The Dumbest and Most Dangerous Startup Financing

Dumbo Corp is a 2-year old startup that recently started selling product to a few large customers.  They have 30 employees and a $250K monthly payroll.  The employees are paid on a monthly basis and Dumbo runs its own payroll through QuickBooks.   

Recently, Dumbo ran into a serious cash flow problem due to a late-paying customer. To bridge the cash flow problem, they delayed paying the IRS $50K in payroll taxes just withheld from the employees’ most recent paycheck. The customer said they would pay within a week and Dumbo would then make the IRS whole.

You know the rest of the story – customer never pays, cash flow problems get worse, Dumbo continues to fund operations with employees’ payroll taxes, Dumbo goes bankrupt.

Now, why is financing operations, when there is a cash flow problem, by not paying the IRS “the dumbest and most dangerous startup financing”?  Big companies often string out vendors to fund operations.  Plus, in a worst-case scenario, bankruptcy dissolves all debts and the corporate veil personally protects employees – right?  No one going to jail here – right?

Wrong and wrong.  Corporate bankruptcy will not discharge this type of IRS tax debt. Even personal bankruptcy will not discharge this type of IRS tax debt.  The IRS will chase you forever.  Plus, the corporate veil is pierced very easily by not paying the IRS.

For trust fund taxes (i.e., withheld payroll taxes), the IRS holds every “responsible person” personally and criminally liable for “willfully” failing to ensure that payroll taxes are paid.  They move very quickly when a quarterly payroll tax return is not filed or there is a payroll tax deficiency. They can demand full payment from any “responsible person” without first trying to collect the payment from the employer or other “responsible persons”.

Oh by the way, a “responsible person” is broadly defined as anyone with substantial authority over business operations even if somebody else has the ultimate authority over which bills get paid.  The IRS has successfully prosecuted CEOs to AP clerks under this “responsible person” definition.

The penalty becomes criminal when a “responsible person” intentionally violates a legal duty – knowingly not remitting withheld payroll taxes.

So, any “responsible person” at Dumbo who knew the IRS was not being paid while vendors, such as the landlord or electric company were being paid is personally and criminally liable.

The IRS process always starts with a notice.  If you receive one regarding payroll taxes – do not take it lightly, even if you never had a payroll.  Get professional help (preferably a CPA) to respond to the notice immediately.  The IRS acts very quickly, including personal visits to the business and bank account liens.

(One fool-proof way to avoid this temptation and a good business practice is never to do your own payroll.  Use a payroll service provider, such as Zen Payroll).



IRS Circular 230 Disclosure

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.