Know Your Company’s Failure-to-Pay Liability

No company expects its cash flow to dwindle to the point that paying taxes becomes impossible. But preparing for such difficulties may protect your company from heavy fines if disastrous circumstances occur. Have Feeley & Driscoll look at the specifics of your company’s failure-to-pay liability, including how you might escape penalty.

Worst-Case Scenario

You may not believe that your business could suffer a loss preventing you from paying your taxes. But disasters happen to even the best companies. Your only hope of avoiding IRS penalties is to prove that your failure to pay was based on “reasonable cause” -- not “willful neglect.” To establish reasonable cause, you must show that you practiced due care in planning for your tax liability but would experience an undue business calamity if you paid the tax.

Obviously, the IRS defines “calamity” in strict terms. You must show that you would have suffered a significant loss (such as having to sell property at a loss) had you paid your taxes in full and on time. And such an excuse’s acceptability is even less likely for unpaid employment taxes, because those involve withholding money from your employees.

A court will examine the facts and circumstances of your case. It will study the amounts in question, your company’s profitability at the time taxes were due and whether you spent money on “lavish or extravagant” expenses, including whether you invested unwisely and how you responded to financially detrimental situations. In fact, the deciding factor will probably be whether your company made irresponsible (and, therefore, unacceptable) decisions that left it unable to pay taxes.

Company-Level Responsibility

For a more specific idea of what the IRS looks at when assessing failure-to-pay penalties, let’s consider an example. The Molasses-in-January Corp. -- a molasses distribution company -- failed to pay its income and employment taxes. The company claimed that contract disputes with customers and slow investment returns had stymied its cash flow. The IRS did not accept its excuses and a court case ensued.

The ensuing investigation determined that, though claiming his company could not pay taxes, the president of Molasses-in-January collected a substantial annual salary, borrowed money from the company and spent thousands entertaining clients at sporting and dinner events. The company also continued paying rent and other expenses. The court ruled against Molasses-in-January because its actions showed that the company had not seriously planned for its tax liability. The court also held that late or nonpayment of employment taxes requires a higher degree of “reasonable cause” than income tax.

Personal-Level Responsibility

Unsurprisingly, many businesses that cannot pay their taxes are already on their way to failing. If your business failed, who would be personally responsible for the unpaid taxes? “The company president” seems the most obvious answer, but this is not always the case. Let’s go back to our troubled friends at Molasses-in-January for another example.

Marty and Chris co-founded the company in January 2005. The fast-spending Marty became president, while Chris acted only as the majority stockholder -- he was not an officer, director or employee. Chris held signatory powers for company bank accounts, but he never actually signed any checks or tried to control the company.

In 2006, Chris learned that Marty did not pay Molasses-in-January’s taxes, so Chris personally borrowed funds and paid the taxes. The following year, Chris again found that Marty was not adequately planning for the company’s tax liability. So he borrowed money and lent it to Marty, who used it to partially cover the taxes due and partially cover operating costs. In 2008, Marty resigned as president and, soon after, the company folded.

Much to his surprise, the IRS demanded more than $100,000 from Chris -- not Marty -- for the balance of the 2005 taxes. Chris disputed the assessment, claiming he was not liable because he did not directly manage the company. To determine liability, the courts asked whether the defendant:

• Made decisions regarding company payments,
• Signed checks (or had the authority to do so),
• Hired or fired employees (or had the authority to do so),
• Managed (or could manage) daily operations, and
• Fully or partially owned the company.

The Tax Court held that Chris was liable for the taxes because he had personally borrowed money to pay outstanding taxes and therefore knew Molasses-in-January was in financial distress. The court ruled that Chris should have arranged to pay the company’s taxes before contributing any funds to its operations.

An Easy Lesson

Ask your forensic accounting firm for more information on such failure-to-pay stories. Make paying employment and income taxes your top priority, especially when times get tough. And if you hold a position of authority in your company, know that you may be held personally liable should your company fail to pay.

For ways to keep your business out of tax danger, please contact our forensic services. We can help you minimize your tax liability and avoid mistakes that could jeopardize your ability to pay those taxes.

Contact our forensic accounting services by email or call us at 1 (888) 875-9770 to look at some ways you can tighten your internal controls to prevent fraud.

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