Don’t steal from yourself. That sounds silly, but it’s what I call hiding personal and business income. When selling companies for my clients, I’m always concerned when I hear that the actual profits are higher than those reported to the IRS. First, a tax audit will usually uncover such hidden income and result in penalties and interest far in excess of the earlier benefits you thought you enjoyed. Second, no corporate nor most individual buyers for a company will include all of such hidden income in their calculation of an appropriate purchase price. Because most of it is excluded, the purchase price is lower, usually much lower, than what you would otherwise have received. And third, knowingly reporting inaccurate income is a felony for which people can and do go to jail. Not a good idea.
Paying the IRS is a high-class problem. It means you’re operating a profitable enterprise on which profit taxes are due. When not paying the IRS what is due, you’re either operating a losing business or you’re cheating in ways you shouldn’t. If losses are the reason for the lack of tax obligations, you need to correct the profit problems fast. If cheating is the reason for the lack of tax obligations, or just taxes lower than you should pay, you’re operating a criminal enterprise. Sounds ominous, but it’s factual.
Those warnings relate to taxes on income. Accurately calculating and paying those taxes is extremely important. Paying taxes on payroll, however, and paying those taxes on a timely basis, is not just important, it’s imperative.
To the Internal Revenue Service, payroll taxes are in a unique category. Withholding, Social Security and Medicare taxes are monies that do not, and have never, belonged to the company or person making the payments. Those funds are, and from their inception always were the property of the Federal Government. Not paying those payroll taxes can result in Draconian actions on the part of the IRS and those actions can be taken immediately.
In addition to holding all company directors, any officers with signature power over a bank account and the accounting managers personally responsible for any and all unpaid payroll taxes, the IRS can also take advantage of that responsibility by seizing both corporate and personal bank accounts. In regard to other company assets, an IRS lien for unpaid payroll taxes is superior to any other loans, including secured bank loans. Your friendly tax collector can padlock the door to your facility and claim the assets. I’ve seen it happen.
Several years ago, when I was just starting a turnaround effort for a chronically unprofitable company, the owner called one morning to tell me that the IRS had shut the plant. The IRS agent actually put a new hasp and lock on the front door with no prior notice. That was the first I learned of the unpaid payroll taxes. We were able to negotiate with the IRS agent and reopen, but it took several days as well as a significant payment against the past due taxes, interest and penalties that was particularly difficult to make.
The problem for companies with insufficient working capital is the ease with which the IRS can become a source of borrowed funds. No need to fill out loan applications; a history of continuing losses is not a problem; just don’t pay the payroll taxes and use those funds to support the business. When that starts, it’s always a short-term loan. Too often, it then becomes a long-term loan. At that point, the unpaid FICA and other payroll taxes become more of a threat to your business than any other factor. Borrowing the payroll taxes is the worst source of funds for any company. If such borrowings are ever necessary, the company has problems that should have been solved earlier and in another fashion.
The rules are easy to follow: For all payroll taxes, pay the IRS first, no exceptions. For all income related taxes, calculate the income accurately and pay the taxes when due.
My own business is a sole proprietorship operated from a home office, but I keep financial records as if it were a much larger corporation. That is particularly true for all of those items subject to fudging. For example, every time I visit a client, I record my mileage and apply the standard IRS allowed mileage charge for that year. My wife keeps a separate bank account for Florida Corporate Finance and never mingles either income or expenses with our house accounts. At the end of each month, she reimburses the house accounts for the mileage charges during that month.
Any business owner or executive should keep similar records of all business-related expenses paid by their company which could be personal. Any personal expenses should be paid by the individual and not by the company. If any such expenses are paid by the company, the owner or executive should write a check to reimburse the company. Doing otherwise is playing Russian roulette with the IRS, and in that game, the IRS always wins.
When developing Strategic Plans for my client companies, I always advise them to keep all of their options open. Among those are a possible sale or other form of corporate relationship for their company. Although a sale of the company may be out in some indefinite future, you never know. An attractive buyer might surface, or the owner’s heirs may be the sellers long before he or she planned. In any case, the value of the company will usually be based principally on its history of earnings. If those earnings are artificially low due to tax games, the price will also be low.
I’ll say it one more time, “Pay the IRS first.” You’ll never regret following that simple policy.
Lee Rust, owner of Florida Corporate Finance, specializes in Mergers & Acquisitions, Corporate Sales, Strategic Planning, Financing and Operations Audits. He can be reached by phone at 407-841-5676 or by email at hleerust@att.net.
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