As most small business owners know, there are various business taxes a company is required to collect, account for, and pay over to the taxing authorities. In Massachusetts, businesses are required to withhold income for both state and federal income taxes for employees, pay additional employment taxes, and unemployment insurance to the state and federal governments. Many companies hire payroll service companies to process these withholdings and payments and file the required returns with the state and federal governments. Other businesses handle these matters “in-house” taking the time to calculate the amounts due, file quarterly and annual returns and pay the amounts due to the Internal Revenue Service (“IRS”) and Massachusetts Department of Revenue (“MDOR”). Unfortunately, despite their best intentions, some businesses neglect to file returns or pay employment taxes and are shocked to learn that, after penalties and interest, tax liabilities have ballooned into the hundreds of thousands, or even millions, of dollars. In situations like this, filing for protection under Chapter 11 of the Bankruptcy Code is often the best way to proceed.
The Snowballing of an Employment Tax Debt
An example of what we have seen on many occasions: Mr. Taxpayer owns a small heating and air conditioning repair company which he operates as a limited liability company called Hot & Cold, LLC. Hot & Cold has 6 full-time employees, each paid at hourly rates. Ever conscious of his overhead expenses, Mr. Taxpayer decides that he will handle the payroll himself. All goes well at first until business begins to slow during the holiday season. Then two of the company’s service trucks suddenly need costly repairs. Strapped for cash, Mr. Taxpayer uses the money for payroll taxes to cover repair costs. Not wanting to alert the IRS to his missed payment, he decides to also skip the filing of his 940 and 941 returns, assuring himself he will get caught up once business picks up in the spring. Unfortunately, business continues to be slow and Mr. Taxpayer continues to make up the difference by not paying the employment taxes throughout the year.
The following fall, business has finally begun to pick up again and Hot & Cold is preparing to file its missing 940 and 941 returns and start getting caught up on the arrears. This is when the problems really begin. After filing the outstanding 940 and 941 returns with the IRS and quarterly payroll reports with MDOR and Massachusetts Department of Unemployment Assistance (“MDUA”), Mr. Taxpayer determines that Hot & Cold owes $120,000 in total, which he intends to begin paying immediately, starting with the IRS. Shortly afterwards, Mr. Taxpayer begins receiving notices of assessment, informing him that penalties and interest have been assessed against Hot & Cold for both failing to pay the taxes and failing to file the returns on time. IRS, MDOR and MDUA have assessed penalties totaling more than $25,000 and interest of more than $5,000. On top of that, each agency is demanding payment in full within thirty days.
Mr. Taxpayer first contacts the IRS to explain his situation and ask if he can pay it over time. The IRS agent hesitantly agrees to let him pay the debts over time, but he has to pay it in full within 12 months, including the penalties and interest. On top of that, the agent adds, the penalties and interest will continue to accrue while he is making payments. His efforts to work with the MDOR and MDUA yield similar results. After factoring in penalties and interest that have accrued and will continue to accrue, Mr. Taxpayer calculates that the initial $120,000 in employment taxes will cost him more than $160,000, assuming he can pay it all within one year. Although Hot & Cold is doing well, it is not doing well enough to pay an additional $160,000 over the next year. Mr. Taxpayer is able to make some, but not all of the payments to the IRS, MDOR and MDUA. After missing three installment payments to the MDOR, he received a Notice of Intent to Levy: if he doesn’t pay in full within 30 days, they will seize Hot & Cold’s bank accounts to satisfy the debt. Mr. Taxpayer knows that if this happens he will be unable to make rent and payroll or purchase materials. Frustrated, Mr. Taxpayer considers simply closing the business and starting something new. “If only they would work with me a little” he thinks. Although he continues to operate the business a few months more, the MDOR ultimately levies the business account, seizing the $8,000 he had set aside for rent and payroll that week. With nothing to pay his employees or landlord, Mr. Taxpayer closes Hot & Cold, with substantial liabilities to the IRS, MDOR and MDUA still outstanding.
Mr. Taxpayer and Hot & Cold faced a situation that is surprisingly common among small businesses in Massachusetts and around the country. A relatively small and temporary problem snowballs until it becomes seemingly insurmountable. Different taxing authorities want their debts paid immediately and have little concern for a company’s other expenses or obligations. Often they are willing to effectively shut down a company in order to be first in line to seize property. Even where they do allow a payment agreement, the terms are often too onerous for a small business to comply with while keeping up with other expenses. Situations like these are what the U.S. Bankruptcy Code is partly designed for. Chapter 11 can often be the most effective ways to deal with debts to multiple taxing authorities.
Why File Bankruptcy to Pay Employment Tax Debts?
- The Bankruptcy Code provides powerful protections against collection activities from creditors, including the IRS and MDOR. Once a business has filed bankruptcy, a provision called the “automatic stay” requires that all collection activity, including levies on bank accounts and seizure of property, cease immediately.
- Once in Chapter 11, small businesses are allowed up to 300 days to propose a plan of reorganization to deal with their debts, including payment of employment taxes. This allows companies an opportunity to assess their situation, make any necessary changes to the business and operate for a time with out the stress and distraction of dealing with demands and threats from taxing authorities.
- The Bankruptcy Code allows businesses up to five years to pay most types of tax debts. The taxing authorities have no right to demand that the debt be paid in less than five years, although in some cases they will agree to a payment plan that is longer than five years.
- Penalties cease to accrue once a bankruptcy case is filed. In the example of Mr. Taxpayer, the late payment penalties continued to accrue on the debt until it was paid, even after he set up the payment plan and filed the returns. In bankruptcy, penalties (but not interest) stop accruing once a case has been filed.
- Bankruptcy can sometimes be used to avoid tax liens that have been filed prior to bankruptcy. Under the Bankruptcy Code, a debt secured by a lien is considered “secured” only to the extent that there owns valuable property that serves as collateral. So if a company has assets worth only $10,000, but tax liens of $50,000, bankruptcy can reduce the tax lien to only $10,000. Once the $10,000 is paid, the lien is discharged.
- Bankruptcy can also help to avoid payment of penalties that arose before filing. In order to be approved, a bankruptcy plan must propose to pay virtually all outstanding tax debts within five years. However, penalties are not considered tax debts for purposes of this requirement and often companies can emerge from bankruptcy with a plan that requires only a small percentage of penalties to be paid.
- Bankruptcy can be used to deal with all of a company’s debts in one forum. Very often when a company enters bankruptcy to deal with tax problems it has many other liabilities as well. These can include bank loans, business credit cards, wages, mortgages, trade debts or outstanding rent. In many cases, the cost of dealing with tax problems before filing bankruptcy causes a business to fall behind on other debts. Bankruptcy allows a business to address all of its debts at once, free from threat of lawsuits, eviction or repossession.
Personal Liability for Business Employment Debts
In the example above, before ultimately being forced to close down Hot & Cold, Mr. Taxpayer considered just giving up and walking away. Mr. Taxpayer would have been surprised to learn later that he is now personally liable for the payment of the so-called “trust fund” portion of the tax debts. The “trust fund” portion of the taxes is the part that was withheld from an employees paycheck and was supposed to be turned over to the IRS or MDOR. Trust fund taxes are different from other business debts in that the designated “responsible party” of the business will be held personally liable for these debts. This is different than withn most other business debts in which the business entity (LLC or corporation) is liable for its own debts and the individual owners are protected. This is major factor for many business owners considering how to handle employment tax liability. While walking away from a struggling business and starting a new endeavor may sound to some like a good option, the threat of personal liability for trust-fund taxes, which cannot be discharged in personal bankruptcy, is a strong motivator for filing a business reorganization under Chapter 11 of the Bankruptcy Code.
Why Call Us About Your Business Debt Problems?
Our bankruptcy attorneys are highly experienced in helping small businesses reorganize under Chapter 11 of the Bankruptcy Code. We understand the complexities of dealing with taxes in bankruptcy and can help guide your business through the process and achieve a successful reorganization. We’ve successfully represented small businesses in many industries including construction, auto sales, government contracting, retail, hospitality, manufacturing and health care. If your business is struggling with debts from employment taxes and associated penalties and interest, call us at 617-338-9400 for a free consultation to determine if reorganizing under Chapter 11 is your best option.