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Small Business Tips

How Small Businesses Get in Trouble with the Government

Stephen Fishman
Tax expert and contributor MileIQ

If you own a small business, it might seem like there are an infinite number of ways you can get in trouble with the government. This is not quite true—the number is not infinite. Here are the four most common ways small businesses get into truly serious legal trouble with the government.

1. Failing to Pay Payroll Taxes to the IRS

Whenever you hire an employee for your business, you become an unpaid tax collector for the IRS. You are required to withhold and pay to the IRS your employees’ income taxes. You are also required to withhold and pay their Social Security and Medicare taxes and make a matching contribution out of your own funds. You must pay these taxes to the IRS throughout the year—smaller employers usually pay them monthly.

As far as the IRS is concerned, an employer’s most important duty is to withhold and pay Social Security, Medicare and income taxes. These are also known as “trust fund taxes” because the employer is deemed to hold the withheld funds in trust for the U.S. government. If you fail to pay trust fund taxes, you can get into the worst tax trouble there is. The IRS can—and often does—seize a business’s assets and force it to close down if it owes back payroll taxes. Although rare, you can also get thrown in jail.

At the very least, you’ll have to pay all the taxes due plus interest. The IRS may also impose a penalty known as the trust fund recovery penalty if it determines that you willfully failed to pay the taxes. The agency can claim you willfully failed to pay taxes if you knew the taxes were due and didn’t pay them. If you paid such taxes in the past and then stopped paying them, that constitutes pretty good evidence that you knew the taxes were due.

How the Federal Trust Fund Recovery Penalty Works

The trust fund recovery penalty is also known as the “100 percent penalty” because the amount of the penalty is equal to one hundred percent of the total amount of taxes the employer failed to withhold and pay to the IRS–which can be a staggering sum.

If you’re a business owner, you’ll be personally liable for the 100 percent penalty—in other words, you will have to pay it out of your own pocket. Business owners include sole proprietors, general partners, and corporate officers such as the president, vice president, secretary, and treasurer, whether or not they own any stock.

Small businesses that are starved for cash sometimes “borrow” the taxes they are supposed to withhold and pay to the IRS. Obviously, this is insanely stupid. It is the absolute last thing any business owner should ever do.

To make sure all your payroll taxes are filed properly and on time, it’s wise to use the services of a reputable payroll tax service. The cost will be quite small if you only have a few employees. Your bank may also provide payroll tax services.

Be aware, however, that even if you use a payroll tax service, you remain personally liable if your taxes are not paid on time. The IRS recommends
 that an employer:

  1. Keep its company address on file with the IRS, rather than the address of the payroll service provider, so that the company will be contacted by the IRS if there are any problems; and
  2. Contact the IRS about any bills or notices you receive as soon as possible. This is especially important if it involves a payment you thought your payroll service already made.

2. Misclassifying Workers as Independent Contractors

You can avoid having to pay payroll taxes to the IRS by classifying a worker as an independent contractor, instead of an employee. Independent contractors are not entitled to any of the benefits that employers are usually required to provide employees, including workers’ compensation insurance coverage, unemployment insurance, or health insurance (required by Obamacare starting in 2015 for employers with over full-time 50 employees).

However, a worker is not an independent contractor simply because you say so or he or she signs a piece of paper saying so. The worker must actually be in business for himself or herself. A worker who is solely dependent on you for his or her livelihood and subject to your direction and control on the job, is your employee, no matter what label you use.

A common way small business owners get into trouble with the government is misclassifying workers as independent contractors to avoid their responsibilities as employers. Federal and state agencies are well aware of this problem, and worker misclassification is a hot button issue for them. These agencies include the IRS, state unemployment insurance agencies, and workers’ compensation agencies.

Because these agencies share information with each other, misclassifying workers as independent contractors can lead to a cascade of government audits, resulting in costly assessments that can put you out of business. For this reason, you need to take great care when you determine whether to classify a worker as an employee or independent contractor, and properly document your actions. For details, read our articles to learn more about hiring employees and independent contractors.

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State Unemployment Insurance Agencies

The worker misclassification issue most frequently arises when a fired or laid off worker who has been classified as an independent contractor files a claim for unemployment compensation, claiming he or she should have been treated as an employee for unemployment insurance purposes. When this happens, state unemployment auditors will investigate the hiring firm. If the state auditors determine the worker should have been classified as an employee, they will require the company to pay all the unemployment taxes it should have paid for the worker going back several years—three years is common— plus interest.

In addition, auditors usually impose penalties for the misclassification. To add insult to injury, if other workers do similar work for the same company, the employer will have to pay UI taxes for those employees
as well. The misclassified employees will also be eligible for workers’ compensation benefits and any fringe benefits the company provides its employees such as overtime, health insurance, and retirement plans.

State Workers’ Compensation Agencies

Unemployment insurance audits can also lead to audits by your state workers’ compensation agency. They also frequently occur when a worker who is injured on the job files a workers’ comp claim. You will suffer harsh penalties if you misclassify an employee as an independent contractor for workers’ compensation purposes and have no workers’ compensation insurance.

Most state workers’ compensation agencies maintain a special fund to pay benefits to injured employees whose employers failed to insure them. You will be required to reimburse this fund or pay penalties to replenish it. 
Moreover, in most states, the injured worker can sue you in court for personal injuries.

Many states try to make it as easy as possible for injured employees to win such lawsuits by not allowing you to raise legal defenses you might otherwise have, such as that the injury was caused by the employee’s own carelessness. 
You will also have to pay fines imposed by your state workers’ compensation agency for your failure to insure. The workers’ compensation agency may also obtain an injunction—a legal order—preventing you from doing business in the state until you obtain workers’ compensation insurance.

Finally, in almost all states, failure to provide employees with workers’ compensation insurance is a crime—a misdemeanor or even a felony. An uninsured employer may face criminal prosecution, fines, and, in rare cases, prison.


Worker classification is also an issue frequently explored in audits of small businesses by the IRS. If the IRS concludes that you have misclassified employees and independent contractors, you’ll have to pay back taxes, interest, and penalties. The assessments the IRS can impose for worker misclassification vary, depending upon whether the IRS views your misclassification as intentional or unintentional. If the IRS determines you unintentionally misclassified a worker for whom you filed all required 1099 forms, you’ll have to pay about 20 cents for every dollar you paid the worker, and 25 cents for every dollar if you didn’t file 1099 forms. But if the IRS finds your misclassification intentional, you’ll have to pay about 50 cents for each dollar you paid the worker.

3. Violating Federal and State Labor Laws

Employees enjoy a wide array of rights under federal labor and anti-discrimination laws. Among other things, these laws:

  • impose minimum wage and overtime pay requirements on employers
  • make it illegal for employers to discriminate against employees on 
the basis of race, color, religion, gender, age, disability, or national 
origin, and
  • protect employees who wish to unionize.

Most states have similar laws protecting employees.

In recent years, a growing number of employees have brought lawsuits against employers alleging violations of these laws. Some employers
have had to pay hefty damages to their employees. In addition, various watchdog agencies, such as the U.S. Department of Labor and the U.S. Equal Employment Opportunity Commission, have authority to take administrative or court action against employers who violate these laws.

Most of these laws, other than some nondiscrimination laws, apply only to employees, not independent contractors. If you have employees, you need to understand and follow these rules. For more information, refer to the United States Department of Labor elaws web page (short for employment laws assistance for workers and small businesses).

4. Violating Federal Immigration Law

Many workers in the United States are immigrants. And some of these immigrants work illegally—that is, they are not U.S. citizens and don’t have a green card or other documentation of their legal status. All employers must verify that their employees are either U.S. citizens or nationals, or legal aliens authorized to work in the U.S. To do this, the employer and employee must complete USCIS Form I-9. The employee must provide identifying information and documents establishing the employee’s citizenship status, such as a driver’s license, Social Security Card, or U.S. passport. The form must be kept by the employer, but need not be filed by with the government.

You are not required to verify citizenship when you hire an independent contractor. However, although you are not required to verify the immigration status of ICs or others coming within these exceptions, it is still illegal for you to hire any worker whom you know to be an illegal alien. The federal government can impose a fine of up to $2,000 for the first offense.

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