Payroll Taxes

There is no limit on how much children can earn and still receive the FICA tax exemption. However, it is important that the wages paid to the child are reasonable for the job performed, and that the hours worked by the child are carefully documented, so it will be clear to the IRS that the child has not been paid for little or no real work performed. In addition, parents should note that their child's financial aid for college may be reduced if they earn more than $1,750 per year.

Small businesses also are not required to withhold payroll taxes for persons who are employed as independent contractors. Using independent contractors rather than hiring employees may be an attractive option for some small businesses. By avoiding responsibility for payroll taxes and all the associated paperwork, as well as avoiding the need to pay benefits, businesses may find that using an independent contractor costs between 20 and 30 percent less than hiring an employee. But misclassifying an employee as an independent contractor can lead to costly consequences for a small business. The IRS examines such relationships very carefully, and in cases where an independent contractor must be reclassified as an employee, the business may be liable for back taxes plus a special penalty of 12 to 35 percent of the total tax bill.

The IRS uses a 20-step test to determine whether someone is an employee or an independent contractor. True independent contractors, according to the IRS definition, are in business for themselves with the intention of making a profit and are not under the direct control of the client company. To protect their companies from potential problems, small business owners should make sure that independent contractors are paid by the job rather than by the hour, set their own hours and rules, work on their own premises using their own equipment, sign a specific contract for each project, and make themselves available to multiple clients. Rather than withholding taxes, small businesses simply file an annual informational return—Form 1099, Statement of Miscellaneous Income—detailing the total amount paid to each contractor. No reporting is required for contractors that were paid less than $600 over the course of a year.

TRUST FUND RECOVERY PENALTY

Small businesses often find themselves faced with a cash flow crisis, one they believe will ease in a matter of days or weeks. The business owner who, when faced with this cash flow problem, decides to pay vendors before paying for payroll tax obligations is making a grave error. A typical scenario may play out as follows. For short-term survival, the business owner or executive decides to meet current creditors' requirements and oblige the IRS to become a creditor. The hope is that in the medium term the business will be able to pay the IRS the delinquent taxes plus interest and penalties. Often, however, the business becomes insolvent and declares bankruptcy. In order to address this problem and avoid significant erosion of tax revenue, in 1954 Congress enacted a penalty—equal to the unpaid payroll taxes—against all responsible persons who willfully fail to collect and turn over the money.

This penalty for the failure to withhold or remit payroll taxes, known as the Trust Fund Recovery Penalty (TFRP), is included under Section 6672 of the Internal Revenue Code. It allows the IRS to hold individuals associated with a business personally liable for 100 percent of the unpaid amount when the business fails to meet its payroll tax obligations. The TFRP applies to employee funds that the employer holds in trust for the IRS—all of the regular income tax withheld and the employee half of the FICA tax—but not to the employer portions of payroll taxes. The penalty is particularly severe because the IRS considers an employer who fails to pay to be violating a trust. The TFRP can be applied in addition to civil and criminal penalties, including the seizure of business assets and forced closure of the business. And since it is a penalty rather than a tax, the TFRP is not erased by bankruptcy.

In order to apply the TFRP to an individual, the IRS must prove the person's responsibility (that he or she had the power to make the decision about whether or not to pay) and willfulness (that he or she knowingly failed to act rather than made an honest mistake) for the business's failure to remit payroll taxes. In making its determination about who to hold responsible, the IRS looks at who made the financial decisions in the business, who signed the checks, and who had the duty of tax reporting. Under these rules, a small business owner can be found personally liable even if a staff member or outside accountant was directly responsible for payroll tax compliance. In cases where both the business and the owner go bankrupt, the company's accountant may be tagged as the responsible party and held personally liable.

Because the law regarding payroll tax noncompliance is so sweeping, small business owners should pay particular attention to the trust fund taxes. It is vital to keep the taxes that are covered by the TFRP current, even when the business is experiencing cash flow problems. If it appears as if the small business is heading for bankruptcy, these taxes should be paid prior to filing, when management can still designate where the IRS should apply payments. After the company files for bankruptcy it loses this option, and the IRS will apply any payments elsewhere since they can collect the TFRP from individuals associated with the company. Not paying the IRS may solve a company's short-term cash flow problems but it will cause serious problems for the person or persons responsible in the long term.