Pay Payroll Taxes Or Go Out Of Business?

We have talked before about the “big boy” penalty. It is one of the harshest penalties in the tax Code.

This is a payroll related penalty. It is not because you were late with a payment or failed to send in a return on time. No sir, it kicks in when you do not send the government any money at all.

And I am reading about two guys who decided to play big boy. One of them surprised me.

The company itself was based in Rhode Island and provided wireless internet in public spaces. Think Facebook at the airport, for example.

Business tanked. Cash was tight. Vendors did not get paid, including the IRS.

The company needed help. They hired Richard Schiffmann as president in October, 2004. In October, 2005 he brought in Stephen Cummings (who had worked there previously as a consultant) to be chief financial officer.

Cummings quickly found out they had problems with back taxes.

The Board granted check-signing authority to the pair: Schiffmann up to $100,000 and Cummings up to $75,000.

The two tried; they really did. But there was nothing there. The Board fired the two in June, 2006.

You know that the IRS eventually knocked on the door. They were angry and they wanted scalps. They went after Schiffmann and Cummings for the big boy penalty.

In the literature, this is known as the trust fund recovery or responsible person penalty. It addresses the income and FICA taxes withheld from employees. Mind you, the IRS wants the employer FICA also, but it is emphasizing the employee withholding. The IRS takes the position that this was never the employer’s money, whose function was solely to transfer the money as agent for the employees to the IRS.

The penalty is 100%.

It is intended to be Defcon 1.

The IRS went after Schiffmann for $394,334 and against Cummings for $254,280.

Think about this. You got hired. You were there for nine months. I doubt you got paid anywhere near $254,280. This is the lousiest job ever.

The two fought back, although there were some procedural misses we will not discuss but which leave me scratching my head. The two for example raised the following arguments:

(1) Schiffmann argued that he did not learn of the liability until late 2005. The most he could be liable for is two or three quarters, which would not add-up to $394 thousand.

He had a point. The penalty technically goes quarter-by-quarter.

But only in a classroom or in a textbook. In the real world, the IRS will argue that – if you could write a check – then you could have written checks for both current and past payroll taxes. Those past taxes become your problem.

And Schiffmann could write checks up to $100,000. Cummings could write up to $75,000.

Gentlemen, let me introduce problem. Problem, let me introduce gentlemen.

(2) They argued that all monies were encumbered and spoken for. They remitted what they could.

This is the “I had to pay … or the business would have folded” argument.

The IRS will respect encumbrances, but there better be a legal obligation. A pinky swear is not enough. 

The IRS will not respect a responsible person prioritizing them down, when the IRS had as much right to what money may exist as anyone else.

Schiffmann and Cummings could not meet that test.

(3) The Board would not let them pay certain bills.

More specifically, the Board would not let them pay taxes.

Now we have something. The IRS looked into this. It decided that there were two directors who raised a fuss, but it also decided that those two could be outvoted by the remaining directors.

And the directors never formally voted on a resolution, so the IRS could presuppose that the two would have been outvoted.

Then the IRS made an interesting observation: EVEN IF the Board has prohibited the two from paying the taxes, the most that would have happened is that the Board would have joined them in also being subject to the penalty. It would not have gotten Schiffmann and Cummings off the hook.

The two were held responsible.

Cummings was the one who surprised me.

He used to be an IRS field auditor.

Can Your Accountant Owe Your Payroll Taxes?

You own an accounting firm. A potential client is willing to pay you $4,900 month to do their accounting, including payroll. You will be writing checks and paying vendors, including deposits with the IRS.

Are you interested?

What can go wrong, you ask. Since this is a tax blog, you can anticipate that someone is going to step on the IRS’ or state tax agency’s tail, but that does not means that someone is automatically wrong. A significant part of my practice is representation, for example, which usually entails arguing that my client is right.

Buddy and Barry are brothers and together own an accounting firm. There is a North Carolina entrepreneur (Erwin) who owns or operated at least 60 restaurants. He has a new deal to start a Golden Corral franchise, which he does under the name GCAD. There will eventually be five franchises under GCAD. 

The restaurants start to lag. There is negative cash flow of approximately $2 million. Understandably, GCAD has difficulty paying its creditors. Erwin hires a new business manager (Pintner), who knows Buddy and Barry.  They are hired to handle the accounting and taxes for GCAD.

Buddy and Barry obtain data by accessing the restaurant computers remotely. After running payroll, they send the checks to Pintner for distribution to employees. GCAD allows them direct access to the bank account to remit withholdings. They do not need further authorization to make payroll tax deposits.

They are also responsible for paying vendors, but that process is a bit different. Initially they send checks for signature, but eventually they are given a signature stamp.

By the way, remember that they too are a vendor of GCAD. They are paid $4,900 a month.

The brothers are aware of the cash stress. They inform GCAD and Erwin that there is not enough money to pay everybody.

Erwin learns that the brothers had failed to remit payroll taxes. He and another partner fund a capital call, sending the brothers $150,000 with the following instructions:

“that absolutely under no circumstances whatsoever were [you] to be late with any taxes.”

That did not seem to take, and GCAD is again late with payroll taxes.

Business does not improve. Erwin obtains release from one of the leases. GCAD goes three more quarters without remitting payroll taxes. Erwin and his partners make another capital call.

Erwin eventually fires Buddy and Barry. He moves the accounting to North Carolina, and GCAD gets current with its payroll taxes. GCAD however does not pay its back taxes. It can’t. It needs all the money it has to remain in business.

GCAD finally folds.

Uncle Sam shows up, and he wants his payroll taxes. Erwin pays some, then immediately countersues to get the monies back. The IRS starts swinging, suing Erwin and Pintner and Buddy and Barry.

Erwin lawyers up. Pintner lawyers up. The brothers do not. They show up in court “pro se,” which means they are representing themselves. I consider that decision to be suicidal.

Why suicidal? The IRS considers the brothers a “responsible person,” and the IRS has a point. The brothers did have quite a bit of discretion over who was paid with the limited cash available. The IRS argues that it gets paid first, a point they are now emphasizing by going after Erwin and Pintner and the brothers for trust fund penalties. This is the “big boy” penalty, and it is 100 percent of the withholding taxes.

How did it turn out? Read the court’s verdict for yourself:

... the Light Brothers are jointly and severally indebted to the United States for the unpaid withholding taxes assessed against them, plus the applicable interest accruing according to law.”

The tab?  Try $325,734.

The monthly $4,900 fee was sweet, but not enough to cover the penalty.

Could representation have saved the brothers? I am speculating at this point, but I do not believe so. The brothers took on too many of the trappings of a corporate officer. The IRS would be harsh on their control over the checking account, for example. The IRS takes priority when it comes to payroll withholdings, and it reserves the right to disregard other vendors – even if not paying other vendors would put one out of business. The brothers paid other vendors (including themselves) before paying the IRS.  They walked directly into the IRS crosshairs.

Can Payroll Taxes Put You In Jail?

Can you go to jail for not remitting payroll taxes?

Let’s set this up:

• You have a temporary nursing staffing agency in Minnesota.
• You treat your nurses as independent contractors.
• You had a predecessor company which the IRS charged with willfully misclassifying workers and failing to remit payroll taxes.  You survived that occasion by settling with the IRS, but the settlement included language similar to the following:

 “... with respect to any other business similar to the ... entities that he might own, operate or control in the future, he would treat as employees for tax purposes all workers who performed functions or duties that were the same or similar as the function or duties performed by the nurses and nursing assistants who worked for the ... entities. In other words, defendant ... was obligated to withhold and pay over employment taxes for the nursing professionals who worked for any of his entities.”

• Minnesota has a law requiring nursing staffing agencies to certify that they are treating their nurses as employees and not as independent contractors. You have made this certification to Minnesota.

So, can you go to jail for not remitting the nurses’ payroll taxes?

A too-common problem is a cash-strapped business falling behind on depositing their payroll taxes. You can fall behind on many types of taxes and still be able to work something out. You fall behind with payroll taxes, however, and the IRS can be very harsh. The reason is that the IRS (and the states also) considers it stealing. You pay an employee $700 and withhold $200 for taxes. That $200 is not your money: it is the employee’s money that you now hold as agent for remittance to the IRS. The IRS reserves one of its most frightening penalties for this: it is called the trust fund recovery penalty. This penalty is 100% (you read that right), and it attaches to you as an individual. You cannot shed that penalty by leaving or bankrupting the business, because the penalty applies to you. It follows you like a bad haircut.

That penalty however is not what we have here. What we have here is Francis Leroy McLain (U.S. v McLain). The case was appealed to the Eight Circuit from the District Court of Minnesota.

The IRS looked at two entities owned by McLain, Kind Hearts and Kirpal Nurses, and came to the conclusion that the nurses were employees.

OBSERVATION: The IRS will almost always say that someone is an employee, whether they are or not. They want the payroll taxes, of course.

McLain owed about $340,000 in payroll taxes. He had been down this path before, and the IRS had not forgotten. They dusted off Section 7202, a very special tax gem for someone who pushes the sled too far:

Any person required ... to collect, account for, and pay over any tax imposes by this title who willfully fails to collect or truthfully account for and pay over such tax shall, in addition to the other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $10,000, or imprisoned not more than 5 years, or both, together with the cost of prosecution.”

McLain left the shores of the responsible person penalty far behind. He sailed into the deep waters of going to jail. He is now dealing with CID, the criminal side of the IRS.

NOTE: A word to the wise: you never want to deal with CID. These guys have badges. They have guns. And they will put you in jail. I know. I had a client who had gone to jail courtesy of CID, and I know a tax practitioner in northern Kentucky who will be going.

As a tax guy, I am hoping that McLain has some serious technical arguments to make in his defense. I am expecting a ferocious goal-line stand. Here comes his first play:

(1)   McLain referred to the two agencies, King Hearts and Kirpal Nurses, as “Kirpal.” He argued that Kirpal was the employer, and, as the employer, only Kirpal had a duty to account and pay over taxes on its employees.

COMMENT: McLain starts off by irritating me. There was a case on this issue before I even came out of school. The case is Slodov v United States. It was a Supreme Court case and included the following language:

“Sections 6672 and 7202 were designed to assure compliance by the employer with its obligation to withhold and pay the sums withheld, by subjecting the employer’s officials responsible for the employer’s decisions regarding withholding and payment to civil and criminal penalties ...”

            McLain was an officer. What part of this did he not get?

            SCORE: IRS (1) McLain (0)

(2)   McLain argues that he had a good faith belief that the nurses were not employees. The lawyers refer to this as “mens rea,” and he argued that his state of mind did not rise to “willful.” Without willfulness, McLain cannot come under Section 7202.

COMMENT: I like this argument. Unfortunately, he had a prior run-in with the IRS on this very same point, which greatly diluted the argument’s persuasiveness.

            SCORE: IRS (2) McLain (0)

(3)   McLain argues that the IRS has to pursue a civil penalty before it can pursue a criminal penalty, and the civil penalty requires a written notice. He received no written notice, so the IRS cannot proceed with criminal prosecution.

COMMENT: I noticed that the Court reminded McLain’s attorney that he “has an independent obligation, regardless of what his client may demand, to refrain from filing frivolous motions.”

            SCORE: IRS (3) McLain (0)

(4)   McLain moved to dismiss the charges because (1) he is a “natural human being” and the United States does not have authority over him.

COMMENT: McLain’s attorney blanched here, and McLain fired him. McLain represented himself from this point on.

A tax protest argument? Seriously?

SCORE: IRS (4) McLain (0)

McLain lost soundly.

This type of action by the IRS is rare. I can assure that – in almost all cases – the IRS does not want to put anyone in jail. They want your money, and being in jail impedes you getting the IRS any money. And all parties in the system – the IRS, the courts and judges, responsible practitioners – are tired of the tax protest siren song.

I am sympathetic to arguments that our tax system left the world of rational thought years ago, but that does not mean the income tax is illegal. It can be irrational, immoral, confiscatory, divisive and destimulative without being illegal.

McLain has taken what could have been a civil penalty – albeit a stiff one – and morphed it into a multi-year stay at Club Fed. There likely is a fairly impressive fine also. He did however enter the tax literature, primarily for being a blockhead.