Friday, November 2, 2012

Borrowing From Payroll Taxes - A Bad Idea!

Payroll taxes are nothing to mess around with!

The other day, on the Debt Guy site, I read this missive:
Dear Jim,
I own a fire protection company that does around 4 million a year. It is a c corp. We are $500,000 behind in payroll taxes. Our business is picking up substantually and I believe we will make it through this extreme situation.
Can you help me?
What is the best way to work this out with the IRS?

Ouch.  First let me explain what payroll taxes are, to those of you who have never employed anyone.   When you become an employer, the government comes down on you to do a number of things.  You are primarily a tax collector, and are charged with collecting taxes from your employees.

You withhold income taxes, of course, and also withhold your employee's Social Security and Medicare taxes - which you then match, dollar-for-dollar.  It ends up being a lot of money.

Depending on your reporting schedule, you are supposed to pay these taxes monthly or quarterly, to the IRS, along with a form which you fill out.   If you hire a payroll company, they will do this all for you, if you set up a "payroll account" and let them cut checks from it.   And this is probably the best way to do this.

However, it is tempting, when a business is failing to rob Peter to pay Paul.   So you put off paying your bills (your Attorney is usually at the top of the list of people who don't get paid) and you delay paying those payroll taxes.   What's the big deal?  You'll make it up next month, right?  Business will get better and things will "turn around" - right?

Wrong.  First of all, not paying the payroll taxes is basically stealing from your employees.  This is their money that they earned, and you are not handing it over to the IRS to cover their tax burden.  And in the past, many employers, particularly in the restaurant business, would play this game, end up going out of business, and leave the waiters and waitresses owing the IRS thousands of dollars.  It wasn't fair.

Today, they don't go after individual employees.  However, the owner of the business and responsible parties (such as the Finance Officer, the President, the person signing the checks, etc.) can be personally liable for these debts.  And when the IRS comes a-calling, they will ask you for a personal check to cover this stuff, or tow your car away.   You are stealing from your employees - and the government - so don't expect much in the way of sympathy.

And even if you can pony up the dough, the penalties and interest can be staggering.  In fact, they can be staggering enough to swamp a business, even if their business is improving (as in the example above).   Basically, the IRS uses these penalties to say, "You should not be running a business in the first place!"  It may seem unfair, but then again, you were caught stealing.

You should never, ever, Ever, EVER think about dipping into the payroll tax fund, to keep operations going.   It may seem like a swell idea, but the IRS is not in the lending business - and neither are your employees.   And like an alcoholic or a crack addict, once you start doing this, the temptation to do it will occur again and again.   And this is why the cut-you-off-at-the-knees penalties are designed to make you stop - one way or another - for good.   It is re-hab for bad businessmen.

If you are getting behind on your payroll tax obligations, or are thinking of dipping into this money to "tide you over" until "business gets better" you should think long and hard about whether your business is in fact, failing.   This is a very typical scenario, and we see it a lot in small businesses.  The suppliers are not paid, and now demand cash for delivery.  Rather than take this as a warning sign or a miner's canary, the businessman dips into the payroll taxes, and remains open for another week, month, or year.

The problem is, when it all goes horribly wrong, and the business finally closes, the tax liabilities are HUGE, and the penalties and interest keep piling on.   Suddenly, a small failure has morphed into a life-changing event - where you will spend the rest of your life paying back the IRS.  You will wish, in retrospect, that you had closed the business and dealt with a relatively painless bankruptcy, early on.

If you are thinking of dipping into the payroll taxes, consider other options.  Maybe it is time to throw in the towel and start over.   Maybe you can lay off employees - or ask them to take a cut in pay.  Maybe there are some expenses you can cut - little things add up.  Maybe you should be raising prices.  Or maybe your personal lifestyle is getting out of hand.   This latter issue is often a real problem for some small businessmen, who think they "deserve" a huge paycheck, even as their business is mired in red ink.  And this illustrates why the IRS comes and tows away the jet skis and bass boat of the business owner.  In effect, these items were bought with the payroll tax money.

I ran into this situation when I ran my own Law Practice.  At one time, I had five employees, and the payroll was pretty staggering.   The problem was, although I had a nice income to support maybe two or three employees, expanding the business with more employees wasn't increasing my income accordingly.  In fact, the more I hired, the less we made, to the point where adding employees was a money-losing proposition.

(As an aside, this illustrates why these tax arguments by the GOP are nonsense.  Increasing a person's personal income tax rates has no effect on the decision to hire or fire employees.   You hire employees to increase productivity and profits.  You fire (or lay off) employees when they are no longer profitable.)

I ended up getting a couple of weeks behind on my payroll tax money, mostly because a client owed me $80,000 that was over six months past due.  It was a nightmare.  The penalties and interest were staggering.  I learned quickly that the IRS is not a lender of last resort!   I used this as a wake-up call, and cut expenses, rented out unused office space, and laid off employees.  A smaller, more nimble business turned out to be more profitable.   In fact, a solo practice turned out to have the highest profit ratio, as almost all overhead was eliminated.  And I also learned to get cash-in-advance, rather than rely on clients to pay in 30, 60, or 90 days - and beyond.

So I used this as a learning experience and as a wake-up call.   If I had kept going down that road of borrowing Peter to pay Paul, I would have ended up bankrupt and likely disbarred.  Yes, not paying taxes is also a crime, too.

It is OK to fail at something.  In fact, you are better off recognizing failure early on and then taking action, than to deny it by playing financial shenanigans, and end up in real trouble later on.  As I noted in an earlier posting:
We see it in business all the time, too.  I mentioned before the young hot-shot Real Estate lawyer in Virginia who seemed to do no wrong.  He came from the "right" family, went to the "right" schools, got top grades, joined the "right" firm and gradually worked his way up - starting his own law firm which became wildly successful.

Then the unthinkable happened - a Real Estate investment scheme of his started to unravel.  Rather than take a loss of a million dollars, which by then he could easily afford to do (although it would have set him back a few years) he decided instead to "borrow" money from client fund accounts - after all, he was the Golden Boy and could not fail!  But of course, this just took a small failure and amplified it many times.

By the time the scheme was uncovered, tens of millions of dollars were lost - and most of it client funds.  Not only did his business collapse, but he lost his job, his law license, his law firm, and was sued and sent to jail to boot.  And all to avoid a small failure - he created a huge one.
That fellow, had he recognized that his Real Estate investments were tanking, could have worked out a deal in bankruptcy, and perhaps even kept some of the properties.   The main thing is, he would have kept his law license and stayed out of jail.  By avoiding a small failure, he courted a big one.

If you run a small business and are struggling to make those payroll tax payments, sit down and think about where this is going, long-term.   Closing the business or dramatically restructuring it might be in order.  The one thing that is for sure, though:  Never, ever, tap into that tax money.  Once you do, it is all over for you!