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 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.
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.
There are 4 kinds of delinquency penalties that frequently hit small businesses:
- Failure to File (I.R.C. § 6651(a)(1))
This penalty is assessed when you file your tax return late. 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.
- 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. 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!
- 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!
- 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.
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.
 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!
 The FTF penalty is assessed at a rate of 5% of the tax due on the late tax return up to 25%.
 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.
 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.
Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company (LLC), partnership, non-profit, or some other type of business entity.
This post is about one useful form of business entity that is frequently overlooked by business advisors and attorneys – the cooperative!
A cooperative or “co-op” is a type of legal entity that is distinguishable from standard, for-profit corporations, LLCs, and partnerships. Co-ops offer a flexible business model that can be used by any group of people who are interested in creating a democratic decision-making company that benefits all members. In other words, co-ops strive to be patron- or member-oriented, rather than investor-oriented like traditional corporations or LLCs.
At their core, co-ops are formed by a group of people who either work or shop there (a brewery co-op or a food co-op), use its services (a credit union or health insurance co-op), or product goods and items for it (a food producers co-op). Co-op members are not to be held liable for any debt, obligation or liability of the co-op.
The International Cooperative Alliance, a global membership association of co-ops and co-op support organizations, has established Seven Cooperative Principles including Democratic Member Control and Concern for Community, among others.
The “common purpose” of individuals wishing to form a co-op can include a number of things, including employee-ownership, group marketing, or group purchasing. Some of the most nationally well-known co-ops include Ace Hardware and REI, as well as dozens of successful agricultural co-ops such as Land-O-Lakes, Sunkist, and Ocean Spray.
Today, artist and freelancer co-ops are becoming more common due to the rise of the “sharing economy” and the realization of individual artists, photographers, software developers and other freelancers there can be great benefits to pooling resources, infrastructure or ideas.
Colorado cooperative law has developed cumulatively over more than five decades.
Today, a standard co-op should be formed under Article 56 of Title 7 of the Colorado Revised Statutes. Article 58 contains the “Colorado Uniform Limited Cooperative Association Act”, recently enacted in 2011. Also, Article 33.5 of Title 38 is a special Colorado code section for housing co-ops.
Interestingly, Colorado law explicitly prohibits the ability to use the word “cooperative” or any abbreviation or derivation of as part of your business name, trade name, trademark or brand unless you are actually formed as a co-op under these statutes, so be careful if you are loosely using the term “co-op” or “cooperative” in your business!
Under Colorado law, co-op members and those on a co-op’s Board of Directors are protected from personal liability from the activities of the company, similar to corporations and LLCs. Co-ops are also allowed to limit membership only to persons engaged in a particular business, persons who will use the goods or services of the co-op, and other membership conditions stated in the co-op’s Articles of Incorporation or Bylaws. Because they are so member-oriented, Colorado law requires a co-op to keep detailed membership lists with contact info.
Under the newer Limited Cooperative Association Act, a co-op can have investor members who do not participate as much in the common purposes of the company. This kind of co-op would have “patron members” who fully own and participate in the co-op and “investor members” who participate in the co-op on a more limited, financial basis.
Because the Article 58 was designed with maximum flexibility in mind, a co-op’s Bylaws and Membership Agreements can set forth all kinds of rules and arrangements for the patron members and investor members as far as how the company is run, how patron member votes versus investor member votes are counted towards certain decisions, and how allocation and distributions are made to these different kinds of members.
Cooperatives and Securities Laws
Both Articles 56 and 58 state that any unit or evidence of a membership interest in a co-op is exempt from the Colorado Securities Act or our state’s “Blue Sky” laws. This means a co-op can offer and sell its membership interests without needing to registered as a broker-dealer, unlike the ownership in a corporation or an LLC. This takes a lot of legal headache and expense away from co-ops who are looking to have dozens or even hundreds of members.
Nevertheless, if your co-op needs to raise a lot of capital and wants to do so by securing many membership fees or contributions, we strongly recommend this is done through a Regulation D private placement offering under the federal Securities and Exchange Commission’s (SEC) rules.
Worker co-ops (i.e., employee-owned companies) are gaining traction like never before as the socially-conscious business movement and sharing economy continue to gather momentum.
The common purpose of the worker co-op is each member’s livelihood – their job and income – as it relates to the success and sustainability of the company as a whole. In a worker co-op, the employees democratically control the management and operations of the company, with each employee-owner having an equal vote.
Generally, this means that all employees, no matter their salary, job title, or years of employment, are entitled to one vote per person on all matters brought before the membership of the company. However, this does not mean all employees have to be involved in every company decision. A worker co-op should still have a Board of Directors, and can also have other officers (for example, a President or a CEO) to set policies, manage day-to-day operations of the company, and determine when important decisions should be put to the members. Of course, the members vote for who is on the Board and can also vote for who the President or CEO is to be.
Taxation of Cooperatives
Co-ops have unique income tax structures governed by Subchapter T of the Internal Revenue Code. This tax structure is similar to partnership taxation, but with some different terminology. Profits of a co-op are called “net margins”. The members of a co-op are deemed “patrons”.
Under Subchapter T, net margins are not taxed a the co-op level, but are instead allocated to the patrons on an annual basis similar to a partnership distribution. Unlike a partnership distribution however, co-op allocations are based on a patrons use of the co-op rather than their investment. For example, in an agricultural co-op, if Farmer A uses 3,000 acres of the co-op’s land and Farmer B uses 10,000 acres, Farmer B had more “patronage” of the co-op and should expect a larger allocation.
Subchapter T states at least 20% of the allocation to a co-op’s patrons must be in cash. The remaining 80% can also be distributed in cash, or in can be retained on the books of the co-op as “patronage equity”, to be redeemed sometime in the future. Consequently, patronage equity allows a member of a worker co-op to build personal assets and net worth by having an equity account that can be redeemed when he or she retires or leaves the company.
Each patron should receive a Form 1099-PATR from the co-op every year reporting the allocation (both cash and non-cash). Then, each patron is responsible for paying his or her own income taxes based on the reported allocation.
If you would like to form a co-op or have a question related to an existing co-op, contact our offices today!
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:
- The manner in which activities were carried on;
- The expertise of taxpayer or her advisers;
- The time and effort the taxpayer expended on the activities;
- The expectation that assets may appreciate in value;
- The taxpayer’s success in carrying on other similar or dissimilar activities;
- The taxpayer’s history of income or loss; and
- 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.