Protect yourself when outsourcing payroll

As an employer, you have many obligations to the federal and state taxing authorities. Among these are requirements that you withhold and pay over Social Security, Medicare and income taxes. The administrative complexities of payroll taxes can cut into the time that you need to run and grow your business, prompting many small employers to outsource the process.

Many small employers contract with a third-party payroll provider to handle some (or all) of their employment tax duties. In addition to lightening your workload, using a reputable and reliable payroll service helps to ensure that filing deadlines and deposit requirements are met.

Match the service to your needs

There are three common third-party arrangements: Payroll Service Providers, Reporting Agents, and Section 3504 Agents. Whether you have the sole responsibility for payroll taxes, or become jointly liable for payroll taxes, varies based on the type of service you use. However, you are never completely off the hook!

Payroll Service Provider (PSP). This is the most common arrangement for a small business. A payroll service provider (PSP) typically prepares employment tax returns for signature by its employers/clients and processes the withholding, deposit and payment of the associated employment taxes. You can authorize your PSP to perform one or more of the following acts on your behalf:

• Prepare the paychecks for your employees;
• Prepare your required Forms 940 and 941, using your employer identification number (EIN);
• File Forms 940 and 941 after you have signed them;
• Make federal tax deposits (FTDs) and federal tax payments (FTPs);
• Submit FTD and FTP information for the taxes reported on the Forms 940 and 941; and/or
• Prepare Forms W-2 for your employees using your EIN.

Using a PSP does not relieve you from your employment tax responsibilities. You are solely responsible: the PSP assumes no liability for your employment tax withholding, reporting, payment, and/or filing duties.

Reporting Agent (RA). The major difference between a PSP and a reporting agent is the fact that a reporting agent can actually sign employment tax forms (such as Form 940 and Form 941) on your behalf. You must complete Form 8655, Reporting Agent Authorization, if you want your PSP to be able to act as a reporting agent and e-file Forms 940 and 941. Using a reporting agent does not relieve you from your employment tax responsibilities. A reporting agent assumes no liability for the employer/clients' employment tax withholding, reporting, payment, and/or filing duties.

Section 3504 Agent. Larger businesses may appoint an agent under Internal Revenue Code section 3504 to undertake the withholding, reporting and payment of federal employment taxes with regard to wages paid by the agent for the employer, as well as the agent's own employees. This is done using Form 2678, Employer/Payer Appointment of Agent. A section 3504 agent agrees to assume liability along with the employer for the employer's Social Security, Medicare and federal income tax withholding responsibilities. 

An agent files aggregate returns (e-file or paper) using the agent's EIN. The IRS can seek to collect any unpaid employment taxes from both the employer and the section 3504 agent who was designated and authorized to pay the taxes. (The section 3504 designation does not apply to FUTA tax, with a limited exception provided for certain household workers.)

You are ultimately the responsible party

You may have outsourced your payroll function to a third party, but you are ultimately responsible for withholding, depositing and paying the federal tax liabilities associated with your business. Even if you forward the tax amounts to your service, expecting them to make the tax deposits, you are the responsible party for the payment of income taxes withheld, and both the employer and employee portions of Social Security and Medicare taxes. This is true even if you were to use a section 3504 agent, although the agent will be co-liable.

As an employer, you are liable for all taxes, penalties and interest due—even if your third-party provider makes off with your payroll tax money. If your service fails to make the federal tax payments, the IRS may assess penalties and interest on your account. You may also be held personally liable for certain unpaid federal taxes.

Four tactics to protect yourself 

Use your name and address. If there are any problems with your account, the IRS will send correspondence to your address of record. For this reason, the IRS strongly suggests that you do not change the address of record to that of the payroll service provider. Doing so may significantly limit your ability to be informed of tax matters involving your business. This is extremely important, since many IRS communications are time-sensitive, and a delay in response can trigger the next level of IRS action.

Know the Tax Due Dates.  Make sure that you know when your taxes are due. The IRS warns that a red flag should go up the first time your service provider misses a payment or makes a late payment. Take action immediately to terminate the service and to ensure that your account status is current.

Monitor What Your Service Is (or Is Not) Doing. Virtually every business is now required to use the Electronic Federal Payroll Tax System (EFTPS) for payroll taxes. You should register on the EFTPS system to get your own PIN and use this PIN to periodically confirm that the required payments are being made on your behalf. Registration with EFTPS gives you online access to your account payment history for the past 16 months. 

To enroll, or to obtain additional information, visit the Electronic Federal Payroll Tax System website or call 1-800-555-4477.  

Contact the IRS Immediately.  If you notice that your outsourcer has missed payments or has paid late, take immediate action.  In addition to terminating the contract, notify the IRS and take steps to get back into compliance.  You won't save any money on the tax liability itself, but you may be able to avert costly penalties.  

The same rule applies if your first indication of a problem comes in a letter from the IRS.  In that case, call the number provided on the letter.  You can also write to the IRS office that sent the document or call the IRS business tax hotline at 1-800-829-4933.  Whatever method you chose, act swiftly.