The Traps Associated with Single Member LLCs and Payroll Taxes

A common problem facing business owners with more than one employee are the risks associated with not paying their payroll taxes.  One quarter turns into 8 or more quarters of not filing payroll returns nor paying payroll taxes withheld from employees’ paychecks.  Business owners who have formed single member LLCs generally file a Schedule C with their individual income tax returns. But is this the best approach from a tax planning perspective?  During the past 25 plus years, LLCs have grown in popularity because of the following advantages they offer:

• Limited liability for managers and members.
• Superior protection via the charging order.
• Flexible management for smaller businesses.
• Avoidance of double taxation from flow-through taxation: profits are distributed to the members, who are taxed on profits at their personal tax level.
• Good privacy protection.
• Greater flexibility in being able to allocate profits and losses to members in varying amounts.

And yet all these advantages are outweighed when the business owner fails to pay his/her payroll taxes, penalties and interest. For a single member LLC, this can subject the business owner to being personally liable and paying more taxes, interest and penalties when compared to a business owner operating through a corporation.

Example: Assume a business has a weekly payroll of $2,500 and the total payroll shows that $400 was withheld in income taxes plus $191.25 of employees’ portion of Social Security and Medicare taxes (which is known as the trust fund of the payroll taxes). In addition, the business owner is required to match the employees’ portion of Social Security and Medicare known as the non-trust fund taxes. Thus, the business owner in this example would be required to deposit a total of $782.50 in payroll taxes with the IRS.

In addition, penalties for failure to timely file payroll tax returns can equal 15% plus an additional 25% penalty for failure to timely pay the payroll taxes. This translates to 40% of the underlying payroll taxes due plus interest. In the example above the business could end up owing not only the $782.50 in payroll taxes plus over $313.00 in penalties and interest or a total of approximately $1095.50 or more. The worst part of this scenario is that the business owner would be held personally liable for all $1095.50. If instead the business owner had operated as a corporation (whether as an “S” or “C” corporation) he/she could have limited personal liability to approximately $591.25 or reduced his/her tax liability by approximately 48%.

If you are facing mounting unpaid payroll taxes in your business, what can you do? The following are a few suggestions:

1. Form a new entity preferably a corporation under state law. This will ensure when applying for a new EIN with the IRS that you indicate you have formed a corporation and not a single member LLC.
2. To avoid double taxation through flow-through of profits and losses complete and file Form 2553 electing Sub-chapter “S” status with the IRS no more than two months and 15 days after the beginning of the tax year that the election is to take effect. For example, if your new business starts on January 14, you must file the election no later than March 22. Failing to file timely means you will not receive Sub-chapter S status for that tax year.
3. Transfer all the existing business and accounts to the new business while making sure to prepare and file all past payroll tax returns at the federal and state levels.
4. Open a new bank account with the new EIN and complete any other state licenses that may be required to be associated with the new business. Do not continue operating using the existing EIN and other state licenses associated with the predecessor business.
5. Have your employees complete new W-4 forms and other forms associated with the new business.
6. Make sure to complete new insurance or other forms under the name of the new business while discontinuing the insurance coverage for the old business.
7. Start making all estimated payroll taxes along with the 941’s and 940’s under the new EIN.
8. Close or cease operating the existing business assigning all lease agreements and other leases to the new business.

While this approach may not offer protection for prior actions taken it will limit your personal tax liability moving forward.

Need help with a payroll tax issue?  Contact The W Tax Group to speak with one of our qualified tax professionals.  At The W Tax Group we can help you get the answers you need with your payroll taxes or any other tax matter.  Call (877) 500-4930 for your free consultation.