Avoiding Payroll Tax Problems

Avoiding payroll tax problemsHiring a third-party vendor can help, but liability remains with your company


Editor’s note: This article is intended for educational purposes only. Consult your tax adviser or attorney for specific guidance regarding your business and its payroll operations.

The IRS often is viewed as being tough when it comes to collecting income taxes, but as many companies can attest, it is even tougher where payroll taxes are concerned: Businesses can get into trouble because they don’t understand the complexity of U.S. payroll tax laws.

Payroll tax complexity may be why nearly 40% of small businesses use a third-party payroll service. While outsourcing the payroll process to an outside company may help with on-time returns, employment tax withholding and forwarding, and even the payroll itself, in the eyes of the IRS, it is the employer who remains liable for any problems. We’ll look at some of the benefits of hiring an outside firm and some of the potential problems.

Defining ‘payroll’ taxes

Every business with employees is required to withhold payroll taxes from paychecks and to pay all applicable federal, state and local taxes. Taxes typically withheld from employee paychecks include FICA (Medicare and Social Security taxes, as required by the Federal Insurance Contributions Act) and any applicable federal, state and local income taxes. Other withholding obligations include FUTA (Federal Unemployment Tax Act) payments and, in several states, disability insurance taxes.

Failure to pay these taxes or even missing a single payment may result in heavy fines and penalties, making it extremely important for every company to calculate accurately the amount of payroll taxes it owes—and to pay it on time.

Who is responsible?

When the IRS attempts to collect payroll taxes from a company that failed to withhold or forward them as required, it can and will go after all “responsible persons.” In fact, the IRS can levy a Trust Fund Recovery Penalty against every responsible person, which, it defines as a person who: (1) is responsible for collecting, accounting for and paying over payroll taxes; and (2) willfully fails to perform this responsibility. 

To the IRS, “responsible person” means not only an operation’s bookkeeper or accountant, but also the owner, officers, directors and, in fact, anyone who makes decisions about whom to pay or who has check-signing authority. What’s more, the rules allow the penalty to be assessed against multiple “responsible persons,” with each person liable for a penalty equal to 100% of the unpaid taxes, plus interest.

Although a person must be both “responsible” and “willful” to be liable, the burden of proof of innocence falls on the shoulders of the individual.

Hiring a third-party service

When it comes to paying employees, it’s not just about keeping track of the number of hours worked and then cutting a few checks. Anyone not well-versed in accounting and payroll processing can be downright overwhelmed and may turn to an outside payroll service to make sure all taxes are paid in full and on time. Working with a payroll partner also enables the business owner and other top managers to focus on other parts of the operation.

When choosing a third-party vendor, it’s always a good idea to see whether your financial institution offers payroll services. Often, banks consider payroll processing a courtesy, which means their price can be lower than what other payroll processing companies may charge.

For those worried about the cost of working with a payroll partner, consider the 2014 Small Business Taxation Survey published by the National Small Business Association, which showed that some small business owners spend the equivalent of three weeks every year dealing with payroll taxes. Some 43% of those surveyed spend between three and 10 hours a month working on payroll taxes and 11% spend more than 10 hours each month.

According to the survey, these taxes come with a heavy price tag as well, with more than a quarter of businesses spending more than $10,000 each year on simply the administration of federal taxes. This doesn’t include the actual tax burden, which 42% of respondents said creates the largest burden on their business.

Potential pitfalls

Before hiring an outside vendor, companies should be aware of their own potential liability, even when using a third party.

A company that decides to hire a third-party vendor hopes the vendor understands how to fill out the forms necessary for reporting income and employment taxes, complies with Patient Protection and Affordable Care Act reporting obligations, and properly calculates and pays in a timely fashion the withheld employee income tax and both the employer and employee’s respective shares of employment taxes. Most employers believe that if they pay income taxes and employment taxes into a vendor’s account or give a vendor authorization to withdraw taxes from the employer’s accounts, those taxes will be paid to the government.

Unfortunately, there are too many situations in which actual vendor performance doesn’t meet employer expectations. Worse, there are times when an employer discovers that funds set aside to pay necessary payroll taxes don’t get paid to the U.S. Treasury as required. Even worse, many employers are shocked to discover that the employer, not the payroll service company, is liable for all unpaid income and employment taxes, even if the taxes were paid to the vendor or withdrawn from the employer’s accounts by the vendor.

Stay informed

When it comes to payroll taxes and avoiding the wrath of the IRS, a good start for all companies is having a basic understanding of the rules for withholding taxes and paying the withheld amounts to the federal government. Next, make sure you check up on the actions of any third-party payroll service you hire. Lastly, seek guidance and advice about the particulars of your business from a competent, qualified tax adviser. 

Problems within the IRS

Every year, stories about indictments and convictions for tax evasion send a scare into taxpayers, usually just as it comes time to file annual tax returns. Earlier this year, those stories were eclipsed by news about an uptick in identity-theft tax fraud. However, a report from the Treasury Inspector General of Tax Administration warns of another big problem: When the IG recently looked at the IRS’s handling of payroll taxes, the IRS was faulted for not cross-checking and verifying payroll services and the companies for which they act. Because of the snowballing nature of payroll tax liabilities, it is important for the IRS to detect and respond immediately when payroll tax defaults occur.

As the IG noted, third-party payer arrangements usually work as intended, although there have been instances in which third-party vendors receive funds from employers for payment of payroll taxes, but fail to remit those taxes to the federal government. This can cause significant problems for employers because, even though the funds have been expended, the taxes still are due. Are the IRS’s controls adequate to protect both the taxpayer and government’s interests when third-party payroll providers don’t comply with payment and filing requirements? Perhaps not.

According to the IG report, processes still have not been established to link all employers with all third-party payers. Of the four most common types of third-party payer arrangements, only a few so-called reporting agents are required to submit an authorization form that discloses the relationship between the employer and the third-party payer. The IRS doesn’t require a similar authorization for employers that use the bulk of payroll services. Adding to the problem, authorization forms are not always processed accurately. The IG’s review of 85 agent-authorization forms processed in 2013 identified 11 forms with errors.