It’s understandable: Being that the various federal, state and local payroll tax systems can be very complex, many small businesses choose to outsource their payroll processing and employment tax filing to third-party payroll service providers. Two recent reports of misappropriations by local third-party payroll service companies, however, highlight the dangers of outsourcing payroll services. In these situations, a third-party payroll service collected payroll taxes, but failed to transfer such funds to the IRS or other tax authorities. The Internal Revenue Code (and corresponding state and local statutes) hold the employer fully responsible for the reporting of its income and employment tax withholding and payment obligations. Accordingly, if an outside payroll service fails to make the tax payments, the employer remains liable for the outstanding taxes as well as any related penalties and interest.
The IRS, along with numerous courts, has concluded that reliance on a bookkeeper, controller or outside payroll service is not a reasonable cause for failure to pay withholding taxes and does not excuse an employer’s failure to comply with the tax statutes in a timely fashion, even when the payroll agent embezzles the employer’s tax payments. Similarly, reliance on an agent and evidence demonstrating that the employer exercised ordinary business care and prudence in selecting and monitoring the agent is often insufficient to warrant abatement of any related penalties.
There are steps you can take to protect yourself from these problems. If you decide to retain an outside payroll processing firm, you should be aware of your continuing liability under the tax statutes. You should follow the advice provided by the IRS in a March 2006 article published by the IRS Small Business/Self-Employed Communications Office in the SSA/IRS Reporter (nprc-inc.org/d_govc/ssa_irs_ reporter_spring_06%20article.pdf) and in an April 2004 IRS consumer alert (irs. gov/newsroom/article/0,,id=122521,00. html):
(1) exercise due diligence in selecting a third-party payroll service, (2) ask the third-party payroll service if it has a fiduciary bond in place that could protect you in the event of default, (3) ask the service provider to enroll in and use the Electronic Federal Tax Payment System (EFTPS), a free service offered by the U.S. Department of the Treasury, so that you can confirm payments made on your behalf, (4) enroll in EFTPS to make any additional tax payments and (5) never allow your address of record with the IRS to be changed to that of the service provider, because the IRS sends correspondence to the address of record and changing your address could significantly limit your ability to stay well informed of relevant tax matters.
Remember, a little caution goes a long way toward protecting yourself from a payroll scam — and protecting your reputation as a taxpayer.