Using Payroll Taxes for Working Capital: Path to Financial Ruin

When cash is scarce, it may seem easy to use the taxes withheld from employees’ salaries for working capital, but the IRS has swift and severe penalties for not paying taxes owed. It is especially harsh for unpaid withholdings; interest and penalties can quickly triple the original liability. Business bank accounts can be seized; criminal penalties may involve prison. Any officers, managers or executives with filing authority can be personally liable for unpaid withholding taxes, regardless of the business’s legal form. There is no protection for personal assets. This item details these penalties to provide a better understanding of the consequences of using withheld taxes as working capital.

Background

A positive net cashflow means that a business is generating sufficient cash to cover its required payments. However, many businesses experience periods of negative cashflow. These periods are often seasonal and anticipatory. A common external source of cash during these periods is a revolving line of credit; the business can take advances as needed for working capital. However, when this is not available, the business may have to delay payments on debt or other obligations, thus diverting working capital.

Delaying payments on accounts payable is frequently used to increase available cash. If a company chooses to use withheld payroll taxes for working capital, the IRS and local tax authorities will impose swift and severe punishment.

Potential Penalties

Types of payroll taxes: There are two categories of payroll taxes. The first is taxes that are the business’s responsibility, including the employer portion of FICA and unemployment taxes; they are paid from company assets. The second is taxes that are the employees’ responsibility, but the employer collects them, predominantly withheld income tax and the employee portion of FICA; they are withheld from the employees’ earnings and remitted to the IRS or other tax agency. This second type is considered held in trust by the employer (trust fund taxes).

Consequences for late or partial payments: The Service imposes civil and criminal penalties on businesses that do not pay the entire tax when due. Sec. 6621(a)(2) provides an interest rate for the underpaid tax of 3% over the Federal short-term rate. If the underpayment is more than $100,000, the rate becomes 5% higher, under Sec. 6621(c). The short-term rate is determined quarterly and is based on the average yield of Federal securities with maturity dates of less than three years.

The IRS also levies a late-payment penalty. The standard penalty is 10% of the tax due. However, if the tax has not been paid within 10 days of receiving a late notice from the IRS, Sec. 6656(b)(1)(iii) increases the penalty to 15%.

Using withholding taxes for working capital is an expensive proposition.

Example: Company U has $100,000 in withholding due. It pays $50,000 on time and $50,000 one month late. The second payment is subject to an annual interest rate of approximately 4%. The penalty is 10% (but could have been 15%). The total cost of U “borrowing” $50,000 for one month is $5,167 (($50,000 x 4%/12) + ($50,000 x 10%)).

Exhibit 1 below shows how to compute the interest rate for this cost.

Additional penalties: Businesses are subject to additional penalties for improperly using collected taxes. According to Sec. 6663(a), if the underpayment is deemed to be fraudulent, the penalty is 75% of the underpayment. Also, if any part of an underpayment is found to be fraudulent, the entire underpayment is treated as fraudulent. Sec. 6663(b) puts the burden of proof on the taxpayer to prove otherwise. Willfully choosing to use collected taxes for other financing purposes could be considered fraud. Sec. 6672(a) provides that failing to collect, account for and pay over withholding leads to a 100% penalty on the tax due.

Businesses are also subject to penalties for failing to timely file returns. For each month, or portion thereof, that the return is late, the business will be fined 5% of the tax due, up to a maximum of 25%, under Sec. 6651(a)(1). These penalties are assessed in addition to the interest charged for the unpaid tax.

Recurrence of penalties: The penalties noted are assessed for each incident. If a business is late on multiple occasions, the penalties apply again to each event. The compounding can have a devastating effect on a business already facing cashflow trouble. Once the penalties and interest are added to the original tax due, the total owed can be over three times the original amount.

Payments made are applied to the most recent liabilities first. Thus, if a company had $10,000 unpaid in June and $13,000 unpaid in July and sent a payment for $19,000, the July obligation would be paid in full; the amount due for June would be reduced to $6,000. Older underpayments, which have higher interest and penalty rates, are paid down more slowly and generate higher fines, penalties and interest.

Personal liability: The Service can also hold the owners, officers, members, partners and others with filing responsibility personally liable for underpaying trust fund taxes, even if the business is a separate legal entity (e.g., a corporation or limited liability company). The underpayment includes fines, penalties and interest.

Criminal penalties: Those who fail to collect, account for or pay taxes due, or to underpay fraudulently, are guilty of a Federal felony. The criminal fine is a maximum of $10,000, with a possible prison sentence of up to five years. Both penalties can be assessed.

State Tax Authorities

Most states also collect income tax withholding and other payroll taxes. Each has its own set of rules and laws. It is beyond the scope of this item to specify each state’s laws, but in Michigan, for example, the criminal penalty is a $5,000 fine, 10 years in state prison, or both.

Conclusion

The Service considers payroll taxes withheld by an employer from employee earnings to be held in trust. If the employer does not remit the withheld taxes, it considers that trust broken. The penalties are severe and quickly become overwhelming. Interest rates of up to 200% annually and penalties that double and triple the total tax owed are merely the financial consequences. Purposefully underpaying can lead to a Federal prison sentence. Certain officers, executives and owners of the business can be held personally liable for the taxes, interest and penalties. The severity and swiftness of financial punishment show that using payroll taxes for purposes other than taxes could put a company out of business permanently.

From Anthony Meder, Credit Analyst, Citizens Bank Corporation, Flint, MI, and Justin Fox, Payroll Manager, DaimlerChrysler, Clarkston, MI (Neither affiliated with Baker Tilley International)