The Case Against DIY Payroll

Payroll processing is complex, requiring the preparer to stay current with federal, state and local laws and regulations.  Payroll requires not only paying employees but also withholding, reporting and paying social security, Medicare and income taxes. Some small businesses categorize payroll service fees as an unnecessary expense.  My view is that payroll service providers save time, improve compliance and reduce risk.

Complexities

My appreciation of payroll service specialization began in a graduate school tax class. A tax partner from the largest public accounting firm in the state was visiting the class. When payroll taxes came up in a discussion, this seasoned CPA quickly admitted that this area was outside of his or his firm’s expertise; his firm used an outside payroll service for its own payroll processing and compliance. During my career in public accounting, all of my employer firms have utilized payroll service providers.

If you search the IRS website, you’ll find thirty-four listings under Employment Tax Publications (okay, a few are Spanish publications, but there are still many unique titles!). Forty-one states have state income taxes on wages, so a payroll processor needs to digest state regulations and requirements. Local income tax authorities also abound. Employee benefits, SIMPLE-IRA or 401(k) plans, wage garnishments, and employee tips compound the complexity of payroll. Quarterly and annual payroll tax filings are required with stringent deadlines. Federal and state unemployment filings need to be prepared and taxes need to be paid. Does your small business have dedicated personnel able to master this information and then stay current?

Penalties

Income tax authorities want employers to remit employment taxes timely. Deposit penalties can quickly add up for any late or short deposits; the IRS penalties begin at 2% for a deposit made one day late before quickly climbing to 10% or even 15% of the deposit. Federal trust fund recovery penalties are 100% of the unpaid trust fund tax may be applied if the IRS determines the responsible person willfully did not pay the withheld taxes. Civil penalties or even criminal prosecution can occur when taxes are withheld and not deposited with tax authorities. Penalties for late filing of Employer’s Quarterly Federal Tax Return or annual W-2 forms incur additional penalties. Accuracy and timeliness are essential for complying with employment tax laws and regulations, both in filing returns and making deposits. Only federal penalties are touched upon here; state and local authorities will impose their own penalties and interest for late returns or late deposits. Errors are costly.

Employer Responsibilities

Outsourcing payroll saves time for a small business, permitting personnel to focus on key business activities rather than payroll. A good payroll service will have the expertise and systems to ensure that your business payroll tax filings and tax deposits are accurate and timely. As an employer you must be mindful, however, that even if you do outsource your payroll, you are still responsible for the withheld income taxes if your payroll service does not deposit them with tax authorities.

Any search of news stories will reveal numerous examples of payroll service providers that embezzled client funds; this embezzler in New York state stole both the employee net payroll checks as well as the payroll withholdings. A smaller case from the early 2000s stole the payroll withholdings, causing several small businesses to close.

So how can an employer defend against fraud by a payroll service? First, use a reputable firm. National firms such as ADP and Paychex have significant systems in place to prevent this type of fraud. State and local payroll providers may be an option, but they should be vetted carefully; ask your CPA if she has any recommendations.

Next, make sure that the filing address on the quarterly and annual returns is yours and that all notices are sent to your business, not to the payroll service address. Payroll service fraud can occur for longer periods when the notices are sent to the fraudster; you should receive any notices and respond to them quickly.

Conclusion

Payroll processing requires knowledge of and compliance with federal, state, and local laws and regulations. Payroll is a specialized knowledge area that can be subject to many changes over time (think about the Affordable Care Act reporting requirements), with significant penalties and interest being applied to late filings or deposits. I urge small businesses to use reputable payroll services and to put internal controls in place to minimize the risks to employers and their employees.