Tax Liability or Current Taxes: Which One Should You Pay First
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When your business owes taxes to the IRS, it’s easy to get trapped into a cycle of non-compliance, which is expensive on several levels. Often, businesses focus on paying off old periods of liability, leaving them unable to pay current taxes. This is the exact opposite of what a business should do. In this article, we will explain the best route to take when handling tax liabilities vs. current tax payments.
The First Step is Compliance
Becoming compliant, and prioritizing making federal tax deposits in full and on time must be a priority for businesses in this situation. Not only does doing so avoid unnecessary penalties and interest, but it’s also a requirement for setting up an installment agreement.
The Importance of Tax Compliance – Form 941
Federal law requires employers to withhold certain taxes from their employees’ paychecks, i.e., employment taxes. Wages are subject to federal income tax withholding, Social Security, and Medicare taxes. Generally, the IRS requires businesses with employees to make federal tax deposits (either monthly or after each payroll) and report those deposits quarterly on the Form 941 withholding return.
Businesses must be current and compliant before the IRS will consider any resolution for old liabilities. To be current, a business must make its federal tax deposits in full and on time. To be compliant, a business must file and pay its tax returns on time (all returns must be filed).
Failure to Pay Current Taxes is a Costly Mistake
The best way to avoid unnecessary penalties and interest is to pay the current taxes on time and avoid new periods of liability. There are several common penalties you will incur if you fail to pay your current taxes:
- failure to deposit
- failure to pay
- failure to file
The failure to deposit penalty is the most aggressive because it maxes out in the least amount of time. The amount of the penalty depends on how many days the payment is late.
The IRS assesses failure to deposit penalties in the following manner:
- 2% for the first 5 days the deposit is late
- 5% for days 6-15
- 10% after day 15
- An additional 5% is assessed (for a total of 15%) for all amounts still unpaid more than 10 days after the IRS issues the first notice of deficiency.
Within a month or two after the business files its quarterly 941 withholding return, the failure to deposit penalties max out at 15%.
Let’s consider an example where a business should be making deposits of $200,000 per quarter or $33,000 per pay period (assuming payroll is on the 1st and 15th of the month). If the business pays old liabilities instead of the current quarter’s deposits, each unpaid deposit will be more than 15 days late and subject to a 10% penalty, totaling $20,000 for the quarter. The IRS will assess an additional 5% penalty on the unpaid balance when it issues the initial notice of deficiency. Over the course of a year, the business will pay $120,000 ($30,000 per quarter) in unnecessary penalties.
In the end, for every dollar a business pays towards old liabilities, it accrues $1.15 in the current quarter. The business just gets further behind.
Negotiating an IRS Resolution is a Step in the Right Direction
Most businesses cannot simply write a check to pay an old IRS liability in full and keep up with the current quarter’s federal tax deposits and other necessary expenses, e.g., rent, utilities, etc. Instead, the business should prioritize the current deposits and secure a resolution, usually an installment agreement, to repay the old liability.
- To negotiate any resolution with the IRS, a business must: Have filed all its federal tax returns, and
- Begin making its federal tax deposits in full and on time.
What do we mean by making federal tax deposits in full and on time? In a perfect world, a business would make (or catch up, if necessary) all deposits for the current quarter, thereby avoiding a new liability when the IRS processes the current quarter’s 941 return. However, that’s not always possible.
In such circumstances, it’s a good idea to begin making federal tax deposits in the middle of the current quarter. The sooner a business prioritizes the current deposits, the sooner it can negotiate a resolution for the old liabilities. An experienced representative can still negotiate a resolution, but it will take longer because the IRS requires that all liabilities must be included in an agreement. An installment agreement cannot be finalized until after the business files the current quarter’s return and the IRS processes it.
Takeaway: Focus on Compliance
In short, paying the old liabilities first is not a good idea. The business will be unable to get current and compliant and will pay more to the IRS because of the continued accrual of penalties. The better solution is to stop the bleeding, avoid the penalties in the first place, and then negotiate an installment agreement and secure a subordination of federal tax lien, if necessary.
When federal tax issues arise, don’t wait for the IRS to file a tax lien or issue levies. Be proactive. It’s best not to try to deal with the IRS on your own. Fill out the form below to speak with a specialist about how we can help.