doing taxes and consulting, I represent taxpayers who are in trouble with the IRS. When the owner told me about her company, I’ll call it XYZ, all I could say is wow, what a great idea for a business. The money was flowing in and customers were waiting in line for their highly specialized services. How in the world could a company only a few years old be in so much trouble with the IRS?
It’s a sad story, but one I hear all too often. The business is a Sole Proprietorship (a subject of another article). The money is flowing in but on a sporadic basis. XYZ has a couple of employees and takes draws out for the husband and wife owners’ personal expenses every month. After all, it’s their hard earned money, right? And they have to live, don’t they? One thing XYZ did right was to hire a bookkeeping company to help them with their payroll reporting. At this point, it’s still “so far, so good.”
Let me tell you the rest of the story. Quarterly, the bookkeeping company prepared and sent the payroll forms to XYZ, told them where to sign, how much and how to pay. Trouble is, after paying wages and draws for the owners and other expenses of the business, there wasn’t enough money left over to pay the payroll taxes. So, instead of paying withholding taxes in full, XYZ paid a very small portion of what was owed. They were sure they could catch up next month or next quarter. This became the modus operandi each quarter. To compound the problem, since they could not pay what they owed, they incorrectly believed they should not file the quarterly Federal Payroll Tax returns, Form 941, until they could. Also, because they did not have any money in the bank, they did not pay any estimated taxes to the IRS, in anticipation of the taxes they would eventually owe on their profit in XYZ.
Believe it or not, still a perception of “so far, so good”, or so it seemed to XYZ. Since the IRS had not received the 941 Forms, the IRS did not know that the company owed payroll taxes and, therefore, did not take any action against XYZ. In addition, since the income tax return for the year did not have to be filed until April of the following year, the IRS had no idea how well XYZ was doing, so, in the eyes of the IRS, there were no estimated taxes due.
Fast forward to first quarter of the next year; tax season. The bookkeeping company prepared the W-2/W-3, 941 and 940 in January. The IRS received the W-2/W-3s and 940, but once again, the 941 was not sent in.
Still with a feeling of “so far, so good” the owners of XYZ took their records to a tax professional to have their personal tax return prepared. When the tax professional asked to see the Payroll Tax returns, he was told that they had not been filed. They were advised to file immediately, even though they didn’t have the money to pay, and did so.
The owners of XYZ soon learned that they owed the IRS approximately 35% of their net profit in XYZ. XYZ had a net income of over $250,000, which meant a tax bill of approximately $87,500. The social security and Medicare portion of those taxes for the two owners amounted to over $38,000 alone.
Oh, and did I mention that the payroll taxes had not been paid?
Still so far, so good? Not! When the IRS received the W-2/W-3 and the newly filed Forms 941, it became aware of the unpaid payroll taxes which immediately activated the Automated Collection System (ACS) process. Threatening IRS letters soon started arriving in the mail. When you have employees, and withhold social security, Medicare and federal taxes from their wages, this is no longer money that belongs to your business, it is what the IRS terms “Trust Fund” money. It needs to be set aside and paid to the IRS on time. XYZ’s salaries to the two employees totaled $200,000. Withholding from the employees’ wages amounted to over $35,000 for the year. In addition, the company must match Medicare and social security which is another $15,300.
With penalties and interest, at the time of the initial IRS collection activity, the company owed the IRS over $45,000 in Trust Fund money and the amount was going up each day. XYZ also owed another $15,300 in matching social security and Medicare. And remember the $87,500 the owners personally owe on the net profit of XYZ. Wow, that’s taxes totaling $147,800 and going up! And, surprise, surprise, XYZ did not have enough money in the bank to pay the taxes. Using my analogy, XYZ has hit the ground. And by the way, there is another penalty the IRS could assess, called the Trust Fund penalty. It doubles the amount of Trust Fund liability. Fortunately for XYZ, that has not been applied.
I know that was a long story, but I wanted to make a point. You can’t ignore the IRS. Sooner or later it will catch up with you. Ignorance of the tax code is not an excuse. So, what should you do to avoid these mistakes?
- If you hire employees, I highly recommend you hire a bookkeeper or professional payroll company to help you with state and federal forms. Follow their instructions to the letter.
- If you decide to do it on your own get advice from a professional before you start.
- Set aside money for taxes each time you earn income in your business. I recommend you have a separate account and that you sweep a percentage of your income into that account. Depending on your business entity and your personal situation, 30-35% might be a good starting point. Your tax professional can help you do some tax planning. It’s better to over-estimate rather than under.
- Always file state and IRS tax and other returns on time. Even if you can’t afford to pay everything you owe, file the return to avoid a late filing penalty.
- Pay what you owe, on time if you can. If you can’t afford to pay on time, go on an IRS installment plan, or better yet, borrow the money and pay off the IRS.
- When you are self-employed you will owe taxes on the net profit of the business. Those taxes include social security, Medicare, federal income taxes and state taxes, depending on where you live. You must plan ahead and forecast what you owe and make estimated payments to the IRS or be penalized for not doing so.
Now for those of you contemplating jumping out of the 20th floor, the economy is not that bad. However, if you want to avoid the mistakes make by XYZ Company, one of the best ways to protect yourself is to set up an advisory team for your company, or a Board of advisors. A good tax professional can help you avoid these kinds of mistakes. Remember, you get what you pay for, so be prepared to pay him/her on an hourly basis if you don’t engage him to do your taxes and tax planning.
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