WHAT IS PAYROLL TAX AND HOW DID I END UP OWING IT?
By Elizabeth Gonsalves, Esq.
“Payroll tax” or “Employer tax” are terms of art used in reference to FICA and FUTA tax. FICA is an acronym for the Federal Insurance Contributions Act. FICA tax is a combination of Social Security tax and Medicare tax, both of which are used to fund a variety of federal insurances and benefits for taxpayers. FICA tax is paid by both the employee and the employer. Employees pay FICA tax from their wages. Employers withhold employee FICA taxes and submit them to the IRS following each payroll along with the employee’s income tax withholding and the employer’s FICA taxes for each employee. FUTA refers to the Federal Unemployment Tax Act. FUTA, with state unemployment systems, provides for payments of unemployment compensation to workers who have lost their jobs. Most employers pay both a Federal and a state unemployment tax. Only the employer pays FUTA tax; it is not deducted from the employee’s wages.
PERCENTAGE APPORTIONED BETWEEN EMPLOYEE AND EMPLOYER
For the 2014 tax year, an employee’s share of the Social Security portion of the FICA tax is 6.2% of gross compensation up to a limit of $117,000 of gross wages (resulting in a maximum Social Security tax of $7,254). The employer is also liable for 6.2% Social Security and 1.45% Medicare taxes making the total Social Security tax 12.4% of wages and the total Medicare tax 2.9%. FUTA tax is typically .6% of taxable wages paid per year. FUTA is paid annually while FICA is paid quarterly.
HOW DID I END UP OWING PAYROLL TAX?
Payroll tax liabilities may be incurred in several ways. The most straight forward way a taxpayer winds up with an outstanding payroll tax liability occurs when an employer fails to submit their federal tax deposits following each pay period for employees or when payment is not issued upon filing a quarterly payroll tax return with the IRS. When federal tax deposits are required and are not submitted following each pay period the IRS assesses a 10% deposit penalty against the tax due which is applied to the balance due in addition to the payroll tax due. This can make it rather easy to fall behind on payroll tax balance dues.
Lesser known situations where a taxpayer may find themselves with a payroll tax assessment occur when a corporate shareholder performs services for the business and issues only distributions to themselves instead of having a portion of their payment issued to themselves as wages. The IRS frowns upon paying corporate shareholders in distributions alone. The reason is because distribution income is not subject to Social Security and Medicare taxes. Social Security and Medicare taxes are paid through wages. A corporate shareholder avoids contributing to Social Security and Medicare taxes and pays only income tax on their distributions if a “reasonable salary” is not paid first. For this reason, the IRS may audit a business or shareholder who shows distribution income to corporate shareholders without showing salaries and wages paid to corporate officers.
Where distributions are paid by a corporation to a corporate officer without also issuing a reasonable salary to the officer, a business risks being assessed payroll tax by the IRS against those distributions paid. The IRS audits the records of the business tracking all income paid to the corporate officer and assesses both the employer and employee portions of Social Security and Medicare tax against the total distribution paid to the corporate shareholder during the year. The assessment is initially made against the business if the business is a corporate entity. Sometime thereafter, typically four to six months following the initial assessment against the business, a personal assessment of the employee portion of the payroll tax will be made against a responsible person associated with the business.
TRUST FUND ASSESSMENTS AGAINST A RESPONSIBLE PERSON
This personal assessment is called a Trust Fund Recovery Penalty and often appears on an IRS notice as a “Civil Penalty.” In this way a business may incur payroll taxes for both the employee’s portion of Social Security and Medicare tax and the employer’s portion of Social Security and Medicare tax. The Trust Fund Penalty portion assessed against a responsible individual for the business is an assessment of the employee’s portion of the tax that should have been withheld from wages for the employees benefit (in trust). The personal assessment is made in addition to the full assessment of both employer and employee FICA tax against the incorporated business. The trust fund portion is a duplicate assessment, not a double assessment. As the business pays down the trust fund portion, the individual personally assessed also experiences a reduction in the trust fund portion owing on their personal account with the IRS. Trust fund penalties are one of the few exceptions to the protections from personal liability afforded to individuals by incorporating one’s business.
The process for assessing payroll tax against a responsible person associated with the business is called a Trust Fund Recovery Penalty Hearing. It is a fairly simple process the IRS engages to complete the personal assessment. A hearing is conducted by scheduling a meeting with persons believed to be responsible for incurring the payroll tax. The IRS is essentially looking to determine who decided not to pay payroll taxes when due. In most cases, Trust Fund Recovery Penalty Hearings are not a forum for contesting a personal assessment unless the persons identified as responsible persons truly did not make payroll tax payment decisions for the business. Persons who were not signatories on bank accounts and did not sign payroll tax returns may contest a personal assessment or argue another individual was responsible for signing pay checks, payroll tax returns and handling financial aspects of the business. If there was more than one officer or shareholder of the corporation that also shared in responsibilities for paying payroll tax, then the Trust Fund Recovery Hearing is a good forum for arguing the personal assessment should be divided by the number of responsible persons for the business. In this way, the amount of the personal assessment may be reduced as to each individual’s personal assessment. Other issues which arise in a Trust Fund Recovery Hearing may be to contest a spouse being personally assessed or a family member who worked for the business but did not make financial decisions for the business. If you are a responsible person for the business and were the person who signed payroll tax returns and pay checks, the best advice is to be cooperative in the hearing and focus instead on negotiations over the payment plan to be agreed upon to allow the business to continue operating.
Professional assistance is advisable if you and your business have a payroll tax liability you cannot pay off in full right away. Negotiations are necessary and begin with preparation of the business’s financial disclosure soon followed by preparation of financial disclosure for the responsible person. Navigating negotiations is an exercise in being tactful and strategic with your figures and records. Feel free to contact me to discuss your matter and your goals for resolution.
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