My experience as an attorney for the past 16 years has taught me that every client loves quick, easy solutions. When it comes to huge business tax liabilities, one might wonder if they can simply close their company and forget about the tax debt forever.
This probably sounds like a pipe dream. But is it?
In truth, there are some circumstances where you can shutter your business, get out from under a massive tax liability, and never have to confront the problem again. But then what happens if you get the bug to start another venture? Are you barred from ever becoming an entrepreneur again if your first attempt resulted in a huge tax liability? Do you always have to pay off the old company’s debt before starting anew? In this article, I explain when, how and under what circumstances you can do just that, and what hazards may stand in the way of such an attempt.
941 Employment Tax Liabilities
Most business owners will tell you that the biggest monthly cost they face is labor. Employees are expensive. It follows, too, that the biggest tax debt a company likely faces is employment tax liabilities. Indeed, the vast majority of my business clients throughout my career have been faced with delinquent employment tax liabilities owed on Form 941. Companies are required to withhold income taxes from their employees’ paychecks, match the FICA (Federal Insurance Contribution Act – the tax money withheld to cover Social Security and Medicare payments), and report the withheld tax on Form 941, every quarter.
Often, when companies are struggling to make ends meet, business owners may decide to short the tax bill owed on the Form 941. After all, rent is due immediately, utilities will be shut off if you don’t pay, and employees will quit if their checks do not clear. But if a company fails to pay employment taxes right away, the IRS will take a minimum of several months to make serious attempts to collect the shortfall.
The problem is, when the IRS does come calling, they do so with massive collections tools at their disposal. Not only can the IRS levy company bank accounts, seize company assets, and even collect directly from a company’s customers, but the IRS can also assess individual business owners with the “Trust Fund Recovery Penalty” (TFRP), or an amount equivalent to the funds withheld from employees’ paychecks that was not paid over to the IRS. Practically speaking, the TFRP portion of the total 941 debt is roughly half (anywhere between 40-60%, depending on the situation) of the company’s total balance owed.
This brings us back to our central question of whether you can close your tax-indebted business and walk away unscathed. For a company that owes 941 liabilities, the answer is usually “no,” but with the proviso that the remaining liability will be substantially smaller. That said, there are often other resolutions you can pursue, such as “Currently Not Collectible” status, or an Offer in Compromise, both of which involve paying the IRS either less than what you owe, or, in rare cases, nothing at all.
By way of example, I had a client whose company owed about $325,000 in 941 debt. The TFRP portion of that debt was $144,000. This means, $144,000 of the $325,000 was income tax that should have been withheld from employee paychecks and sent on to the government by the business owner.
This also means, however, that if the company had closed, the president of the company would have reduced the total amount owed by approximately $181,000, which represents the employer FICA matching, and all penalty and interest that accrued on the company debt.
Numerous times throughout my career, I have assisted businesses in changing their entity formation, and reopening their closed, indebted business in such a way as to ensure that the non-TFRP debt (or, in the example case, $181,000) never comes back to life to haunt them. This is often a lengthy, complicated strategy, and it always necessitates the close assistance and advice of a tax attorney. But for a chance to gain $181,000, most business owners will put up with complications, and a bit of a wait.
Finally, many of my clients have gone from owning a business with a 7-figure tax debt, to closing the liable company and settling the resultant personal debt by way of an Offer in Compromise as an individual for a tiny fraction of the original corporate debt.
Some of those clients have then started new ventures that take flight without the heavy tax debt burden that plagued them prior to my involvement. In other words, I have quite often made “pipe dreams” come true.
Note: There are instances where, if a business does not close and re-open properly, the IRS could sue the individual officer for more than just the TFRP. Always consult an attorney before attempting this procedure.
One of the hazards of starting a new business venture after an old one Failed is “Successor Liability.”
Under IRS Collections rules, successor liability is when the IRS seeks to impose liability because the taxpayer sold or transferred assets to – or merged with – another corporation and the recipient or surviving corporation is liable under state law for the debts of the predecessor corporation. In other words, if two companies merge or consolidate, and one of the companies owes a tax debt, then the surviving company can be made liable if a state statute says that it must assume the debts of the old company.
For the purposes of this blog, I will not be addressing the sale of shares of a corporation, but rather the sale of actual, tangible assets of a corporation (or a customer list, accounts receivable, etc.). Ordinarily, when selling shares of a business to a buyer, that buyer assumes all encumbrances—including tax debt – that flow from purchasing the shares.
Even if no formal merger or consolidation between two companies happens, the IRS may consider a business merger or consolidation to be a “de facto” – or “in effect” – merger or consolidation. In other words, if Company A owes $200,000 in tax debt, closes its doors, and then and then sells $100,000 in assets to Company B, Company B could be on the hook for Company A’s tax debt up to $100,000 (the value of the assets Company B purchased).
When deciding whether to assess Company B with Successor Liability under a “de facto” merger theory, the factors the IRS considers include whether:
- Company A continues the business or performs the same functions of the taxpayer;
- Company A’s employees become the employees of the second corporation;
- Company A and the second corporation are owned or controlled by the same individual or individuals;
- Company B’s business activities are carried out in the same location as Company A;
- less than full consideration is paid for the transferred assets; and
- the business relationships remain relatively static.
In short, the IRS conducts a sort of “smell test” to determine if Company B is just a mere continuation of Company A, or even worse, a naked attempt by the company’s owner to escape Company A’s debt by creating Company B.
Keeping these factors in mind, a good tax attorney can help you successfully orchestrate a merger that avoids Successor Liability, and ensures that any “Company B” will survive the merger/transfer without fear of being assessed with the balance owed by Company A.
Under the theory of “Transferee Liability,” an asset of a Company A (the delinquent taxpayer) is passed along to Company B, without addressing a federal tax lien. Assuming that, again, Company A owes $200,000 to the IRS, and Company A gives (in legal circles, a gift of such property might be referred to as a “quitclaim” deed) to Company B a building worth $100,000 without addressing the tax debt, the IRS would collect the value of the asset transferred by taking it away from Company B.
In some cases, Company B is buying Company A, and the contract specifically calls for Company B to assume the tax debt of Company A. In those cases, it’s academic; the IRS has every right to collect the debt from Company B, and Company B should not be surprised that it is confronted with paying Company A’s tax debt.
Another way the IRS can target corporate tax debt after the death of the corporation is by garnishing “insider” distributions to a corporate shareholder. For example, if a corporation repays a “loan” from a shareholder before addressing delinquent tax liabilities, the shareholder could be on the hook for the tax balance, up to the amount they collected in distributions. Even “unreasonable” salaries or bonuses paid to shareholders could be collected by the IRS to fulfill the company’s corporate tax debt.
Finally, the most common form of “transferee liability” is when a company with a tax debt sells assets for less than fair market value (such as selling a Mercedes for $1), leaving the company insolvent, then the IRS could pursue the value of the Mercedes from the buyer. If this happens prior to the tax debt arising, the IRS could still go after the buyer if there is proof that the sale of the asset was done with the intent of defrauding the IRS (this could also get all involved in criminal-case hot water).
If you are working with a Revenue Officer, it is even more important to be careful of these transfers, as an RO has the ability to refer such cases to the IRS Examinations Unit, which can then assess the tax debt for collection against an officer/shareholder.
In cases where the IRs identifies a “nominee” of the taxpayer who is holding an asset to avoid collection, the IRS can file a lien against the nominee, pertaining to the asset to which they hold legal title.
The IRS states that “no one factor determines whether a nominee situation is present”, but rather they look at the totality of the circumstances to determine if a “nominee lien” is appropriate. The IRS sets out several factors to determine if a “nominee lien” is appropriate, including whether the taxpayer previously owned the property, whether the nominee paid little or no consideration for the property, whether the taxpayer retains possession or control of the property, whether the taxpayer continues to use and enjoy the property conveyed just as the taxpayer had before such conveyance, and whether the taxpayer pays all or most of the expenses of the property.
Note that, if the IRS files a lien against the property held by a nominee, it does not mean that lien extends to all assets actually owned by the nominee. Moreover, the Notice of Federal Tax Lien (NFTL) will usually make that clear, listing the taxpayer – along with the nominee – on the notice itself.
To ensure you do not run afoul of any of these actual-fraud or “constructive fraud” situations, it is important that you consult a tax professional – preferably an attorney – before you set out to sell, divest, bequeath, or gift assets to someone else when you owe taxes to the federal government.
Certificate of Discharge
One way that a skilled attorney will help a business avoid any of these assignments of liability from a purchase of assets is to submit what’s known as an “Application for Discharge of Property from Federal Tax Lien.”
Done right, a buyer submitting this form to the IRS can facilitate transfer of property owned by a liable taxpayer, to a buyer, free and clear of the federal tax lien. This usually requires some 3rd-party help from an appraiser, along with a skilled attorney who can help shepherd the application through the IRS department that handles such applications. Ordinarily, the IRS demands two different appraisers from disinterested third parties. In many cases, however, I have seen the IRS so pleased to see any lump sum toward the debt that they will approve these applications even if there is only one appraisal (so long as it is within the realm of reason).
Keep in mind, the “applicant” for the purposes of these applications is the buyer, not the delinquent taxpayer. It is in the buyer’s interest to take possession of this property without being burdened with the tax lien. Sometimes, however, an individual taxpayer can purchase assets from their own corporation, and seek to remove the lien as part of the sale, e.g., John Stamos, president of John Stamos Industries, Inc., seeks to remove the lien from a red Ferrari owned by JSI, Inc. The IRS views JSI, Inc. as an entity distinct from John Stamos himself. As long as John Stamos has rendered an agreed-upon payment to the IRS for the value of the vehicle through the application process, the Ferrari should pass to Mr. Stamos free and clear of any tax liens.
For those feeling especially adventurous, a select few clients of mine have closed their corporate business, re-opened a new version of their business as a different entity (usually a sole proprietorship), and “played chicken” with the IRS, offering up the liable corporation’s assets to be seized. Whether this gambit will be successful often depends on the type of assets to be seized; assets on wheels are generally easier to seize and sell at auction and tend to have more potential buyers at an auction, raising the specter of the government collecting enough funds to cover the debt. Huge, proprietary assets that are not on wheels (large machinery like printing presses, metal fabrication machines, etc.) are very hard to seize, and often difficult to sell to a limited pool of buyers. Unfortunately, the IRS does not allow the delinquent taxpayers to bid on their own property. Some states will differ in this regard, however, if your business has a state tax liability.
If your business owes a large tax debt to the IRS, the worst two strategies are inaction and panic. There is no need for either. There are numerous – often hidden – strategies that we can pursue on your behalf to allow you to move on for a heroic second act for your business. While you may not qualify for all of these strategies, do not let fear of the problem disqualify you from all of them. Give us a call, and let us find the strategy that will best fit your business, and your plans for your future.