Don't Forget to Pay Your Uncle – Uncle Sam that is!

October 2, 2008

9:00 am

By Harriet Jacobs, CPA, MST

Here’s a sad story about an entrepreneur with cash flow problems.  We’ll call her Ursula Undercap.

Ursula was a technological wiz.  She was always coming up with ideas which were usable, useful, and on the cutting edge.  She worked for a tech firm for a number of years, but decided that other people were making more money from her ideas than she was.  So, Ursula decided to strike out on her own.  She opened a corporation named Undercap Tech, Inc., and started out on a shoestring budget.

Prospects were good.  There were several small successes in the first year, and Ursula was surprised to find that she was quite good at marketing her ideas.  She knew that she ought to have more cash on hand as a cushion, but assumed that she could borrow funds if necessary and as long as cash flow from current operations covered all of her monthly expenses, it wasn’t a pressing issue.

While driving to the office one morning, Ursula thought of an amazing, new concept.  The concept was huge, and so was the project.  Ursula analyzed her needs, and set out to hire about twenty more employees, including people who could work with her to flesh out her ideas, the assistants they would need, two marketing people, and an in-house bookkeeper/office assistant to keep up with the day to day running of Undercap Tech, Inc.  She hoped that her cash flow would sustain all of the new staff she needed to complete the project, but she also knew that this was her big chance to succeed.  She had to make it work, no matter what!

The new bookkeeper began paying the bills, under Ursula’s supervision.  Each week, they would look at how much money they had in the bank, and Ursula would tell the bookkeeper which bills to pay and which ones could wait.  Obviously, the staff had to be paid, or they would leave.  There was too much at stake to allow the new project to be understaffed.

Ursula saw that her resources were being stretched too thin, so she went to the bank to ask for a loan.  Actually, she went to five banks.  Unfortunately, each of them told her that they still considered Undercap Tech, Inc. to be a start up business, and therefore, they couldn’t lend her money at this time.  Two banks, however, did promise to lend her money as soon as she had signed contracts with at least three businesses for her new project.  She knew that she could hang on until then if she was very careful.  So, she started paying her suppliers in 60 days, rather than 30.  And she stopped making her payroll tax deposits.  She figured that the contracts would come in and that she would at least have her bank loans by the time the IRS came around.

Well, you know the rest of the story.  The project took much longer to perfect than anticipated.  Businesses would not sign contracts until they saw the finished product.  As a result, Ursula couldn’t get a bank loan.

Fast forward eight or ten months.  Somehow, Undercap Tech, Inc. has stayed in business.  The employees have all been paid, usually on time.  The vendors grumble, but take their money in 60 or 90 days.  Only the payroll taxes are owed.  The corporation now owes all of the taxes for three calendar quarters, plus substantial penalties and interest.

Then one day Rudy Revenue Officer arrives from the IRS.  He tells Ursula that Undercap Tech, Inc. owes a large sum of money, and that he is there to collect it.  She is very apologetic, explaining that she had expected to have the money available by now, but the new project took longer to develop than expected, and the corporation won’t be able to pay the liability until the project is brought to market.

So Rudy starts asking Ursula about her personal finances.

“Why do you want to know?” she asks him.  “This is a corporation, and I am not personally liable for the corporation’s debts.”

“That is generally true,” Rudy replies, “but you can be charged personally for any Trust Fund taxes which you were responsible to pay over to the government on behalf of the corporation.  Every penny of the withholding taxes you took from your employees’ pay checks, as well as the employees’ withholding for Social Security and Medicare can be collected from you personally, regardless of whether the corporation stays in business or goes under.  Now, I understand that you have substantial equity in your house and that you don’t owe any money on your late model luxury car.  You also have a large balance in your 401(k) plan from your former employer.  We’re going to have to analyze all of your personal financial information to determine if you can pay the liability through monthly installments or if you’re going to have to take out personal loans to pay the entire amount right now.”

This sounds pretty scary – and it is.  Many owners of corporations believe that they are personally protected from all corporate creditors.  The truth is that a “responsible person” who “willfully neglects or refuses to pay” Trust Fund taxes to the government can be held personally liable for those taxes.  In addition to the types of federal payroll taxes mentioned above, Trust Fund taxes can also include such things as state withholding or sales taxes.

Ursula Undercap has learned her lesson, and she would like you to learn it, too.  Make sure that your business is adequately capitalized, and never neglect to pay your payroll taxes.  It’s just bad business.

TECH cocktail Community Contributed Knowledge

Harriet Jacobs, CPA, CVA, ABV, MST is a tax manger at Frost, Ruttenberg & Rothblatt, P.C. of Chicago and a former IRS Collection Division Employee. She has published articles in technical journals on various tax topics, has presented numerous tax seminars to groups around the Chicago area, and has taught income tax courses at a community college. She has also been invited by the IRS to address a high level training course in California, and to be a panelist on an IRS sponsored web cast originating in Washington, DC. Harriet can be reached at [email protected]

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