This article is part of a series on how three entrepreneurs survived run-ins with the IRS. Today's story: To keep his motivational speaking and sales training business afloat, Bert Martinez had to find a way to maintain cash flow. His solution: Skip payroll taxes until he could get caught up. Big mistake. Below, Bert explains in his own words what happened.
I never expected to run into problems with the IRS when my business as a motivational speaker and sales trainer started to take off. We always paid our taxes. But in 1999, when my company was about three years old, we ran into cash flow problems. On paper, our business was growing. We made seven or eight significant sales that year. But payments from our clients weren't arriving dependably. When they did come, we had to cut checks for our seven or eight employees, pay off our credit lines, and catch up on our lease. I should have been leaving money in reserve for our payroll taxes, but I didn't. When you are in survival mode, it is the easiest money to borrow. In 1999, I paid no payroll taxes whatsoever.
By the first quarter of 2000, the collection notices from the IRS started to arrive. We owed about $20,000, plus interest and penalties. When you have good cash flow, that amount isn't a big issue. When you have cruddy cash flow, it is.
Around the same time I was trying to come up with the money to pay the IRS, one of my five children, a daughter who was then nine years old, was hospitalized for what doctors thought was leukemia. She turned out to have lupus, which is also very serious, and she spent about 45 days that year in the hospital.
During my daughter's health crisis, the business -- and my tax problem -- took second place. One day, the bank called to tell me I had overdrawn my checking account. It turned out the IRS had gone ahead and withdrawn $5,000 out of the account. It was a very, very stressful couple of days. Checks I had written to my suppliers bounced. I called and told them what happened. They didn't charge me late fees. My banker even refunded a couple of hundred dollars in overdraft fees, even though he didn't have to do that. I was grateful that they were sympathetic, but it was humbling to share my predicament.
Obviously, I couldn't ignore my tax problem anymore. I went to my attorney and accountant for help. I think I had put it off because it was hard to admit I messed up. I thought I could handle it on my own. They advised me to go to the local IRS office, rather than call the 1-800 number. You'll get a human being on the line, they said, but not one who has much authority to help you.
When I went to the local IRS office in the third quarter of 2000, the contact there asked me for a lot of financial information. I produced everything the government wanted. I tried to work out a payment plan. My lawyer had told me the IRS did not have a right to take all of the money, but I had to sit down and work out a solution. I was negotiating from a position of weakness. I was overdrawn, and I needed them to hurry up and be reasonable with me. The people at the IRS were indifferent. They had all of the power in the situation. I tried to build a rapport anyway. Hostility only begets hostility. Finally, the IRS agreed to return the $4,000 it had taken from my checking account and kept $1,000 as the first payment. It reduced the penalties and interest, as part of the arrangement. Although we worked things out, I was haunted by the fear that the IRS would seize my bank account again. I was afraid to make a deposit for a while.
I paid off everything by 2001. Today my business, which is based in Houston and Phoenix, is thriving, with close to $1 million in annual revenue and 10 full time employees, and clients such as Budget car rental and Dole.
What I learned from my experience with the IRS -other than how essential it is to keep up with payroll taxes -- is the importance of maintaining good cash flow. It's what keeps your business alive, and it is more important than the profits you have on paper. After the crisis, I hired a bookkeeper to help me manage my cash flow. It's now very clear to me that if you are not paying taxes because of other expenses, your business is not healthy. I wish I had realized that in 1999.
Tips on avoiding a payroll tax debacle:
It's easy for cash-strapped companies to give in to the lure of using payroll tax money to keep the lights on. But don't -- Uncle Sam does not take it lightly if you don't hand over the money you've taken out of employees' pay. If you fail to pass it on to the government as required, your employees won't get credit for having paid it, and you will create tax problems for them. "If it's not rectified, you will go to prison," says CPA Howard Samuels, managing partner of S&C LLP, which advises many entrepreneurs from its offices in New York City and Fairfield, N.J. Here are some tips on how to avoid this slippery slope and what to do if you fall behind.
- Avoid the temptation. Create a separate bank account for your payroll needs. Deposit your entire payroll into it twice a month. "This way, there is never any extra cash sitting in a company bank account that can be easily spent," advises Samuels.
- Take action immediately if you're late with your payroll taxes. Pay the entire amount and any penalties in full right away, if you can, says CPA Gary Milkwick, VP of operations at The Tax Club in New York City. If you're five days late, the penalties go up 2 percent; 16 days or later and it's 10 percent; 26 days late and you're looking at a 15 percent penalty. If you need more time to get caught up, work with your accountant to negotiate a payment plan or make what is called an Offer in Compromise to settle for a smaller amount, advises Milkwick. The IRS has a formula to determine who qualifies for an OIC, so be prepared to provide lots of financial documentation if you go that route.
- Don't miss any more payments. If you run short of cash, you're better off paying almost any other obligation late than your payroll taxes. The IRS doesn't have the patience to work with businesses that are habitually late on payroll taxes and won't hesitate to levy your bank account or to put liens on your property if you fall too far behind. "They would rather shut the business down," says CPA Philip Liberatore, based in La Mirada, Calif. -- As told to Elaine Pofeldt