7 Common IRS Compensation Penalties Every Small Business Should Know
Every small business owner should understand their responsibilities regarding compensation and taxes, whether they have employees to pay or only themselves. But juggling accounting and taxes can become overwhelming, and many end up in hot water dealing with IRS penalties and potential legal consequences simply due to oversight and lack of knowledge.
However, some business owners try to reduce their tax burden or boost dividends/distributions by administering unreasonable compensation. That said, the best way to avoid these hefty fines is by:
Understanding small business taxes and the most common penalties
Establishing accounting processes that help you maintain that organization and accuracy
Being accurate and honest about your finances and taxes—and knowing when to hire a professional
These tax penalties tend to arise in S corporations and closely held corporations (i.e., a business with more than half of its stock owned by up to five people). Below, let’s examine the potential risks when a business owner or employee receives unreasonable compensation.
7 Types of IRS Penalties for Compensation
1. Reclassification of Distributions & Penalties/Interest on Back Taxes
If the IRS finds that the owner(s) (a.k.a. officers in an S corporation) or employees received unreasonably low pay, it could reclassify distributions as salary or wages. The company and individuals involved will be responsible for paying back payroll taxes (e.g., income, FICA, and unemployment taxes).
If the IRS determines that you underreported your compensation and underpaid your taxes, you could also be on the hook for paying them back via penalties and interest—which can be very high. These potentially significant penalties are greater than any tax savings you might get.
2. Failure to Pay Employment Tax Penalty
Say you or your employees receive reasonable compensation but fail to withhold and pay employment taxes. Yep, this is another big area where employers could be penalized.
Your business must deduct payroll taxes from employees' wages to avoid the Trust Fund Recovery Penalty (TFRP). This name comes from the fact that you hold the funds in trust until you send the payment to the IRS each month.
The TFRP applies to any owner or employee who “willfully” underreports or underpays their employment taxes. According to the IRS, “The amount of the penalty is equal to the unpaid balance of the trust fund tax.”
Bottom line: Establish a solid payroll management process and get a reliable provider!
3. Accuracy-related Penalty
Don’t let a lack of understanding or overlooked income cost you. That’s what will happen if the IRS finds you reported unreasonably low compensation and underpay your taxes—in which case, you could be hit with a fine of 20% of the underpayment amount.
The IRS can levy this tax penalty for substantial understatement of income tax or negligence, such as failing to keep proof that you qualify for the credits or deductions you claim or checking the accuracy of that credit or deduction.
A penalty of this size could cause substantial, potentially irreversible damage to your small business. Implement solid recordkeeping practices and, when you can afford it, partner with a tax professional to ensure your taxes are reported accurately.
4. Revoked S Corporation Status
Suppose the IRS discovers you and your fellow shareholders have consistently underpaid yourselves and taken distributions while performing substantial duties for the S corporation. In that case, you could be dealing with more than tax penalties—your business could lose its S corp status.
In other words, you’ll be dealing with long-term repercussions, as your company would be treated as a C corp. That means the business would be subject to double taxation (i.e., income is taxed on both the corporate and shareholder levels).
As an S corp, it’s essential to set up all shareholders as W-2 employees, pay them reasonable salaries, and ensure they report and pay their individual taxes appropriately.
5. Failure to File & Failure to Pay Penalties
While these are two separate penalties, they go hand-in-hand and should be considered together. They’re also pretty straightforward—so be sure to file and pay your taxes on time!
If you don’t file your taxes by the due date, you’ll be slapped with a monthly penalty of 5% of the unpaid taxes until you pay them, up to the maximum fine of 25%.
And if you fail to pay your taxes, the monthly penalty is 0.5% of the unpaid taxes. You can set up a payment plan to reduce this to 0.25%. On the other hand, the penalty can increase to 1% if you fail to pay within 10 days of getting an IRS notice of levy. Overall, note that the penalty can reach 25%---so pay as soon as possible to avoid increases.
6. Estimated Tax Underpayment Penalty
Finally, self-employed individuals MUST remember to pay their quarterly estimated taxes. Unfortunately, many (especially new) business owners forget this. According to the IRS, you have to pay 90% of what you will owe for the taxable year. If you don’t pay enough on your estimated taxes or you pay late, you’ll be subject to this tax penalty.
You can also avoid the IRS penalty on underpayment by paying 100% of the tax shown on your return for the previous year in equal quarterly amounts.
7. Legal Repercussions
This one may not be a penalty per se, but the financial and reputational risk of your company being brought to tax court can be high. Your business could become embroiled in lawsuits or shareholder disputes if your compensation practices are found to be unethical or in violation of tax laws.
Not only will you have to deal with IRS penalties, but you’ll also have to pay legal fees and possibly additional fines or settlements. Typical catalysts for legal action include the compensation and tax mistakes discussed earlier, such as understating (or overstating) compensation and failing to withhold employment taxes, as well as poor practices like misclassifying workers as independent contractors to avoid payroll taxes.
Understand Tax Penalties for Compensation Violations
When it comes to your small business tax liability, knowledge is power. Understanding your responsibilities for your company structure, paying owners and employees reasonable wages/salaries, reporting every owner and employee’s income accurately, and filing and paying on time are the best first steps to protecting your business from tax penalties.
These tips may seem like common sense, but things can quickly slip through the cracks when you’re busy running your business! To mitigate these common, avoidable missteps, contact JLS Accounting to learn how our tax professionals will take the tax and compliance stress off your plate.