IRS Penalties & Small Business

IRS Penalties

There are many kinds of tax penalties the IRS can assess against a small business, and the facts and circumstances behind when they may be applied are very different.  What they all have in common, however, is they can significantly increase your tax bill!

This post will provide a quick overview[1] of some of the tax penalties you may encounter if you are a small business owner.  This post also provides information on how to abate or waive tax penalties the IRS may have imposed.

Background

The IRS uses tax penalties to “encourage voluntary compliance” with the federal tax system.  However, the tax code and rules are admittedly complex.  Some taxpayers are unable to comply despite their best attempts to do so.  Many small business owners have so much on their plates, they make mistakes.

The good news is the tax code authorizes penalty relief for taxpayers who may have made a mistake.  The bad news is the IRS tends to do a very poor job of administering these tax relief programs in a fair or consistent manner, especially if the taxpayer is not being assisted by a tax professional such as a CPA or attorney.

Understandably, the IRS would rather not waive penalties – it means less money for them!  The IRS is also chronically understaffed, and does not choose to devote much of its limited resources to those certain departments that work on taxpayer penalty abatement requests.

As such, successfully obtaining relief from tax penalties usually requires the assistance of a tax professional who is familiar with the IRS’s various internal offices and administrative procedures.  If you would like to speak with us about your tax penalty problem after reviewing the information below, please do not hesitate to contact us.

Delinquency Penalties

There are 4 kinds of delinquency penalties that frequently hit small businesses:

  1. Failure to File (I.R.C. § 6651(a)(1))

This penalty is assessed when you file your tax return late.[2]  If you properly request for an extension on filing due dates, it can alleviate this penalty.  However, some kinds of returns, such as the quarterly Form 941 employer tax return, cannot be extended.

  1. Failure to Pay Tax Shown on Return (I.R.C. § 6651(a)(2))

This penalty is assessed when you don’t pay the entire amount of your taxes showing as due on your returns on time.[3]  If you file your return and make the payment late, you will be hit with both penalties.

Remember, even if you correctly request an extension on a tax return, you do not get an extension to pay your taxes, only an extension to file!

  1. Failure to Pay Tax Not Shown on Return (I.R.C. § 6651(a)(3))

This penalty is assessed if you owe additional amounts after an audit or adjustment on your return, and you do not pay the new amounts within 21 days.  If you owe more than $100,000 after the audit or adjustment, you have only 10 days to pay the bill![4]

  1. Failure to File Informational Returns (I.R.C. § 6721)

This penalty is assessed against a small business that did not file its annual W-2 or 1099 forms.  There are 2 tiers of penalties here:

  • Negligence Standard

The first is similar to the “Failure to File” penalty above.  It is a negligence penalty, meaning you simply forgot or made a mistake.  This is calculated at $100 per return up to a maximum of $1,500,000.  Thus, the more employees or contractors you have working for you, the higher this penalty can be.

  • Willfulness Standard

The second is a willful “intentional disregard” standard, calculated at $250 per return or 10% of the aggregate amount of the items reported on the W-2/1099 forms.   This goes beyond forgetting or making a mistake – you purposefully refused to file the returns or tried to hide information from the IRS.

So, if your total payroll was $500,000 that year, your penalty would be $50,000 – a sum that might be equal to the cost of another employee!  Paying this level of penalty would be unsustainable for many businesses.

In my experience, when the IRS notices a business did not file its W-2/1099 forms, it assumes the “intentional disregard” standard and slaps you with the higher penalty.  Once it has done so, the burden will be on you to prove you did not fail to file the returns willfully.  Usually, simply sending in the missing returns after receiving notice the government is missing them is not enough.  You must submit a statement explaining your late filings were due to a mistake or unplanned accident.

Unfortunately, nothing in the IRS notices or letters informing you of the missing returns or your new Section 6721 penalties will inform you about the lower “negligence” penalty level!  If you have been impacted by this kind of penalty, please contact our tax resolution team at once.

Accuracy-Related Penalties (I.R.C. § 6662)

This penalty comes up after an audit or other adjustment on the tax you reported on your returns.  The policy behind this particular tax penalty system is to make sure taxpayers are taking reasonable and well-researched positions in support of the numbers they list on their returns.  In layman’s terms, if you take a position that is so far out there and completely unreasonable, you will be at risk for this penalty.

The IRS will hit you with a 20% accuracy-related penalty if your incorrect position was due to negligence, a disregard of rules and regulations, or a substantial undervaluation misstatement.

The IRS will hit you with a steeper 40% accuracy-related penalty if your incorrect position was due to gross valuation misstatements or undisclosed transactions or information.

Reasonable Cause

All the tax penalties discussed above can be abated or removed if you can show your delinquency was due to “reasonable cause”.  You must show you exercised “ordinary business care and prudence” in preparing your return,  determining what you owe, and when/how to pay it, but nevertheless, were unable to prepare an accurate return, file it on time, or pay on time with suffering undue hardship, due to circumstances beyond your control.

The internal IRS offices require taxpayers to meet a very high burden under the reasonable cause standard before they will waive penalties.  Undoubtedly, the IRS has heard every excuse under the sun!  You will have to demonstrate your “ordinary business care and prudence” in managing and operating your business, and then carefully document your special set of “circumstances beyond your control.”

Major illness, death, strikes/riots, and natural disasters are surefire “circumstances beyond your control” that will allow for penalty abatement.  Sometimes, a business’s severe economic distress can also justify penalty abatement, but only if this is argued very carefully before the IRS.  For example, perhaps your biggest customer filed for bankruptcy and did not pay you for tens of thousands of dollars of product or service.  If you can carefully draw the line between losing that anticipated income and missing your tax payment deadlines, this may justify abating tax penalties.  (In my experience however, a lot of employees at the IRS will assert financial distress never justifies paying your taxes late, even though this argument is provided by the Treasury Regulations and discussed by many tax court cases!)

Importantly, if you try to blame your tax noncompliance on a bookkeeper, accountant, bad office manager, or any third party who you brought on to help with your taxes, this will never be reasonable cause.  The IRS holds the taxpayer ultimately responsible for compliance, and this is a nondelegable duty.

Unfortunately, convincing the IRS to waive your penalties is generally an uphill battle.  More often than not, you will be summarily denied and will have to file an administrative appeal to get the IRS to actually look at your case carefully.  There are also some tricks and special programs that may help you, but the IRS does not readily provide this information to taxpayers.  If you need any help with a penalty abatement or even understanding if you may qualify for one, contact DTG Law today.

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[1] Please be aware that the tax code is complicated, and this is by no means a comprehensive summary of all the issues and technicalities behind tax penalties!

[2] The FTF penalty is assessed at a rate of 5% of the tax due on the late tax return up to 25%.

[3] The FTP penalty is assessed at 0.5% per month update to 25% of the amount of tax that was not paid by the due date.

[4] This penalty is assessed at 0.5% per month update to 25% of the amount of tax that was not paid by the due date.

Entity Formation Basics: The S Corporation

S Corps (larger file size)

Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company, partnership, non-profit, or some other type of business entity.

This post is about a very common form of entity for smaller companies – the “S corporation.”

A corporation is defined as an independent legal entity that is owned by shareholders.  A corporation can have just one shareholder or, as may be the case for a large publicly-traded company, millions of shareholders.  Shareholders are protected from liability because the corporation, not the shareholders, is held legally liable for the actions and debts the business incurs.

While corporations are owned by shareholders, they are supposed to be managed by a Board of Directors and operated by officers (President, Secretary, Treasurer, CEO, etc.).  If you are a smaller, closely-held corporation, the same individuals may serve in these different capacities, meaning one person might concurrently be a shareholder, a member of the Board, and the President.  Understandably, this may get confusing!  However, it is important to realize each role carries its own duties and responsibilities under the law.  As such, understand the differences in these roles if you are hoping to create and operate a corporation of your own.

Today, maintaining a corporation tends to be more complex than other business structures because of various administrative, tax, and legal requirements, some of which are discussed here.  If you are interested in forming a corporation, we strongly advise consulting with a business attorney who can help identify and prepare you for the many legal requirements and decisions you will run into (for example, do any of the founders need to make an 83(b) election?).

Forming an S Corporation

A corporation is formed under the laws of the particular state in which it is registered.  To register, you need to file certain documents, typically Articles of Incorporation, with the Secretary of State office.  The individual who actually files these formation documents is usually called the “Incorporator”.

Immediately upon filing the Articles of Incorporation, the corporation should identify its shareholders, and the shareholders should then elect the Board of Directors.  Again, all major management decisions in a corporation are made by the Board, and one of the first management decisions should be to appoint officers, the individuals who can perform the necessary acts for the business to actually get off the ground (for example, opening a bank account, hiring employees, signing a lease, negotiating with vendors, etc.).

After the corporation, the IRS by default will treat it as a C corporation unless or until you file Form 2553 with the IRS.   In other words, an S corporation is really just a special type of corporation created through an IRS tax election.

“Pass Through” Taxation

 Taxation is often considered the most significant difference for small business owners when evaluating “C corporations” versus “S corporations” or other entity types.  (For a discussion of C corporations, click here.)

Traditional C corporations are separately taxable entities who pay taxes at the corporate level, and then shareholders who receive dividends pay taxes again at the individual level.

In contrast, S corps are pass-through tax entities. They file an informational federal return (Form 1120S), but no income tax is paid at the corporate level.  Instead, the profits and losses of the business are “passed-through” to the owners to be reported on their personal tax returns.  Any tax due from company profits are thus paid at the individual level by the owners, not the company.

If you are a small business owner contemplating receiving regular payments from your corporation’s net profits, ensuring your Form 2553 is filed right away is crucial.

Ownership Restrictions

An S corporation can have only one class of stock.  Therefore, there can’t be different classes of investors who are entitled to different dividends or distribution rights, which is a strategy that might be desired if you are looking to have investor shareholders with less management and dividend rights than the company’s founders.  Additionally, the one-class-of-stock restriction also means an S corporation cannot easily allocate losses or income to specific shareholders, as is allowed in a partnership or LLC.

With some limited exceptions, a shareholder in an S corporation cannot be another entity; a shareholder can only be an individual.  Also, there cannot be more than 100 shareholders.  For this reason, startups who are seeking to fundraise through equity financing or going public might find they quickly hit the 100 shareholder limit.

Finally, foreign ownership of an S corporation is prohibited.  Every shareholder in an S corporation has to be a U.S. citizen.

Accounting Issues

 Bookkeeping and accounting issues for an S corporation may be more complex than other entity types.

 Money distributed to a S corporation shareholder can be in the form of distributions or a salary (assuming the shareholder is also running the company as an officer).  There are more burdens with taking a salary (higher tax rate, employer tax obligations, preparing a W-2 form, etc.), so the savvy S corporation owner may try to take as much of his or her income from the S corporation as distributions.  Of course, this ultimately means less tax money for the IRS, and so this is a hot button issue for them!  The IRS scrutinizes the payments an S corporation makes to its shareholders to make sure the characterization conforms to reality.   If the IRS targets your business, wages may be recharacterized as dividends, costing the corporation a deduction for compensation paid.  Conversely, dividends may be recharacterized as wages, which subjects the corporation to employment tax liability.

 Also, as discussed above, the allocation to shareholders of an S corporation’s income and loss is governed by stock ownership, and there are complex rules for how this is to be done.  As such, maintaining an S corporation’s books properly can be cumbersome.  Having a good accountant to assist with this aspect of your business is absolutely essential!

If you’re considering starting a business or revisiting a current one, contact us today.

 

Entity Formation Basics: The C Corporation

C Corps (larger file size)

Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company, partnership, non-profit, or some other type of business entity.

This post is about the standard corporation, also called the “C corporation”.

The corporation is one of the oldest forms of business entity, with predecessors identified both in ancient Rome and ancient India.  Complex societies needed a way to allow groups of people to form an independent body that had the right to own property, make contracts, sue and be sued, and perform various other legal acts.

Today, a corporation is defined as an independent legal entity that is owned by shareholders.  A corporation can have just one shareholder or, as may be the case for a large publicly-traded company, millions of shareholders.  Shareholders are protected from liability because the corporation, not the shareholders, is held legally liable for the actions and debts the business incurs.

While corporations are owned by shareholders, they are supposed to be managed by a Board of Directors and operated by officers (President, Secretary, Treasurer, CEO, etc.).  If you are a smaller, closely-held corporation, the same individuals may serve in these different capacities, meaning one person might concurrently be a shareholder, a member of the Board, and the President.  Understandably, this may get confusing!  However, it is important to realize each role carries its own duties and responsibilities under the law.  As such, understand the differences in these roles if you are hoping to create and operate a corporation of your own.

Today, maintaining a corporation tends to be more complex than other business structures because of various administrative, tax, and legal requirements, some of which are discussed here.  If you are interested in forming a corporation, we strongly advise consulting with a business attorney who can help identify and prepare you for the many legal requirements and decisions you will run into (for example, do any of the founders need to make an 83(b) election?).

Forming a Corporation

A corporation is formed under the laws of the particular state in which it is registered.  (Read our post on incorporating in Delaware here.)

To register, you need to file certain documents, typically Articles of Incorporation, with the Secretary of State office.  The individual who actually files these formation documents is usually called the “Incorporator”.

Immediately upon filing the Articles of Incorporation, the corporation should identify its shareholders, and the shareholders should then elect the Board of Directors.  Again, all major management decisions in a corporation are made by the Board, and one of the first management decisions should be to appoint officers, the individuals who can perform the necessary acts for the business to actually get off the ground (for example, opening a bank account, hiring employees, signing a lease, negotiating with vendors, etc.).

Double Taxation

Taxation is often considered the most significant difference for small business owners when evaluating “C corporations” versus “S corporations” or other entity types.   (For a discussion of S corporations, click here.)

Traditional C corporations are separately taxable entities with the IRS and nearly all state Departments of Revenue (corporate income tax rates range from 4% in North Carolina to 12% in Iowa).  C corporations file a corporate tax return (Form 1120 for the IRS) and pay taxes at the corporate level.  They then may face the possibility of double taxation if corporate income is distributed to the shareholders as dividends, because then tax is paid again at the individual Form 1040 level.

If you are a small business owner contemplating receiving regular payments from your company’s net profits, this double taxation issue could be very costly, and thus should be avoided.

Raising Capital

So then why do so many companies accept double taxation and form a C corporation anyways?

C corporations have no restrictions on ownership.  A shareholder can be an individual, another corporation, a trust, or any other type of legal entity.  Also, a shareholder in a C corporation does not have to be a U.S. citizen or a U.S.-based entity as in some other entity types.

Probably the biggest reason however is that C corporations can have multiple classes of stock.  This means a company can have “Class A” preferred stock with priority dividend payments, more voting rights, and a higher position on the priority ladder in the event of a liquidation or bankruptcy, and then “Class B” common stock that is lower-ranked and much more prevalent for equity financing, the process of raising capital through the sale of stock to outside investors.

Thus, if you are planning to seek venture capital or to go public one day, the C corporation is probably the better choice. VC firms prefer the familiar structure and management of a conventional corporation and are well-versed in Delaware corporate law.    Similarly, many investment bankers insist a company be incorporated in Delaware before they take it public through an Initial Public Offering (IPO).

If you’re considering starting a business or revisiting a current one, contact us today. 

Entity Formation Basics: The Limited Liability Company

LLC (larger file size)

Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company, partnership, non-profit, or some other type of business entity.

This post is about one of the most popular entities for closely-held businesses – the limited liability company or “LLC”.

In 1977, Wyoming passed legislation allowing for an entirely new type of company called a “limited liability company” to very little notice or fanfare.  Today however, over two-thirds of all new companies formed are LLCs!

An LLC is a hybrid business entity having certain characteristics of corporations and certain characteristics of partnerships (or sole proprietorships, if there is only one owner).  An owner of an LLC is called a “member” and LLCs can have just one member or hundreds of members.

Like a corporation, LLCs offer limited liability to the company’s owners and have certain rules and requirements for management and maintenance set forth under state law.  Like a partnership, how an LLC is governed and how its owners get paid for their participation and/or investment depends on the bargained-for contract between the owners, i.e., the Operating Agreement.

Have a Good Operating Agreement!

Because LLCs are “creatures of contract,” there is a great deal of flexibility in how you can organize and run an LLC, but failing to set forth this information in a well-written Operating Agreement (your contract with the LLC and all your fellow members) is a recipe for disaster.  While a single member LLC’s operating agreement can be fairly simple and straightforward, multiple-member LLCs usually have more complex operating agreements to handle many things, including management responsibilities, the allocation of profits and losses, capital accounts, vesting provisions, dispute resolution, etc.

Even if you go into business with your very best friend and each of you is in perfect agreement at the onset, human nature is such that there will inevitably be a disagreement at some point down the road, especially if your business becomes very valuable.  If you do not have a comprehensive Operating Agreement to reference, you (or your lawyers) will be forced to cobble together scraps of evidence that reflected your prior decisions or understandings about the LLC.  A neutral third party, such as a judge or arbitrator, might not interpret this piecemeal information the way you hoped, and the process can be very expensive.

LLCs and the IRS

In the eyes of the IRS, an LLC is not a separate taxable entity like a corporation is.  This means there is no separate “limited liability company” tax return form or code section for LLCs.  Instead, the IRS refers to LLCs as “pass-through entities,” which simply means that the tax liabilities of the company “pass through” to the LLC’s members’ personal income tax.

If you are the only member of your LLC, the IRS will automatically classify your company as a sole proprietorship (and you will report the activity of your LLC on a Schedule C submitted with your Form 1040 income tax return).  If you have several members in your LLC, the IRS will treat it as a partnership (and you will file the Form 1065, U.S. Return of Partnership Income) and each member should receive a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., every year.

Some LLCs choose to be taxed as corporations.  To do this, you must file Form 8832, Entity Classification Election.

Why would an LLC make this choice?  The most common reason is if your business wants to keep a substantial amount of its profits as “retained earnings”.  Retained earnings for a corporation are generally taxed at a lower rate than they would be when “passed through” to a personal Form 1040 tax return.

Once you elect corporate taxation for your LLC, however, you can’t switch back to pass-through taxation for five years, and if you do switch back, there could be negative tax consequences.  In other words, you should treat the decision to elect corporate taxation for your LLC very seriously, and with guidance from legal and tax experts and a solid understanding of how cash is going to be needed to operate your business.

Corporation or LLC?

The reason LLCs have surpassed corporations as far as choice of entity for closely-held businesses is because they are more flexible and generally easier to manage and maintain than a corporation.

If you are wondering if an LLC is right for you, however, be advised that anyone starting a new business should consult with his or her legal and tax advisors before making the big “choice of entity” decision.  There are many subjective considerations and factors which will weigh in favor or against any particular choice.

For example, if you are planning to seek venture capital or go public, forming a C corporation rather than an LLC is the better choice.  Venture capital firms don’t care for the unpredictable and unique management of LLCs, and prefer the familiar structure and management of a conventional corporation.

Morever, VCs generally cannot invest in an LLC.  If you set yourself up as an LLC, and then seek VC funding, you will have to spend a lot of money changing from an LLC to a C corporation, if your particular state’s law even allows this.  Further, the LLC ownership structure simply isn’t a good fit for a publicly-traded company.

If you’re considering starting a business or revisiting a current one, contact us today. 

 

 

Artists and the Hobby Loss Rule

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Individuals who are engaged in creative pursuits often maintain other employment to supplement their income.  For example, a painter might work full-time as an art teacher or college professor, or may moonlight as a theater stagehand.  Many artists also slog away in professions completely unrelated to their creative endeavors.  Nevertheless, they may devote evenings, weekends and summers to making, promoting and selling their art, thus running a business enterprise apart from their “day job.”

However, these individuals may find themselves owing thousands of dollars to the IRS should their creative business pursuits be classified as merely a “hobby.”

This happened to Susan Crile, a painter and multimedia arts whose works have been displayed in top museums like the Metropolitan Museum of Art and the Guggenheim.  Susan’s art business came into question with the IRS because she is also a tenured professor of studio art at Hunter College.  

Since well before obtaining her teaching position, Susan devoted a substantial amount of time and money earning a living primarily as an artist.  In addition to the costs of supplies and studio space, it took a great deal of promotional efforts to have her pieces noticed by curators and art dealers and to be displayed all over the world.  Through such efforts over 40-plus years, Susan was able sell 356 works to art collectors and buyers, including a number of large corporations like AT&T, Exxon-Mobile, Bank of America and Charles Schwaab.  These successes sustained her business to some degree, but not enough to provide for Susan’s living expenses entirely.  Her teaching career filled that need, but as a dedicated artist, she has always continued to put in the time at her business.

Like countless artists before her, Susan wrote off expenses related to her making and selling art on her personal income tax returns.  Such expenses included supplies, travel, the costs of reaching out and maintaining communications with galleries and collectors, and hiring assistants to help with social media.

Unfortunately, in 2010 the IRS accused Susan of underpaying her taxes by more than $81,000 from 2004 to 2009 because it claimed her efforts as an artist were not a separate profession or business, and not something she intended to make money from, but something she did as part of her job at Hunter.  

To make this argument, the IRS invoked a set of tax code provisions often called the “Hobby Loss Rule.”  Under Section 162 of the Internal Revenue Code, a taxpayer is allowed deduct all of the ordinary and necessary expenses of carrying on a “trade or business.”  However, the taxpayer must show that he or she is engaged in the activity with an actual and honest objective of making a profit.  If an activity is not engaged in for profit, it is a “hobby” under the meaning of Section 183.  

The kicker of the Hobby Loss Rule is actually when a taxpayer loses money.  Taxpayers can deduct expenses of a “trade or business” in excess of earnings, thus allowing them to claim a net loss.  A “hobby” may only deduct its expenses to the extent of the profits of the activity, and cannot generate a net loss.  In other words, net losses from a hobby may not be used to offset income from other sources, like a professor’s salary, but net losses from a trade or business can.  

Susan’s 2004 through 2009 tax returns reported earnings from sales of her artworks on her Schedule C, but also reported a number of expenses that ultimately resulted in large overall losses for her art business, which she then used to offset other income.

When the IRS looks at whether a taxpayer’s enterprises is a “trade or business” or a “hobby,” a number of factors are considered:

  1. The manner in which activities were carried on;
  2. The expertise of taxpayer or her advisers;
  3. The time and effort the taxpayer expended on the activities;
  4. The expectation that assets may appreciate in value;
  5. The taxpayer’s success in carrying on other similar or dissimilar activities;
  6. The taxpayer’s history of income or loss; and
  7. The taxpayer’s personal motives.

Accordingly, Susan’s attorney stated that her goal was to show the tax court that “art is not a business like other businesses.” During trial, she called a number of art industry experts, including the dean of the Yale School of Art, Robert Storr, and a 40-year curator, gallery director, and art dealer, Renato Danese.  

These experts explained that an art career, and the prices for which an artist can sell his or her work, can be highly volatile.  They explained it is not uncommon for artists to make no money for years at a time, and so it is reasonable for artists to have other jobs or careers apart from their own art businesses.   

In October 2014, the Tax Court Judge finally made a determination, and it was hailed as a victory to artists everywhere.  Judge Albert G. Lauber held that Susan had met her burden of proving that her activities as an artist carried her actual and honest objective of making a profit, and therefore under tax law, should be considered a professional artist entitled to report her full losses on her Schedule Cs.

Despite Susan’s success, artists and creators are wise to still be wary when it comes to the Hobby Loss Rule.  Under Sections 162 and 163, there remains a fuzzy line between a hobby and a business venture, especially when taking all the 7 factors outlined above into consideration of a particular creative industry.  A tax advisor or attorney familiar with these nuances can help you distinguish between the two and ensure you are compliant with tax laws.  If the IRS initially disagrees, a tax professional can also help you work with the IRS to support and substantiate your positions.