Using a third party payroll service can be an effective business practice, but as an employer you must always understand your tax obligations.
When making the decision to outsource payroll functions, the employer must use care in finding a provider that has the reputation and proven track record for servicing its clients. Doing research online, through business associates, trade groups, or other trusted sources is critical. In the end the decision to employ a payroll service provider is far-reaching and can be key to the success or failure of your enterprise. Due diligence and care are essential in your choice and once that choice is made, follow the advice of President Ronald Reagan: “Trust but Verify.”
There are several categories of third party payroll service providers that can be utilized depending on the level of service needed and the degree to which you want to delegate your role in the process.
Payroll Service Provider (PSP)
The Payroll Service Provider (PSP) is the most common type of third party provider used by small businesses. PSPs typically prepare employee paychecks, prepare payroll tax returns, make tax deposits and payments, and provide employee W2 forms at the end of the tax year. The employer signs and files the tax returns when using a PSP. When an employer uses a PSP, the employer remains liable for all tax return filings as well as payments. The PSP does not have any liability.
Some businesses utilize the services of a Reporting Agent which differs from a PSP primarily in that the Reporting Agent can sign and file tax returns for the employer. Reporting Agents must be authorized to act through the use of IRS Form 8655 which allows them to sign for the employer. As with the PSP, the employer remains ultimately liable for filing and payment of all taxes. The Reporting Agent carries no liability.
Section 3504 Agent
The final category of providers is the Section 3504 Agent. This category of provider takes on additional responsibilities and is authorized to do so through IRS Form 2678. Due to the more complex nature of the relationship, the 3504 Agent is most commonly used by a larger business. Due to their additional functions and responsibility, this category of provider can be held liable for failures to file or pay over taxes. Even though the 3504 Agent can be held liable, the employer is also liable for the ultimate filing and payment of company taxes.
Keep the following in mind if you decide to employ a third party payroll service provider:
Ř The employer is ultimately responsible for the deposit and payment of federal tax liabilities.
Ř Even if you transfer funds to the provider, you do not transfer your liability, and if the provider fails to turn over the funds to the IRS, you will be held responsible for the unpaid tax, penalties and interest.
Ř IRS may hold officers and key employees within a company personally responsible for unpaid taxes that the company cannot pay.
Ř IRS will correspond with the employer if there are problems and the employer is held accountable for responding to notices or inquiries. It is critical that steps are taken to ensure that the address Internal Revenue Service has for the employer is not that of the payroll service provider so that correspondence is properly directed to the company and not the provider.
Ř Virtually all federal tax deposits are made via the electronic Electronic Federal Tax Payment System (EFTPS). Employers must ensure that the provider is using the EFTPS system. In addition, the employer should register on the EFTPS system and then verify that payments are being made. By doing so the employer can spot problems, make deposits if necessary, and be alert to issues as they develop.
Ř It is critical that the employer maintain a close ongoing relationship with their provider and that the employer contact the IRS if they see problems that are not fully resolved.
Even when payroll service providers are prosecuted in those cases where fraud is committed or funds are deliberately stolen, the employer remains liable for the unpaid taxes and must either pay them or face the potential of financial ruin.
Recently, a payroll service provider filed bankruptcy in the Western District of North Carolina located here in Charlotte. A number of businesses had relied on the provider to pay over their taxes to the Internal Revenue Service and the various departments of revenue; however, the provider had failed to turn over funds it held on behalf of the clients.
The end result is that the various clients have been required to pay the tax twice, first by turning over funds to the provider for deposit, and second by having to pay out those same amounts, plus penalty and interest, to the IRS and state tax authorities.
This is the type of costly lesson that few businesses can afford to learn and one that might have been avoided had the businesses exercised diligence in maintaining an overview of their tax matters through available resources such as the EFTPS system and by attending to correspondence generated by the taxing authorities.
The choice to use a third party payroll service provider can be a valuable approach to growing your business but it is one which must be attended to with care, requires ongoing commitment to monitor the process, with the absolute understanding that you, the employer, are in the end responsible for your taxes.