Small Business/Self-Employed Tax: When IRS Trouble Comes

If you are in business for yourself, or you work for someone who is, know that the IRS is watching. The three major concerns of the IRS here are:

• Are workers wrongly classified as independent contractors when they are legally employees?
• Is the business making payroll tax deposits?
• Are all transactions—especially large cash transactions—made to the business being reported to the IRS?

Self-Employed—You’re a Prime Audit Target

Because the IRS claims that most tax cheats are self-employed, it is not surprising that this group is more closely scrutinized than are wage earners. With 47,000 employees, the IRS’s Small Business/Self-Employed Division is the biggest of all. If the IRS chooses to come after you by way of an audit—or worse, a criminal investigation—be aware that it can easily get to your bank and other financial records. So, if you’ve been foolish enough to deposit unreported income in your bank accounts, the IRS can find it.

If you are audited, the IRS will want to know:

• Did you report all of your business’s sales or receipts?
• Did you write off any personal living expenses as business expenses?
• Does your lifestyle apparently exceed the amount of self-employment income reported?
• Did you write off automobile expenses for travel that was not business related?
• Did you claim large business entertainment expenses?

If you are self-employed and audited, be sure to read Chapter 3 and concentrate on “Living Beyond Your Means.”

Employees or Independent Contractors?

If your business is improperly treating workers as self-employed—that is, as independent contractors—expect trouble if the IRS calls. The IRS has the power to change the classification of any worker, with expensive consequences for the business owner.

By calling workers “independent contractors,” business owners avoid burdensome tax reporting, bookkeeping, and withholding taxes from their workers’ paychecks. Moreover, entrepreneurs dodge the tax expense of matching employees’ FICA contributions and paying the unemployment tax. The tax savings and reduced paperwork of improperly calling employees independent contractors can be significant—unless you get caught. Violators can be penalized up to 35% of the payments made to the wrongly classified worker, plus interest.

In any event, a business must annually report to the IRS amounts paid to true independent contractors as well as employees. Within one month after the end of each calendar year, owners must file Form 1099 for each independent contractor paid more than $600. Owners must also send a copy of Form 1099 to the contractor.

If the IRS finds that you failed to issue a Form 1099, you may be hit with a separate penalty. (Internal Revenue Code § 3509.) Plus, it bolsters the IRS’s case that you misclassified the worker.

Misclassification of independent contractors is an IRS priority. The IRS has targeted for audit businesses suspected of wrongly classifying workers, such as building contractors, medical professionals, graphic designers, and neighborhood beauty shops, to name a few.

IRS and state auditors can assess an employer not only the payroll taxes that should have been collected and paid, but also the reclassified employee’s unpaid income taxes. And as the penalties and interest mount, businesses can receive audit bills of 50% or more of wages paid. For example, if you paid Millie Ways, an employee, $20,000 as an independent contractor, the IRS might hit you with $10,000 in taxes, penalties, and interest for the misclassification.

How to Classify a Worker

To determine worker classification from the IRS point of view, see Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding. (See the IRS’s website at www.irs.gov.) Here is a summary of the SS-8 factors, gleaned mostly from court decisions.

Factors Tending to Show the Worker Is an Employee of Your Business

• You require—or can require—the worker to comply with your instructions about when, where, and how to work.
• You train the worker to perform services in a particular manner.
• You integrate the worker’s services into your business operations.
• You require the worker to render services personally; the worker can’t hire others to do some of the work.
• You hire, supervise, and pay assistants for the worker.
• Your business has a continuing relationship with the worker or work is performed at frequently recurring intervals.
• You establish set hours of work.
• You require the worker to devote the majority of the work week to your business.
• You have the worker do the work on your premises.
• You require the worker to do the work in a sequence that you set.
• You require the worker to submit regular oral or written reports.
• You pay the worker by the hour, week, or month, unless these are installment payments of a lump sum agreed to for a job.
• You pay the worker’s business or traveling expenses.
• You furnish significant tools, equipment, and materials.
• You have the right to discharge the worker at will and the worker has the right to quit at will.

Factors Tending to Show the Worker Is an Independent Contractor

• The worker hires, supervises, and pays her assistants.
• The worker is free to work when and for whom she chooses.
• The worker does the work at her own office or shop.
• The worker is paid by the job or receives a straight commission.
• The worker invests in facilities used in performing services, such as renting an office.
• The worker can realize a profit or suffer a loss from her services, such as a worker who is responsible for paying salaries to her own employees.
• The worker performs services for several businesses at one time—although sometimes a worker can be an employee of several businesses.
• The worker makes her services available to the general public.
• The worker can’t be fired so long as she meets the contract specifications.

People Who Are Automatically Employees by Law

In most situations, the status of a worker is determined by the above-listed factors. Certain workers fall into special tax categories, and the usual IRS criteria don’t apply. Workers who are automatically employees include:

• officers of corporations who provide service to the corporation
• food and laundry drivers
• full-time salespeople who sell goods for resale
• full-time life insurance agents working mainly for one company, and
• at-home workers who are supplied with material and given specifications for work to be performed.

Exempt Employees and Small Business Owners

The tax code states that licensed real estate agents and door-to-door salespeople are tax-classified as nonemployees or exempt employees. They may be treated as regular employees for nontax purposes, however, such as liability insurance and workers’ compensation.

Sole proprietors or partners in their own business are neither employees nor independent contractors. They pay their own income tax and Social Security/Medicare self-employment tax. But a shareholder in his incorporated business is legally an employee of his corporation in most cases.

How Independent Contractor Rules Are Applied

Let’s look at two workers—one an employee and the other an independent contractor—who provide similar services but fall into different tax classification categories.

State Rules May Be Different

IRS classification rules are similar to those of most states for state taxes and unemployment rules, but there are differences. For example, in California, a person working for a licensed contractor who performs services requiring certain state licenses is classified as an employee unless he, too, has a valid contractor’s license. If you plan to hire independent contractors, check the law in your state to see if there are special rules in effect.

Part-Time Workers

John operates a desktop publishing shop specializing in writing and designing brochures, flyers, and other promotional materials for small businesses. At the start, John does most of the work himself, turning any overload over to others, including Sue, Ted, and Ellen, all working out of their homes. John collects from the customer and pays these people as independent contractors. So far, so good.

But as John’s business grows, he brings Sue, Ted, and Ellen into his office to work part-time under his broad supervision, an average of about one or two days per week each. The rest of the time they work for themselves. John continues to treat them as independent contractors. By law, he shouldn’t. If he continues along this line, he’s tempting fate—and the IRS. John is exercising significant control over these workers and using their services in-house on a regular basis. Under the IRS guidelines, they are all employees, even if they are regularly employed elsewhere.

How Business Owners Can Protect Themselves

Here’s how to prove a worker was an independent contractor if you are audited:

• Enter into a written contract with the independent contractor. Spell out the responsibilities of each party and how payment is to be determined for each job. The contract should allow the independent contractor to hire his or her own assistants.
• Require the independent contractor to furnish the tools, equipment, and material needed for the job.
• Have the independent contractor do all or most of the work at his or her own place—not at yours.
• Make it clear that the independent contractor is free to offer services to other businesses besides yours.
• Pay for work by the job rather than by the hour, week, or month. Require the independent contractor to submit invoices for each job before you make payment.
• Require the contractor to show proof of a business license and insurance.
• Require the worker to prove she is reporting what you pay her on her tax return.

The IRS invites businesses or workers to submit Form SS-8 for an IRS analysis of whether or not a particular worker qualifies as an independent contractor. I don’t suggest using this form because it will alert the IRS to the issue. Instead, consult a tax professional, or use your own judgment based on what you read here and in other Nolo books.

Payroll Taxes—IRS Dynamite

If you own a business with employees, each payroll period you must hold back from each employee’s paycheck:

• federal and maybe state income tax, and
• FICA contributions (Social Security and Medicare).

How much income tax is withheld from each employee’s earnings depends on the number of exemptions claimed by the employee when he or she started working for you. The FICA contribution is a percentage of the employee’s gross earnings, which you must fully or partially match.

An employer turns over withheld taxes to a bank qualified as a depository for federal taxes. Use a federal tax deposit form with your payment. Many states have similar tax withholding forms.

A small business employer must deposit payroll taxes either monthly or quarterly, depending on the size of the payroll.

All employers must also send the IRS:

• Form 941, Employer’s Quarterly Federal Tax Return. This form must be filed every three months as long as your business has employees. Form 941 reports the amount of your employees’ federal income tax and FICA withheld for the previous quarter.
• Form 940, Employer’s Annual Federal Unemployment Tax Return, or FUTA. Form 940 is filed once a year. On it, you report your total quarterly payroll tax deposit. On this amount, a federal unemployment tax is calculated. The FUTA tax is paid by the business and is not withheld from its employees’ paychecks.

According to the IRS, most businesses are delinquent in filing or paying employment taxes at one time or another. The IRS considers payroll taxes the most serious of all tax debts. The theory of the payroll tax law is that the employer acts as a collector for the government, holding its workers’ taxes in trust until paid over to the IRS. Consequently, the IRS views operating a business while owing payroll taxes as illegally borrowing money from the U.S. Treasury.

The Dreaded Trust Fund Recovery Penalty

Here’s a familiar scenario: Your small business is struggling. You pay the rent and your employees’ wages, but not the payroll taxes. You know things will turn around next month, however, when the big order comes in. And Christmas is just around the corner; you are sure you’ll pull out of the slump and be able to pay Uncle Sam in full.

Six months go by. Your sales have gone down. Orders stopped coming in and holiday sales were terrible. Your suppliers have sued you and your landlord is threatening to evict. You haven’t filed payroll tax forms or deposited payroll taxes for the last four quarters. You shut down and sell your assets to pay off the creditors—although you don’t pay the IRS the payroll taxes you owe. You manage to avoid bankruptcy by the skin of your nose.

If you did it this way, woe unto you. You should have paid the IRS first and then, if need be, filed for bankruptcy to handle private creditors. This is because the IRS is the creditor to be most feared.

When payroll taxes haven’t been paid, the IRS can review a company’s books, speak to employees, and then hold its owners, managers, and bookkeepers personally responsible for the payroll taxes due. The IRS transfers the business payroll tax obligation to individuals—penalizing them for the business’s failure to make the payroll tax deposits. This is known as the Trust Fund Recovery Penalty (TFRP). It applies primarily to incorporated businesses. If your small business was an LLC, a partnership, or a sole proprietorship, you can be found directly responsible for payroll taxes without the TFRP provision.

Because the penalty equals the taxes owed, it’s also called the 100% Payroll Penalty. (Internal Revenue Code § 6672.) And although in most instances the TFRP is transferred to employees of a defunct business, the IRS can—and will—impose the liability on people working for an ongoing business as well.

The relevant section of Internal Revenue Code §6672 states:

Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable for a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.

The IRS has three years to assess the TFRP against responsible people after the tax was originally assessed against the business. Once the TFRP is assessed against the responsible people, the IRS has ten years to collect it from them.

How Businesses Can Minimize Payroll Tax Trouble

Give top priority to making payroll tax deposits when they are due. Never borrow from your employees’ tax funds. Even if you eventually make the payment to the IRS, the penalties and interest can be substantial. Pay Uncle Sam first, not last. If you can’t pay, then maybe you shouldn’t be in business.

Stay out of trouble by using a bonded payroll tax service to both file and make all payroll tax deposits. Banks and companies like ADP and Safeguard offer this service at reasonable prices. If they goof up and don’t get a form or payment in on time, they will pay the late payment penalty.

If your business is able to make only a partial payment of payroll taxes, write on the lower left-hand portion of the check that the payment is designated to the trust fund portion of the tax. Also, enclose a letter stating that you designate the payment to the trust fund portion.

The trust fund portion is the employee’s income tax and FICA contributions. The smaller part—the employer’s share of the FICA contribution—is not subject to the Trust Fund Recovery Penalty. This reduces the amount that the IRS can assess against responsible persons by around 8% (every little bit helps).

How the IRS Determines the Responsible People

On average, the IRS finds 1.6 responsible persons for each defunct business owing payroll taxes. There is no limit, however, and it’s not uncommon for six or more people to be declared equally responsible. And all are jointly and severally liable for the entire amount; the penalty is not divided among the group—each person owes all of it to Uncle Sam until the penalty is paid in full.

The TFRP is one of the scariest parts of the tax code. It is directed at business owners, but it can also be assessed against low-level employees with no financial stake in the business. IRS investigations of businesses owing payroll taxes are conducted by revenue officers. They begin by putting together a list of people with any authority over business finances.

• Who made the financial decisions in the business?
• Who signed or had authorization to sign on the checking account?
• Who had the power to pay or direct payment of bills?
• Who had the duty of tax reporting?

To get this information, the officer may interview everyone whose name comes up when she asks the above four questions. She looks at bank and corporate records for the names on bank signature cards, and to find out who actually signed checks and who were corporate officers.

Anyone whom the revenue officer believes acted willfully in preventing the IRS from receiving the payroll taxes is found liable. Unfortunately, “willful” does not mean that you intentionally tried to beat the government out of payroll taxes. It means only that you knew about the payroll taxes and knew they weren’t being paid. Under this test, the IRS has found $100-per-week bookkeepers liable for enormous sums of money. The reasoning is that if the bookkeeper paid other bills, she could have paid the IRS.

Revenue officers often ignore business realities in order to find responsible persons. Most vulnerable are people with check-signing power and with corporate titles, but without any real authority.

Check-signing power. Revenue officers often assume that anyone who had the power to sign checks is guilty. They often ignore IRS rules stating that the TFRP should not be imposed based on check-signing authority alone. (Internal Revenue Manual 5632.1(3).) This is in line with court decisions that an employee with no financial interest in the business, but who signed checks under the explicit directions of a boss, is not a responsible person under the TFRP.

Corporate titles. Running a close second to check-signing power is the IRS assumption that anyone with a corporate title— president, secretary, or treasurer—is a responsible person. IRS policy, however, states that this presumption should be made only if the corporate officers do not cooperate in the IRS’s investigation. (IRS Policy Statement P-5-60.) In many small corporations, titles bear little relationship to who really runs the business.

An individual may be responsible for the TFRP but not for all the tax periods. You aren’t liable for the TFRP for payroll taxes owed before you came onto the scene or after you departed.

IRS Interviews of Potentially Responsible People

In interviewing each potentially responsible person, revenue officers ask the questions on IRS Form 4180, Report of Interview With Individual Relative to Trust Fund Recovery Penalty or Personal Liability for Excise Tax. If you are ever called for IRS questioning about a business with which you were associated, study the form ahead of time so that you won’t be caught off guard. Depending on how much tax is owed, you might also review the form with a tax attorney before meeting the IRS.

At the interview, you can bring a representative with you—a tax lawyer, CPA, or enrolled agent. (See Chapter 13.) And you should, especially if you were the bookkeeper or check writer or had financial dealings in the business and don’t believe that you should be held responsible.

Appealing a Trust Fund Recovery Penalty

If you are found to be a responsible person by a revenue officer, you will be sent a preliminary notice and a tax bill. Revenue officers tend to find as many people responsible as is remotely possible. But their decisions can be protested to the appeals division, where many TFRP responsible-person findings are reversed. If you don’t think you really were responsible, then you should appeal.

The preliminary notice you are mailed or handed informs you of the amount of the penalty and that you have 60 days to file an appeal. The procedure is similar to the appeal of an audit—you must file a written protest with the appeals office. (See Chapter 4.) If you don’t appeal, after 60 days the preliminary notice becomes final and you will receive a formal demand for payment. (Internal Revenue Code § 6672.) If you don’t pay, the IRS can go through its normal lien and levy process to enforce collection. (See Chapter 6.)

A sample protest letter is shown below, followed by the case history that led up to this letter.

If You Lose Your Trust Fund Recovery Penalty Appeal

Many TFRP cases don’t have endings as happy as Sandy’s in the following example. If you really were a responsible person—that is, you knew about, had the authority to pay, and should have paid the payroll taxes—there may be no way to avoid the penalty. Nevertheless, if you find yourself in this awful predicament, keep reading to find your options:

Go to court. If you really believe you aren’t liable, you can challenge a TFRP in court. You can sue in tax court (the easiest route), in the U.S. District Court nearest to you, or in the U.S. Court of Claims. (See Chapter 5.)

Sample Letter to Appeal Trust Fund Recovery Penalty

Sandy and Crazy Calhoun’s—A Case History

Crazy Calhoun’s was a popular singles spot owned by three partners. At the height of its glory, the least competent of the partners, Tom, bought out the other two partners. Tom lived in the fast lane and preferred play to work. He let his employees run the business. His neglect and expensive tastes caused the business to fall behind in its bills—including federal payroll taxes.

Sandy was a longtime employee of Crazy Calhoun’s. She worked her way up from cocktail waitress to bar manager. Because C.O.D. liquor deliveries during Tom’s frequent absences needed to be paid, Sandy was authorized to sign checks. She was uneasy about it, but went along because she knew if the bar didn’t have any booze, she’d be out of a job.

One day, a revenue officer showed up asking for Tom, who was out. The officer said he was padlocking the doors if he didn’t get immediate payment of at least $2,000 for back payroll taxes. Sandy replied that she had authority to write checks for liquor deliveries only, unless Tom specified more. Several times in the past, Tom had phoned the bookkeeper saying that Sandy could sign payroll checks. Sandy asked her fellow workers what to do. They all agreed Tom would want her to write the check to the IRS, so she did.

Several months later Crazy Calhoun’s was padlocked by the same revenue officer. By then, Tom had disappeared. Suppliers had

stopped making deliveries for nonpayment; most employees had quit. Sandy got a new job. Eventually, Tom showed up in jail in Hawaii.

Sandy is found responsible

About two years later, a new IRS revenue officer paid a surprise visit to Sandy at home. Unlike the first guy, this man was very nice. He said he was investigating Crazy Calhoun’s and needed to ask a few questions. He went through an interview and asked Sandy to sign a statement, thanked her, and left.

Two months later Sandy found in her mailbox an IRS notice of Proposed Assessment of Trust Fund Recovery Penalty. The nice man had found Sandy liable for $128,000 in payroll taxes of Crazy Calhoun’s. She was hysterical. At 28 years old, Sandy owned a five-year-old Chevy, some old furniture, and a cat. She earned $350 a week as a waitress and was supposed to pay an IRS bill on which interest and penalties were running at over $1,500 per month.

Sandy appeals

Sandy hired an attorney for her appeals hearing. The attorney felt that Sandy had a fair chance of winning an appeal. The most difficult thing to overcome would be the statement—Form 4180—that she had signed. The form is designed to virtually guarantee anyone interviewed will be found liable.

Her attorney sought out other former Crazy Calhoun employees, who backed Sandy’s story that she never had authority to pay business taxes. The former manager, Jack, was living 2,500 miles away. Jack was sympathetic and said Sandy was telling the truth. He was afraid to put this in writing for fear the IRS would come after him.

Lois, the former bookkeeper, had prepared checks for the business but never signed them. She was not being pursued by the IRS. She gave a statement that Sandy could sign checks only to pay for liquor C.O.D.s and that Tom had sole authority to pay all other bills. Sandy’s lawyer submitted a statement from Lois.

At the hearing, Sandy’s lawyer presented a statement from Lois and her own statement summarizing the attorney’s conversation with Jack. Also, Sandy stated she had paid the IRS only once, under the duress of the revenue officer. At the end of the hearing, the appeals officer stated that the case was closed. About 60 days later, Sandy received his report—she was not held to be responsible for the taxes.

Tax court doesn’t require you to pay the IRS any tax before filing your suit. However, to sue in a district court or the court of claims, you must first pay at least some of the taxes claimed due and then file a lawsuit seeking a refund. The minimum amount you must pay is equal to the unpaid payroll taxes due for one employee for one quarter of any pay period. This means that if you are found liable for a large amount—say $50,000—under the TFRP, you only need to pay the taxes for a minor employee—perhaps only $100—to contest the whole $50,000.

While you can go to tax court without a lawyer, as a practical matter, you will need an attorney to sue in either a district court or the court of claims. (See Chapter 5, “Other Federal Courts–Paying First Is Required.”) Expect to pay a minimum of $10,000 in legal costs.

File for Chapter 13 bankruptcy. A TFRP can’t be discharged, or wiped out, in a Chapter 7 bankruptcy. However, you can include a TFRP in a Chapter 13 repayment plan. See Chapter 6 for a description of bankruptcy. To try to get the TFRP partially wiped out in Chapter 13, consult a good bankruptcy lawyer.

Pay or compromise. If you throw in the towel, just deal with the TFRP as with any other kind of tax bill. See Chapter 6 to find out your options. Your best bets may be either an installment agreement or an Offer in Compromise.

Request a nonassessment or nonassertion. A little-known tax code provision allows people found responsible for TFRPs to request a “nonassessment” or “nonassertion.” (Internal Revenue Code §6672; Internal Revenue Manual 5.7.5.1 et. seq.) I have had this request granted when my client showed she was broke and the IRS concluded it wasn’t worth the effort to try to collect the penalty—even through she was clearly responsible for the payroll tax.

Are Other People Responsible?

If you or your tax professional submits a written request to the IRS, the agency must disclose the names of other people found responsible for the TFRP. Furthermore, the IRS must describe in writing its efforts to find and collect from each of them. It’s clearly in your best interest to give the IRS any information you have regarding the location of assets of other responsible persons—unless you are feeling charitable.

Also, if you end up paying more than your proportional share of the TFRP, you can sue the others for the difference. For example, you and two other people are found responsible for a TFRP of $33,000. The IRS grabs your $15,000 IRA. Since your share is only $11,000, you may sue the other two people for the $4,000 difference. But don’t look to the IRS for help in collecting from the two others; it’s not their job. (Internal Revenue Code §6672.)

Cash Transactions Over $10,000

As part of a government campaign against the underground economy and money laundering, all cash and cash equivalent business transactions over $10,000 must be reported to the IRS, using Currency Transaction Reports, or CTRs. Some state tax agencies have similar reporting laws and forms.

Cash equivalents include traveler’s checks, money orders, and bank drafts. Personal checks of any amount are exempt from CTR reporting, presumably because banks keep copies of personal checks, thereby creating a paper or electronic trail the IRS can follow.

All businesses that receive cash or cash equivalents must report each customer’s name and Social Security number for each transaction over $10,000 on IRS Form 8300. Banks report these transactions on Form 4789. (For details, see IRS Publication 1544.)

CTRs are used by the IRS to identify people who unload nontaxed money by purchasing luxury goods—such as cars, yachts, and jewels—or by taking lavish trips.

Within 15 days of receiving over $10,000 in cash or cash equivalents in a business transaction, you must send Form 8300 to the IRS. And when you deposit that money into your bank—or if your total cash deposits for one day exceed $10,000—your bank will report it to the IRS unless you are specifically exempt from this law. Large grocery stores and a few other types of businesses are exempt from CTR reporting.

Failing to file a Form 8300 can get you fined, audited, or both. And CTR violations may be sent to the IRS criminal investigation division. (See Chapter 10.) In short, not filing a CTR can cause you more problems than if you had reported the cash in the first place.

Chapter Highlights

• Self-employed people have the highest audit risk so they should keep very good records.
• If you hire others for your small business, be aware of the tax rules for independent contractors and employees.
• Hiring employees means you have to withhold taxes from their pay and follow all federal and state payroll tax requirements.
• Cash transactions in your business must be reported to the IRS if they are over $10,000.