Chapter 6
Arsonists and Regulators
“Google ‘IRS 941 Prison,’” I tell my clients, “to see what comes up.” It's pages of explaining how employers can go to prison for not properly forwarding payroll trust funds on to the federal government. It's the dumbest crime in America, but stressed‐out entrepreneurs do it every day because they are so desperate to maintain the status quo. The 941 is the payroll tax that an employer withholds from the employee's checks and is obligated to forward those funds to the IRS on behalf of their employees. The employer is merely a trustee of these funds and there is absolutely zero business purpose or claim to that money in any way. A good payroll agency will not even process your payroll without these funds, because the failure to pay them is so fraught with peril. Death remains the only way out of a 941‐withholding problem, not bankruptcy, not a sale, not a liquidation, only death. If you stay out of prison, plan to survive on government‐allowable standards of expense (See Figure 9.2, page 241) and on the government seizing future tax returns and placing a lien on your social security checks.
The most powerful collection agency in the world (the U.S. Treasury) has made it very clear that collecting 941s is a top priority. Every time I have any influence or even proximity to payroll I get written statements from the payroll company that they will not process a payroll without the 941 funding and will immediately issue a letter to the board chairman, bank, and corporate attorney notifying them of the company's failure to fund.
But desperate entrepreneurs still play with this money as though it were operating funds. They're following some fantasy about just using the money today and paying it back next week, but it's playing with a loaded gun. As I type this, I'm dealing with a couple who built a wonderful business over many years but lost control recently, ran tight on cash, and didn't pay the 941s. These add up quickly in a company with a decent‐sized payroll, and now they owe $600,000 in 941s. But the owners are dead broke. There is no cash, everything is mortgaged to the hilt, and the IRS is starting to put pressure on them. The following redacted email from their Enrolled Agent sums up their situation:
That's how it ends. After the long series of bills and letters, which were so bland and confusing, you didn't really read them. Then an agent contacts you, usually at home. You'll find out they've been poking around your business and other assets as well. Soon you're being requested to provide every financial report available. Consider this request a federal subpoena when you get it. You'll provide details (under oath) of every financial transaction for every account you have had any influence over in the past several years.
Then the IRS seeks to collect. Tax liens are placed on every asset you own. Remember, you documented every single asset under oath, under penalty of perjury. Lying on any federal form is a felony. Then you start liquidating your assets to satisfy the debt. Then the IRS looks at your income. Let's say you're a CEO of a $20 million business and pulling in $200,000 a year. The bank is okay with your pay, and they agree it's reasonable and market based. You live well but you've also got to put kids through college and your spouse has grown accustomed to a certain level of comfort. Meanwhile, the revenue officer collecting from you and her boss may have combined salaries that are less than your $200,000. But they are above the national standards that the IRS will use to benchmark your allowable standard of living. It's quite simple, they take your entire paycheck and give you back a small amount for food and living expenses. And they keep the rest. You're now raising a family of four on $55,000 a year. This causes you to default on your other personal debts. You file bankruptcy, and you still have the IRS demanding their money, collecting because you still owe the money and bankruptcy does not relieve you of 941 obligations. Think you can sneak some extra income on the side? If you don't disclose that income on your tax return, that's another felony.
I have worked with several IRS Revenue Officers while helping clients who made this insane 941 decision. My experience has been that the officers were always pleasant and professional but also very good at their jobs. And very serious. And like a bank workout officer, they want you to be humble, compliant, and focused on getting out of trouble. Unlike a bank workout officer, the IRS agent works for the US taxpayer, and they can feel a missionary zeal about their work.
It's not just CEOs who have this liability. If the company lacks funds to pay, anyone with financial control is targeted. This usually includes the CEO, CFO, controller, and maybe even the payroll clerk. Professionals like consultants, CPAs, or payroll services can be swept up in these issues if not careful. The IRS will size up everyone's ability to pay and then go for those who have the most money first. They only need to collect once. It's much easier to collect from one than many, and if the CFO has a large, perhaps inherited, lake house with lots of equity, that's a tempting target.
The key here is to avoid these collectors and other regulators of their ilk. Given the choice to abruptly shut a business down and cut every single job, or not pay the 941s, I would shut down the business that minute without hesitation. There is no business in the world so fantastic and valuable that I would take that risk for. None.
Not transmitting 401k deposits is similar, but you'll be dealing with the U.S. Department of Labor. It's called embezzlement and it's a federal felony. Google “401k withholdings prison” and you'll see why this is another terrible cash‐management idea. The point here is absolute control and compliance with these trustee responsibilities.
Labor
All earned labor must be paid, and it is the highest priority in any commercial situation. Lenders and federal collectors all stand behind earned labor in the debt stack. In the United States it is sacrosanct, and even more so north, south, and east of us. As most employers know, the regulator's hammers start falling 72 hours after a lapse in timely payroll. Employee loans or liabilities cannot be deducted from final pay, and most states cover earned vacations and benefits in the obligation.
Employees have been protected with several well meaning laws, to protect workers against companies leaving town in the middle of the night, or shortchanging wages, or somehow draining all their assets, shutting down the business and stiffing workers on final wages. One such law created for these protections is the Worker Adjustment and Retraining Notification (WARN) Act which mandates that companies provide proper (60‐day) notice to employees of a planned mass layoff. The federal threshold for compliance is a company with 100+ employees, though some states have their own version of WARN, usually with lower employment thresholds – around 50. Failure to comply with these regulations mandates fines equivalent to six months of payroll (triple fines on the 60‐day notice). Improper actions by management may invite the Department of Labor to target the owners and officers personally for payment. Certainly, these laws keep companies from skipping town.
The risk of proper WARN notice compliance is that a company has to guess (a completely murky guess) when it might be out of business and make public notice of that date. Immediately, the supply chain stalls, employees are freaked out, and customers start to abandon you with great haste. It is the stink of death upon a company that perhaps doubles or triples its odds of demise, but the notice does give workers 60‐day notice to work on a new job or career.
States have developed their own unique laws with the same good intentions, but often, they have been applied poorly and have set legal precedent. I know of a failed paper company in Massachusetts that had a near‐death experience in 2008/2009, recovered, and then stalled again several years later. Although it was an old factory in a modern economy, management was doing everything they could to keep it alive. But, as the business failed, they filed proper WARN notices and were nearing the end of their options. Then a gutsy investor showed interest, and the dance of investment heated up. It looked like salvation was just around the corner and the business lurched along on anemic cashflow. Then the salvation investor got cold feet at the eleventh hour and pulled out. It was game over. All jobs were immediately lost and wages paid. What wasn't paid immediately was accrued vacation, sick, and benefit time. The company lacked the cash but went and collected receivables, and within two weeks they had enough to pay all those obligations and be 100% satisfied on labor.
The employees ended up whole, but there was that two‐week gap on the benefit payments. A shark lawyer found them and sued under Massachusetts law under which the corporate officers are personally liable for triple‐damages on the delayed payments. The original amount was $500,000 and now the former employee‐CFO is being sued personally for $1.5 million in total damages. This is just a guy who was trying his best and had his final pay delayed as well. The judge agrees this was not the intent of the law, but it has been poorly prescribed over time and precedence has been set. This sets up situation in which officers and directors are incentivized to wipe out jobs and businesses faster, just to limit their personal liabilities. I am told that Connecticut has a similar law and other states may as well.
Other Ways to Get in Trouble
States mandate that employers carry workers' compensation insurance. In exchange for this costly mandate, employers are shielded from claims for injuries an employee might suffer on the job. As you might expect, the risks for not complying are massive, but insolvent managers often choose not to pay these bills (again, I would shut my own company immediately before not carrying worker's comp insurance). Penalties for failing to provide this coverage to your workers can include criminal prosecution, civil suits, and personal liability for treatment of the injury.
A quick side note on workers' comp and safety, most entrepreneurs I meet are not actively managing this cost and striving to provide a safer work environment for their employees. I know of a wood‐working factory where losing a finger was accepted as inevitable for tenured employees. Safety has great leverage in the workforce. It can lower insurance rates, lower absences, lower attrition, and protect your neighbors or it can do the opposite in every way.
Environmental and labor problems are two corporate issues that can follow you home. We saw this in the BP Gulf of Mexico spill where employees were criminally prosecuted for lying in the aftermath. A coal‐mine owner was recently sent to jail for environmental fines because he directed dumping to happen. A contractor I worked alongside in a decommissioning is now in prison because he improperly and inadvertently moved some chemical laden pipe. Instead of reversing his actions and dealing with the regulators, he tried to cover it.
It's a field of landmines, and businesses have to be exceptionally diligent in their environmental, safety, and labor compliance.
Working with Regulators
Years ago, our family business was selected for an IRS audit. The business was growing fast and the idea of an audit sounded like a big waste of time to my dad, a busy entrepreneur. Ever the salesperson, he cleared out a private office for the auditor with its own phone and printer. Fresh doughnuts and coffee were brought in every morning that week and the flirty secretary checked in on him frequently. The auditor was made to feel like an honored guest. At the end of the week, the auditor said everything checked out, the accounting was very tight, and that he would mark his file appropriately so future audits would be less likely.
The best news about federal and state regulations is that they are applied equally to the marketplace. If you run a clean shop, the regulators will spend more time with your competitors.
Like Lenny in John Steinbeck's Of Mice and Men, sometimes these agencies just don't realize their own strength and can destroy businesses, almost like Godzilla's swaying tail. I recently worked with a family business that was marked with a failed state inspection report for a similarly named business. It was not their business that failed the inspection but a similarly named business in the same town. It was 100% a simple bureaucratic misfiling, but the failed audit report got attached to my client and not to the other business. The state agency took 11 months to rectify this error, during which the largest and most profitable customer (35% of revenue) pulled their business based on the misfiled inspection report. The company went into an immediate death spiral.
The story that gave birth to this entire chapter on unregulated regulators happened at Chemco, an industrial chemical processing company in a run‐down rustbelt city that had been losing its manufacturing base and population over the prior 40 years. At 165 employees, the company would have been a small manufacturer 20 year ago but was now quite sizeable in a city littered with abandoned buildings.
The company had operated for about 72 years but had been in tumult recently, having cycled through four owners in the previous three years. Throughout its history, the company had a friendly and supportive relationship with the local county environmental regulators. Chemco operated under a waste water discharge permit that required certain testing, reporting, and compliance. For decades this was never an issue. Things weren't perfect but there was a productive working relationship between the company and the county regulators.
By August our turnaround had finally taken hold after four grueling months. One month after the acquisition, scrap rates soared to 60% before the entire process line had to be shut down, taken apart, and rebuilt. This shutdown and the preceding high scrap levels had pushed customers to the limit of patience with Chemco and new management. We were backing up major auto manufacturers and we knew the customers were making calls in the market to re‐source us. We were in a race against the clock to catch up on late shipments, rebuild customer confidence as much as we could, and show the stability they needed to see. Things were going well by late September as we were finishing out our second profitable month, and everyone could feel the sun starting to shine again.
Then the Environmental Protection Agency (EPA) staged a 2:00 a.m. raid, just as they do on TV shows, with a fleet of SUVs, all carrying guns and wearing their “Federal Agent” raid jackets. They shut down the whole factory (we were a 24/7 operation), had employees assemble in the lunch room while supervisors and managers were pulled into separate offices to be interviewed. Every computer was “mirrored” by a special forensics team flown in from Atlanta. Toward dawn, more managers were called at home and asked to come in to be interviewed. After about 10 hours of shutdown the EPA agents left, but on the way out they called the Occupational Safety and Health Administration (OSHA) to rush over and give us a friendly surprise audit. You know, one last kick while you're down. OSHA came in and found nothing, which was the only satisfying moment of that crazy week.
Everyone was completely rattled because we had no idea about what was going on. If we didn't know what had happened, we didn't know how to fix it, and we were afraid to even turn the equipment back on. We opted to perform our weekly maintenance then and keep the equipment down for another 24 hours as we tried to figure out what happened. This disrupted seven weeks of dependable shipments to our customers. Worse yet, we had no idea what to tell them.
We had already “no‐showed” at the morning production calls with our customers, so they knew something was up. It was really hard to put a comforting spin on a conversation that went like this:
Chemco: We lost 10 hours of production due to … a visit from the EPA this morning. Customer: A planned visit? What happened? Chemco: We don't know – but I'm sure it's nothing. Customer: Are they coming back? Chemco: We don't know – Hey, we've done a pretty good job of catching up on orders lately, eh? Customer: Are you running now? Chemco: No, we're doing our weekly maintenance, but we'll be up and running in another 24 hours. We'll run through Sunday to catch up. Customer: So, no one knows why the EPA raided your facility today? And you've just taken us to yellow‐light status with two auto factories? Chemco: No, well, but …
The next day we were back up and running and ran the facility hard to catch up on business. Ninety days later, the three largest customers all pulled their business in quick succession. That was 82% of revenue and forced the business into immediate liquidation with the loss of 165 jobs in a town that could not afford it.
So what happened? There were, in fact, dirty waters being released into the county treatment system (never into a natural waterway) and the county tracked it back to the factory. Instead of calling management, they set up monitoring and tracked the factory's releases for over a month. With regularity, exceedingly high discharges were being released late at night. Some as high as 3,000 times the legal limit. Instead of calling management (as had been protocol for the company's 72‐year history) the county called the state who called the EPA and, collectively, they all dreamed of a big headline‐grabbing bust. Then the dirty discharges suddenly stopped. For days, I can only imagine, they waited patiently, stretched thin by the suspense of what might be happening inside the factory. After a week they couldn't take it anymore and came charging through every door in the building at 2:00 a.m.
No one knew it then, but our third‐shift wastewater treatment supervisor had recently checked himself into rehab for a heroin relapse, on the same day that the dirty releases suddenly stopped. No one knows what actually happened, but the best we can figure is that he was concocting strings of hoses to bypass the entire wastewater treatment and monitoring system and would knowingly, willfully discharge bad liquids into the county system. Why? No reason; the best I can figure is something similar to arson that satisfied some insane urge with zero upside value. That's it, an employee had done an awful thing and then left. The EPA was empty handed and upset. I kept telling them to imprison the perpetrator, but to them, busting some junkie drying out in rehab wasn't very appealing. But after making such a public spectacle with our raid, they needed to close the file with an indictment, so eventually they got around to prosecuting the remaining legal shell that once supported 165 families.
I've rehashed this thing repeatedly and come up with the following:
- In retrospect new management should have taken a box of donuts over to the county regulators the first month and invited them over for a factory tour, new management presentation, and a lunch. If we had done that, they would have been much more likely to pick up the phone and not played their dangerous game of Gotcha. I now meet with environmental regulators as standard protocol when I take over industrial facilities.
- Could we have caught this employee's 45‐day bender through more frequent drug screenings and better supervision of supervisors? Maybe, though he faked the log books and had the discharge‐monitoring sensors sitting in buckets of clear water while he simply bypassed them with dirty hoses. It was an unsuspected and brilliantly concealed crime of insanity that led to the most destructive blunder I've ever witnessed.
Every day there are random, unknowable liabilities circling the cosmos looking to wipe out a business. As a CEO or owner, you must be ever‐vigilant.