From time to time, every business experiences a cash shortfall. Bills come in from vendors, employees have to be paid, an installment on your bank loan is due, and the landlord is knocking at the door.
What do you do?
Don’t use the money you’ve set aside for certain tax obligations because you can be held personally liable for 100% of this money.
Tax money that’s sacrosanct
Some of the money that a company collects is not to be touched. The company is merely a fiduciary holding the money in trust.
Examples of trust fund taxes:
- Withholding from employees’ paychecks for federal income taxes and FICA
- Withholding from employees’ paychecks for state income taxes and, where applicable, other state tax obligations (e.g., disability contributions)
- State sales taxes
If you fail to pay over these trust fund taxes, you can face a 100% penalty for the unpaid taxes. The federal government has a Trust Fund Recovery Penalty. And many states, including California, have the same rule for state payroll taxes. The penalty applies if a “responsible person” (someone with decision-making power and check-writing authority) willfully fails to pay these taxes. Willfulness is inferred when a responsible person knows the taxes are unpaid but chooses to pay others instead.
Regardless of whether there are other owners besides you or that you set up your company as a corporation or limited liability company to achieve personal liability protection, the government can seek to recover all of the trust fund money from you. The government has three years to go after any responsible person and up to 10 years to collect the amount owed. The personal assets of the responsible person are fair game here. And the IRS can get your assets using a federal tax lien, levy, or seizure action.
Let’s take an example. Say you have an S corporation with three equal owners, all of whom have the authority to make day-to-day business decisions (including who to pay) and to write checks or make electronic bank transfers. Your business is in a cash crunch and with the limited funds you have, you choose to pay your vendors so you’ll continue to have inventory. You don’t pay the U.S. Treasury the amount owed for income tax withholding and the employees’ share of FICA. The IRS can choose to recoup all of the unpaid taxes from you alone. You and your co-owners are “jointly and severally liable” for these taxes. It means that the government usually pursues the person with the deepest pockets. If you pay, you can seek to recover a share from your co-owners, but that isn’t the government’s concern.
State sales taxes
Like wage withholding, merchants who collect sales taxes are merely holding the funds for their states. Say your state has an 8% sales tax rate and you sell a $10 item. You collect $10.80 from the customer; 80¢ belongs to the state. The failure to pay your sales tax collections can result in serious penalties. Ever notice a store on Main Street that’s been shut with a notice posted on the door saying “Closed due to failure to pay sales taxes”?
What to do?
If you find yourself in a cash crunch, recognize that the first parties to be paid are the federal and state government with respect to trust fund money. After that, it’s up to you to decide how to apportion the limited funds you have among your employees, vendors, and other creditors.
If you need additional cash, don’t be tempted to use trust fund money. Use any other resource you can to meet your obligations. Borrow from family and friends. Tap out your credits. Even take distributions from your retirement accounts (though this should definitely be a last resort).
Finally, let this difficult experience teach you a valuable lesson about cash flow management. Use software or online solutions to help. And work closely with your CPA or other financial advisor so you never again face a cash crunch.