Small Business Taxes & Management

Special Report

Withholding Tax Compliance


Small Business Taxes & ManagementTM--Copyright 2012, A/N Group, Inc.



There are many reasons employers don't withhold or pay employment taxes. For some, it may be an attempt to use the government as a bank to 'borrow the money for a short while' with good intentions to pay it back later. For others, it may be a situation where an employer collects the taxes and elects to keep it during a period of financial difficulty rather than pay it to the IRS. Regardless of the reason, federal law requires employment tax withholding and payment by employers.

Employment taxes consist of federal income tax withholding along with social security and Medicare taxes and unemployment taxes. Also, many states have withholding requirements for various employment related taxes, such as income taxes. In addition, any business that has employees is liable for unemployment insurance contributions on at least a portion of the wages. Improper reporting or payment of employment taxes affects the ease with which employees can claim future benefits from these programs.

The IRS takes a variety of steps to combat employment tax non-compliance. The agency has a number of civil actions it can take like audits and filing tax liens against property the taxpayer owns. In addition to civil actions, IRS Criminal Investigation investigates and refers for prosecution individuals and businesses that have willfully attempted to avoid filing and paying employment taxes. These efforts have led to significant criminal convictions resulting in incarceration and fines.

Prison time is not unusual, for both federal and state violations. In many cases the taxpayer is still required to make restitution.


Eight Most Common Types of Employment Tax Non-compliance

Pyramiding. "Pyramiding" of employment taxes is a fraudulent practice where a business withholds taxes from its employees but intentionally fails to remit them to the IRS. The cause is often a lack of profit or capital for operating costs, so the business owner uses the trust funds to pay other liabilities. The quarterly employment tax liabilities accumulate (or "pyramid") until the employer has little hope of catching up. Businesses involved in pyramiding frequently shut down or file for bankruptcy and then start a new business under a different name starting the cycle over.

Unreliable Third Party Payers. There are two primary categories of third party payers--Payroll Service Providers and Professional Employer Organizations. Payroll Service Providers typically perform services for employers such as filing employment tax returns and making employment tax payments. Professional Employer Organizations offer employee leasing meaning that they handle administrative, personnel, and payroll accounting functions for employees who have been leased to other companies that use their services. Many of these companies provide outstanding services to employers. Unfortunately, in some instances, companies of both types of services have failed to pay over to the IRS the collected employment taxes. When these employment service companies dissolve, millions in employment taxes can be left unpaid. Employers are urged to exercise due diligence in selecting and monitoring a third party payer. For example, when choosing a third party payer, employers should look for one that is reputable and uses the Electronic Federal Tax Payment System (EFTPS). This allows the business owner to verify payments made on their behalf. Also, an employer should never allow their address of record with the IRS be changed to that of the third party payer.

Frivolous Arguments. Unscrupulous individuals and promoters have used a variety of false or misleading arguments for not paying employment taxes. These schemes are based on an incorrect interpretation of "Section 861" and other parts of the tax law and have been refuted in court. One variation of this scheme involves the improper use of Form 941c, Supporting Statement to Correct Information on Form 941, to attempt to get a refund of previously paid employment taxes. Employer participants could also be held responsible for back payments of employment taxes, plus penalties and interest.

Offshore Employee Leasing. This scheme, which was designated as a Listed Transaction by the IRS, misuses the otherwise legal business practice of employee leasing. Under the typical promotion, an individual taxpayer supposedly resigns from his or her current employer or professional corporation and signs an employment contract with an offshore employee leasing company. The offshore company indirectly leases the individual's services back to the original employer using a domestic leasing company as an intermediary. The individual performs the same services before and after entering into the leasing arrangement. While the total amount paid for the individual's services stays the same or increases, most of the funds are sent offshore as "deferred" compensation. The "deferred" compensation is then paid to the individual as a "loan" or ends up in an account under the individual's control. Promoters of these arrangements improperly claim that neither employment taxes nor income taxes are owed on the "deferred" compensation. Because it is a Listed Transaction those who use the scheme are required to disclose their participation on current tax returns, and will be liable for the unpaid tax and subject to penalties and interest. Civil and criminal actions are being taken against promoters and participants in offshore leasing schemes--one promoter was convicted of defrauding the U.S. and sentenced to 70 months imprisonment, two other promoters have been ordered by the courts to stop marketing the scheme and a San Diego doctor plead guilty to tax evasion and is awaiting sentencing.

Misclassifying Worker Status. Sometimes employers incorrectly treat employees as independent contractors to avoid paying employment taxes. Generally if the payer has the right to control what work will be done and how it will be done, the worker is an employee. Employers who misclassify employees as independent contractors (and are not eligible for relief under Section 530 of the Revenue Act of 1978) will be liable for the employment taxes on wages paid to the misclassified worker and subject to penalties.

Paying Employees in Cash. Paying employees wholly or partially in cash is a common method of evading income and employment taxes. There is nothing wrong with compensating an employee in cash, but employment taxes are owed regardless of how the employees are paid. And the IRS will build its case using all available information even if there are no payroll records or checks.

Filing False Payroll Tax Returns or Failing to File Payroll Tax Returns. Preparing false payroll tax returns intentionally understating the amount of wages on which taxes are owed or failing to file employment tax returns are methods commonly used to evade employment taxes.

S Corporation Officers Compensation Treated as Corporate Distributions. In an effort to avoid employment taxes, some S Corporations are improperly treating officer compensation as a corporate distribution instead of wages or salary. By law, officers are employees of the corporation for employment tax purposes and compensation they receive for their services is subject to employment taxes.

The IRS encourages employees to report any concerns that an employer is failing to properly withhold and pay federal income and employment taxes. Employers must report employment taxes withheld from their employees on Form 941. Employers are also responsible for filing Form 940, Employer's Annual Federal Unemployment Tax Return.


Failure to Deposit

Failure to deposit withheld taxes is a serious problem for a number of reasons. First, the IRS (and the states) get very serious about not depositing withheld taxes. It's much more significant than being late with your income taxes. Taxes withheld from your employees' pay never belonged to you; you were just holding them for the IRS (or state). They're sometimes referred to as trust fund taxes. (Most states consider sales tax in the same category.) And the penalties here can quickly add up. The penalty starts out at 2% for deposits 1 to 5 days late; 5% for deposits made 6 to 15 days late; and 10% on deposits made 16 or more days late. The penalty is 15% of amounts still unpaid more than 10 days after the date of the first notice asking for the tax due or the day you received notice and demand for immediate payment, whichever is earlier. That's a very expensive way to borrow money.

Second, you can be held personally liable for the unpaid amounts. And, should you end up paying the amount personally, you will not get a deduction for the payment. Moreover, any outstanding liabilities are not discharged in bankruptcy.

Except in cases where an employer is basically ignoring his or her responsibilities or just using the withheld amounts for personal spending, holding onto the withholdings generally indicates a serious cash flow problem that and the business probably need outside assistance.

If you're already behind one or more quarters, talk to your accountant or tax adviser. You may have options. But the longer you wait, the worse it will get.


Copyright 2012 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 09/18/12