Tips for Payroll Outsourcing

By Stephen J. Dunn

Does your business use an outside payroll service?  Are you thinking of using one?

Payroll service companies perform an important function assisting employers comply with laws.  But these services also pose risks for employers.

There are three categories of payroll service companies.  In all three categories, the payroll service company computes employees’ withholdings and net pay, compiles payroll accounting records for the employer, and prepares payroll tax returns for the employer.

The first category of payroll service companies are payroll service providers (“PSPs”).  A PSP prepares payroll tax returns using the employer’s employer identification number (“EIN”).  The employer signs and files the tax returns.

The second category of payroll service companies are reporting agents (“RAs”). An RA prepares payroll tax returns using the employer’s EIN, signs them for the employer, and files them.

The third category of payroll service companies are Section 3504 agents, also called professional employer organizations (“PEOs”).  A PEO purports to take over as employer for designated employees.  A PEO prepares payroll tax returns using its EIN, and signs and files the returns.

An IRS table compares the three categories of payroll service companies.

Employers transfer to a PEO funds to cover their net pay, payroll tax withholdings, and other payroll withholdings, such as 401(k) plan contributions or health or dental insurance premiums.  The PEO undertakes to pay the net pay to the employees, the payroll taxes to the taxing authorities, the other withholdings to the persons entitled to them.  An RA similarly receives employer funds.  A PSP may receive employer payroll funds.

The risk, of course, is that a payroll service company will receive employer payroll funds but fail to remit them to the employees, taxing authorities, or others entitled to them.

The IRS cautions that an employer who contracts with a payroll service company remains liable for filing its payroll tax returns and depositing its payroll taxes.  A contract between a payroll service company and an employer is a creature of state law.  Under the U.S. Constitution, Federal law, including Federal tax law, is the supreme law of the land.

The IRS often prosecutes payroll service company principals for failing to pay over to the IRS payroll tax funds which they have received from customers.  But this is little consolation to the employers who must to pay their payroll taxes a second time, or to all of us who work our entire careers paying into the Social Security trust fund only to have it compromised by such schemes.

One of my clients, a physician whom we shall call Dr. A, used a well-known payroll service company in his medical practice.  Dr. A’s contract with the payroll service company  called for payroll taxes to be automatically withdrawn from Dr. A’s practice bank account and paid over to the taxing authorities.  Dr. A’s office manager was constantly angling for more power—a very bad characteristic in an employee.  The office manager quietly discontinued the payroll tax direct deposit feature, and embezzled the funds which should have been used to pay Dr. A’s payroll tax obligations.  The office manager had embezzled large sums in this manner before the scheme was discovered.  Dr. A remained personally liable for payroll taxes withheld from his employees’ wages but not paid over to the taxing authorities.  Dr. A had hired the office manager on the recommendation of his prior attorney.  At the time the prior attorney recommended the office manager to Dr. A, the prior attorney was defending the office manager from having embezzled from his prior employer, also a physician.  Dr. A did not learn of the embezzlement perpetrated the office manager against his prior employer until Dr. A began investigating the office manager’s embezzlement perpetrated against Dr. A.

If there are issues with an account, the IRS will send correspondence to the employer at the address of record.  The IRS strongly advises that an employer keep its address as the address of record with the IRS, and not change its address of record to that of the payroll service company, to keep informed of tax matters, and not facilitate an embezzlement of the employer’s employment tax funds.

The IRS urges employers to use the Electronic Federal Tax Payment System (“EFTPS”).  EFTPS enables employers to confirm that Federal tax deposits are being made on their behalf.    Treasury regulations require employers incurring payroll over $200,000 in Federal payroll taxes in a calendar year to use EFTPS, but all employers should use EFTPS.    When an employer registers on EFTPS it will have on-line access to its tax payment history for 16 months.  EFTPS also enables an employer to make tax deposits which its payroll service company does not make on its behalf, such as estimated income tax payments.

I prefer large payroll service companies.  They are more likely to be in existence and able to pay a claim caused by their malfeasance.    Larger payroll service companies are also likely to have tested and effective systems in place to serve employers.  Before using a smaller, local, payroll service company, an employer should ensure verify that the company is bonded against employee dishonesty.  Before using any payroll service company, an employer should inquire about the company with attorneys, accountants, bankers, and other employers.

There is no substitute for an entrepreneur remaining in touch with his or her business, and practicing effective checks and balances in the business.

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