January 8, 2015

Another Fine Print Warning

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We have cautioned before about the importance of reading the fine print on a document, but here is a potential issue that you may not realize is there even if you do read the fine print. 

When you start a new business, open a trust or an estate, form an LLC or partnership or form any other kind of entity or association, whether or not it is a pass-through entity (that pays no taxes itself, like an LLC or partnership) or a taxable entity (like a corporation) you have to obtain an Employer Identification Number (EIN) from the Internal Revenue Service.  This serves sort of like a Social Security Number for the new entity, and it is the identifying number by which you will report the entity’s activity to the IRS as required under its various regulations.  You apply for an EIN using a Form SS-4.  There are comparable forms for state registration as well.

One blank to be filled in on the Form SS-4 is an innocent enough sounding entry calling for you to identify the “Responsible Party.”  The temptation is to assume that this is just the contact person in case IRS should have any questions or should require any additional information in either the application process or later in the operation of the business.  The instructions to the Form SS-4 don’t sound that ominous either.  They state that the “Responsible Party” is, in essence, the person who will have control over the entity’s assets and the ability to make decisions about how to spend the entity’s money.  But even that does not disclose the full effect of the “Responsible Party” designation.  That designation is, in effect, a confession.

The entity will have payroll obligations if it has employees, and those obligations will involve withholding of income taxes and other payroll taxes and there may be state sales taxes collected, all of which are to be turned in to the appropriate taxing authority.  These are all what are sometimes referred to as “trust taxes” where the entity is in effect collecting money that belongs to someone else (such as FICA, employee income tax withholding, sales tax that belongs immediately to the State on collection, and the like).  While the entity is charged with immediately turning in to the taxing authority those withheld or other collected amounts, sometimes that doesn’t happen.  Sometimes mistakes are made; sometimes the entity will be in a bad cash flow position and someone will decide to pay the rent instead of the withholding deposits (figuring they can catch up on the tax deposits in the next month); sometimes the employee in charge of the ministerial act of generating checks for payment will misappropriate money otherwise destined for the taxing authorities, or any number of other occurrences may cause withheld money not to be turned in.  When that happens, the taxing authority will come looking for someone to be personally liable for those taxes.  That person is called a “Responsible Party.”

All too often, the reason that trust taxes are not turned in is because the business is not doing well, greatly increasing the chances that the tax deposit will never be paid.  If a business is underfunded and the inventory is under a floor plan financing arrangement or other inventory financing plan, the company may find itself in the Catch-22 position of needing to sell its inventory assets to stay in business and having to pay-off the floor plan lender in order to sell the assets, but requiring the entirety of the sale proceeds in order to do that.  That business’s clerk might then apply most of the proceeds (including the withheld sales tax) to release the asset for sale.  If after that, there is only enough money left to pay the net payroll, the entity may forego turning in payroll taxes in order to stay in business, and so forth.  That clerk may or may not be found to be a responsible party by his/her conduct, but the officially designated Responsible Party (who by listing of his/her name on the SS-4 has admitted that he/she has authority over the disposition of the entity’s assets) will no doubt be held to be the Responsible Party that he/she has thus confessed to being.  At that point, while the designated Responsible Party may have had no actual knowledge of any of those specific transactions, when the network ultimately collapses, he/she will find him/herself being assessed a 100% personal liability penalty by the taxing authority.  Depending on how long this has been going on, that could well be tens or even hundreds of thousands of dollars.

Every entity has at least one Responsible Party, whether designated on the SS-4 or not.  You are cautioned not to lightly allow your name to be used as the designated Responsible Party on this innocent sounding start-up document.  You should never permit your name to be used on the SS-4 as the Responsible Party unless you intend to actually have full and continuing review of trust tax collection and payment in the entity.  And if anything irregular appears to be going on, you must attend to it immediately, or a very expensive surprise may await you from the IRS or from a state taxing authority.