guest commentary by David Potts
Editor’s note: David Potts is a certified public accountant with more than 33 years experience. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case. Feel free to e-mail topic suggestions or questions to firstname.lastname@example.org
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Sometimes a business will find itself in a cash crunch and in need of quick cash. While many business owners go to the bank and borrow for their short term cash needs, I have observed many businesses over the years use a simple trick to get a bit of “easy” money. They just borrow the needed funds from their employees. It’s quick, easy, and their employees don’t have to know the employer is borrowing their money. Usually the employer believes he will need these funds only for a few days or weeks.
If you are not familiar with this technique, here's how it works. When an employer pays an employee, the employer must always withhold payroll taxes. The common taxes withheld are Social Security tax, federal income tax, and state income tax. For our discussion today, we will ignore the state income withholding rules and focus on the federal rules. The IRS refers to these withheld payroll taxes as trust fund taxes because the employer, by law, must withhold these taxes and hold them in trust until they are due, then remit the withheld taxes to the IRS. The employer is liable for a matching amount of social security taxes withheld from each employee up to an annual limit.
The IRS does not know that the employer has withheld their employees’ taxes until the business files their Employer’s Quarterly Federal Tax Report. If an employer decides not to pay their employees’ payroll taxes withheld, he effectively borrows the money from his employees’ “trust account” until the date the IRS receives and processes the employer’s tax report then demands payment for the unpaid taxes reported. As the payroll periods come and go, the more payroll tax withholdings an employer will have access to and the amount of the loan can increase.
It kind of works like a line of credit from a bank. The main difference between borrowing an employee’s money designated as payroll taxes and a bank is that a commercial loan officer wants to loan money to businesses where as the tax collector can get a bit huffy when a business’s impromptu and unapproved lending method is discovered. Where a bank will generally be happy to extend your line of credit, tax collectors generally don’t smile at you.
Some of you reading this article might feel uneasy about this type of informal lending arrangement. That unease shows you have wisdom, knowledge and good judgment. The above description is not really an informal lending arrangement, but the description of a business in poor financial health and is possibly nearing its end.
A business, to get in this situation, is usually struggling to generate positive cash flow. In order dig out of this circumstance the business must earn enough money to pay past due amounts, current amounts, plus penalties that are designed to be punishing. Penalties include a failure to deposit penalty that scales up from 2% on the amount of a late deposit to 15% when the late payroll tax deposit is paid later than 10 days after the first IRS notice demanding payment. If you file your quarterly Employer’s Quarterly Federal Tax Return on time and still have unpaid taxes due, the IRS will assess you a penalty of up to 25% of any unpaid taxes paid after the return’s due date. If you fail to file the Employer’s Quarterly Federal Tax Return on time, the penalty for filing the return late could add up to another 25% of unpaid payroll tax. The potential penalty on a $1,000 late payment of federal payroll taxes could be $650 without calculating interest expense assessed by the IRS.
If you are a business owner and you find yourself in a circumstance where you don’t have enough money to pay all your bills on time, don’t prioritize payments to your vendors and lenders ahead of the payment of your federal tax deposits. The IRS has a very big bat when it comes to collection of past due payroll taxes with tools such as liens and levies.
If your business finds itself with past due payroll taxes and they are accumulating, you need to consult a CPA for help and early enough to prevent the business’s tragic end.