Payroll tax mistakes that turn into personal liability for small business owners

The mistakes that cost the most

The most damaging payroll tax mistake is treating money withheld from employees' paychecks as working capital and paying it to the IRS late or not at all. Close behind are missing the required deposit schedule, misclassifying employees as independent contractors, paying owners incorrectly, and letting quarterly returns and year-end forms drift out of agreement with what was actually paid. The first one carries a special risk: the IRS can assess a penalty equal to the unpaid withheld taxes against the individuals responsible for paying them, not just the business.

Payroll tax problems are part of the tax relief work at Malnory, McNeal & Company, and our firm's view is blunt: the IRS treats failing to pay payroll taxes as the most serious kind of tax delinquency, and penalties grow quickly. This guide walks through the common myths behind those mistakes. It is general information; if you are already behind, talk to a licensed CPA or tax attorney before you contact the IRS.

Myth: the withholding is the company's money until the deposit is due

It is not. When you withhold federal income tax and the employee's share of Social Security and Medicare from a paycheck, the IRS describes that money as held in trust for the government until it is deposited. That is why these are called trust fund taxes. Using them to cover rent, inventory or a slow month is, in the IRS's eyes, using someone else's money.

The consequence is the Trust Fund Recovery Penalty. According to the IRS, the amount of the penalty is equal to the unpaid balance of the trust fund tax, meaning the withheld income tax plus the employee's share of withheld Social Security and Medicare. It can be assessed against individuals personally. A business that closes does not make the liability disappear for those individuals.

In practice, the slide usually starts with good intentions. A large customer pays late, payroll still has to go out, and the deposit is pushed a week to keep the lights on. Then another week. By the time the owner looks closely, there are several quarters of unpaid deposits plus penalties and interest, and the cash that would have covered them is long gone.

Myth: only the owner can be held personally responsible

The IRS can assess the penalty against any responsible person, which it defines as someone who has the duty to perform and the power to direct the collecting, accounting and paying of trust fund taxes. Its examples include officers, employees, directors and payroll service providers. Titles alone do not decide it; authority over which bills get paid does.

The second element is willfulness. The IRS says the person must have known, or should have known, about the unpaid taxes and either intentionally disregarded the law or was plainly indifferent to its requirements, and it states that no evil intent or bad motive is required. Choosing to pay other bills while payroll taxes go unpaid is exactly the kind of decision that creates this exposure. Bookkeepers, controllers and board treasurers who sign checks should understand this as clearly as owners do.

Missing the deposit calendar

Deposits are not made when it is convenient. The IRS requires each employer to determine, before each calendar year, whether it is a monthly or semiweekly depositor, and federal tax deposits must be made electronically. Free options include the IRS business tax account, Direct Pay for businesses and the Electronic Federal Tax Payment System. Filing deadlines run alongside deposits.

The schedule is not a choice you make once and forget. A business that grows can move from one schedule to the other, and a new hire, a bonus run or a large commission payment can change how much is due and when. The safest arrangement is a calendar owned by one named person, with a second person who checks each quarter that every deposit and filing on it actually happened.

• Form 941, the quarterly federal tax return, for employers that withhold income tax or Social Security and Medicare.
• Form 940 for federal unemployment tax, which only the employer pays; the IRS says deposits are due for a quarter when the tax for that quarter exceeds $500.
• Forms W-2, which the IRS says must be furnished to employees and filed with the Social Security Administration by January 31.
• Electronic filing of information returns, which the IRS requires for employers filing 10 or more, including Forms W-2.
• State unemployment tax reports and payments to the Texas Workforce Commission, on their own schedule.

Contractor or employee: the classification trap

Paying someone on a 1099 instead of through payroll looks simpler and cheaper, and that is exactly why it is a frequent mistake. The IRS looks at the whole relationship under three categories: behavioral control, meaning whether the business controls what the worker does and how; financial control, meaning whether the business controls the business side of the job; and the type of relationship, including written contracts, benefits and whether the work is a key part of the business. No single factor decides it.

If a business treats an employee as a contractor without a reasonable basis, the IRS says it may be held liable for employment taxes for that worker. When classification is genuinely unclear, either the business or the worker can file Form SS-8 for an official determination, though the IRS notes it can take at least six months. A better habit is to document your reasoning for each contractor relationship when it starts, and to revisit it if the work changes.

Myth: the payroll company carries the risk

Outsourcing payroll is a good decision for most small businesses, and our firm offers it for exactly that reason. But it does not move the legal responsibility off the employer. The IRS lists payroll service providers among those who can be responsible persons, and it does not list the employer as excused because it hired one.

Protect yourself with a few habits. Check periodically that deposits actually posted, using your IRS business tax account. Compare the quarterly Form 941 to your payroll register and your books. Make sure the provider has authority only to do what you intend, and that notices from the IRS reach you, not only the provider. If something looks off, ask the question that week, not at year-end.

Pay attention when you change providers or bring payroll in-house. Transitions are when deposits get missed, because each side assumes the other made the last one. Confirm in writing who is responsible for the final deposit and quarterly return under the old arrangement, and check your IRS account afterward to make sure nothing fell through the gap.

Paying the owners the wrong way

Owner pay mistakes depend on the business structure. In a sole proprietorship or partnership, owners generally are not paid through payroll at all; running owner draws through payroll creates its own problems. In an S corporation, the opposite applies: the IRS says the corporation must determine and report a reasonable salary for shareholders who provide services, and courts have held that calling compensation a distribution does not avoid employment taxes.

I see S corporation owners who take no salary at all, and owners of disregarded LLCs who put themselves on payroll as if they were employees. Both need correcting. Another common one is fringe benefits that should be on the W-2 but are not, such as a company vehicle used personally or certain owner health insurance arrangements; the rules vary by entity type, so ask your CPA how each benefit should be reported. If you are deciding whether the S corporation structure fits, whether an LLC should elect S corporation status explains the trade-offs.

If you are already behind

The first rule is to stop the problem from growing. Make current deposits for current payroll on time, even if past periods are still unpaid, because new unpaid periods add to the exposure. Gather the payroll registers, Forms 941 and deposit history so the size of the gap is known. Do not ignore IRS notices. Make sure any missing quarterly returns are filed, too; an unfiled return is a separate problem from an unpaid balance, and both need to be addressed.

The second rule, from our firm's experience, is not to meet with the IRS alone. How early questions are answered can shape the outcome, and a representative who knows IRS procedures can communicate for you once authorized. The general process, including your right to representation, is covered in what happens when the IRS audits a small business.

A quarterly payroll checkup

Payroll problems that are caught in the same quarter are usually simple to fix. Problems found a year later are not. This is the review I recommend owners, or their accountant, do every quarter. If you also want to make sure nobody inside the business can misuse payroll, internal controls for a small office explains how to separate the duties.

Our Dallas office handles payroll processing, payroll tax filings and payroll tax problems for businesses across the Dallas–Fort Worth area. Whether you outsource payroll or run it yourself, the checklist below keeps the numbers honest.

• Confirm every federal deposit for the quarter posted in your IRS business tax account.
• Reconcile the payroll register to Form 941 and to the payroll accounts in your books.
• Review the payroll liability accounts on your balance sheet; they should be close to zero after deposits.
• Review any new contractor relationships and document the classification reasoning.
• Check owner compensation against your entity type.
• Read and file every notice from the IRS or the Texas Workforce Commission.

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