Designated Employment Tax Payments to Minimize Employer Tax Penalites

By Scott E. Vincent

Employment tax administration is a constant challenge for business taxpayers. The rules are complex, and employers are faced with collecting employment taxes and depositing them with the Internal Revenue Service ("IRS") in connection with every payroll. Even the most sophisticated taxpayer will probably be faced with a mistake, and resulting IRS penalty assessment, at some point.

The federal tax deposit penalty is one of the most frequently faced employment tax penalties because of its relation to recurring payroll taxes. This penalty is often miscalculated by taxpayers and the IRS and, as a result, overpaid. Beginning January 18, 1999, the IRS Restructuring and Reform Act of 1998 initiated a new opportunity for taxpayers to designate the application of payroll tax deposits and significantly reduce overall tax payments. This article briefly outlines the background and key factors to consider in applying this new legislation.

Basic Federal Tax Deposit Requirements

The administrative requirements for federal tax withholding and deposits are too detailed to set out in full here, but the general framework is important in understanding the new strategy for minimizing employment tax penalties. Of course, the key to avoiding the deposit penalty completely is making deposits on time and in the proper amount.

Timing

Most employers are required to make deposits either monthly or semi-weekly. Monthly deposits are required on the fifteenth day of the month following the month in which the liability arises. Semi-weekly deposits are required the week following payroll, as follows: (1) Wednesday of the following week for liabilities incurred on the previous Wednesday, Thursday or Friday, and (2) Friday of the following week for liabilities incurred on the previous Saturday, Sunday, Monday or Tuesday.

Whether monthly or semi-weekly deposits are required depends on the taxpayer's aggregate deposits during a twelve-month "lookback period." This lookback period for calendar year taxpayers is the 12-month period that ends on the preceding June 30. Thus, the lookback period for calendar year 1999 is the 12 months ending on June 30, 1998. Taxpayers with aggregate payroll tax deposits of more than $50,000 during the lookback period are required to make semi-weekly payroll tax deposits. This aggregate total includes income taxes and social security taxes for all of the taxpayer's employees. As a result, total payrolls as low as $200,000 annually are likely to require semi-weekly deposits.

In addition to these general rules, there are a variety of exceptions for situations such as household employees, for whom annual deposits are often acceptable. There are also special rules in many other situations, such as a daily deposit rule for taxpayers that accumulate more than $100,000 of undeposited taxes in a deposit period.

Deposit Amounts

Taxpayers are generally required to deposit the full amount of employment taxes due to avoid deposit penalties. However, there are two important "amount" exceptions to the penalty for failure to deposit:

1. The amount required is paid with the quarterly tax return and is less than $1,000; or

2. The amount deposited is at least 98% of the deposit due (or the amount due less $100, if that amount is greater).

This "98% rule" is one key factor in the overall timing strategy that must be considered to minimize federal tax deposit penalties. Basically, the remaining 2% can be paid later, so it may be used to avoid or minimize other more costly penalties with planning around the timing of payments. It is important to note, however, that the IRS intends the 2% "cushion" to be for minor errors, rather than a planning and timing tool.

Applicable Penalties

Internal Revenue Code Section 6656 imposes a penalty on employers for failure to make deposits on the dates required. The penalty is incremental, based on how late the deposit is made, as follows:

2% if the deposit is one to five days late;

5% if the deposit is six to 15 days late;

10% if the deposit is more than 15 days late; and

15% if the deposit is not paid within 10 days of notice and demand by the IRS.

The penalty only increases on the key dates indicated. Thus, the same 5% penalty applies whether a late payment is made on day six or day 15, which gives taxpayers a timing opportunity for planning. For example, there may be little incentive to pay a deposit that is already subject to 10% penalty until receipt of notice and demand from the IRS. While interest does run on the outstanding liabilities, there may be other deposits for which penalties can be avoided, or other periods for which penalties can be more effectively minimized.

IRS Calculations

The IRS calculates the failure to deposit penalty with a "first-in, first-out" or "FIFO" allocation method. Under this approach, the IRS automatically applies new deposits against the earliest outstanding liability at the time the deposits are received. Thus, once a given deposit is missed or even paid late, subsequent deposits will be applied first against the taxes and penalties due for that prior deposit, and then toward the current period. This results in the current period deposit being deficient and generating another deposit penalty. Until the chain is broken by full payment of all balances outstanding, multiple periods where penalties apply will continue to accrue over time even if only one original deposit was late or deficient. This problem is often referred to as "cascading" or "snowballing" penalties and can have a devastating financial impact on the taxpayer.

Congressional Relief

The IRS Restructuring and Reform Act of 1998 ("RRA of 1998") attempted to give relief to taxpayers faced with cascading payroll tax deposit penalties.

The act added a new provision allowing taxpayers 90 days from the date of a penalty notice to designate how to apply their deposits. This is intended to give taxpayers an opportunity to avoid the "cascading penalty problem" by having current deposits applied toward current periods and ending the cycle of missed deposits and newly assessed penalties.

RRA of 1998 also provides that taxpayers switching from monthly to semi-weekly depositor status will not be liable for late payment penalties for their first semi-weekly deposit. It is important to note that the taxpayer must affirmatively contact the IRS to request and receive this waiver of the deposit penalty; the IRS will not automatically waive the penalty.

The IRS also announced on June 28, 1999, that penalty notices for the first quarter of 1999 did not properly include a written notice of the RRA of 1998 changes, including the notice required to be sent regarding designated payments. Therefore, the IRS is giving taxpayers 90 days from the date proper notice is sent on these issues to designate payments in other than the IRS first-in, first-out method.

Finally, it is important to note that taxpayers must currently elect to make voluntary payment designations if it is beneficial. Otherwise, the IRS will continue to automatically use its first-in, first-out method of designating payments until at least calendar year 2002.

Summary of Deposit Variables

Minimizing tax deposit penalties requires a complex calculation of variables in order to best time and designate payments made to the IRS. As a summary, taxpayers need to consider at least the following key issues:

1. Carryforward of deposits from prior periods;

2. Time deposits are due (monthly; semi-weekly; next-day; other);

3. Safe harbor rule for 98% deposits (possibly allowing alternative designation or use of 2% of a given deposit);

4. Number of days a deposit is late and the applicable penalty percentage, as previously outlined;

5. Automatic designations of tax deposits by the IRS (first-in; first-out approach);

6. The 90 days from the date of an IRS penalty notice to designate payments.

These variables must be applied in the context of all outstanding liabilities in question, both current and late deposits as well as penalties. In addition, the time value of money for the taxpayer, and the interest charged by the IRS on outstanding liabilities, must also be considered.

Computation Help

Multiple-period deposit issues do require complex calculations to minimize penalties in light of the above-referenced variables. It is important to note, however, that designating payments in some method other than the IRS first-in, first-out approach usually generates overall savings. As a result, all taxpayers should make the calculations required if deposit penalties may apply.

CCH Incorporated, a tax resource publisher, advertises an Internet site that may be helpful in making these calculations. The website (http://payroll penalty.com) offers to help determine whether designating payments would be beneficial. According to the website, calculations are free for savings of $500 or less, but require a fee for savings of more than $500.

Conclusion

Most employers will deal with federal tax deposit penalties at some point. The IRS currently calculates these penalties, and applies payments of federal tax deposits, in a way that maximizes the taxes and penalties required. The new rules noted here provide an opportunity for employers to minimize their liabilities and avoid the "cascading penalty problem" arising from current IRS administration of payroll tax deposits and penalties. Any employer with payroll tax deposit penalty liabilities should carefully consider these issues.