Many small businesses handle payroll in-house, but a growing number outsource this task to a third party. There are different types of payroll companies. And there are very good reasons why you might want to use one of them if you don’t already do so. But caution is advised.
Types of payroll companies
You can use a third party to help you meet your payroll obligations. Depending on the scope of services you use, this help can include:
- Calculating employee withholding.
- Paying employees’ paychecks (by paper or direct deposit).
- Making federal and state tax deposits.
- Preparing employer tax returns (e.g., quarterly Form 940). This can be federal and state-level returns (e.g., state unemployment tax returns).
- Preparing and distributing employees’ W-2s and submitting the annual transmittal to the Social Security Administration.
If you outsource payroll tasks, you have several types of options:
- Payroll Service Provider (PSP)—a company that agrees to perform any or all of the tasks listed earlier.
- Reporting Agent (RAF)—a company that informs the IRS of its relationship with you (you authorize the company). The RA is required to file returns electronically and can exchange information with the IRS to resolve issues.
- Section 3504 Agent—a company much like an RAF but assumes joint liability for FICA and withholding taxes.
- Professional Employer Organization (PEO)—a company that performs some or all employment-related tasks, including payroll. This arrangement is often referred to as co-employers because you make hiring and firing decisions while the PEO handles payroll. You remain liable for employment taxes because the IRS is not bound by any agreement you have with such company.
- Certified Professional Employer Organization (CPEO)—a company certified by the IRS to perform employment tax withholding, reporting, and payment functions. Generally, the CPEO is solely liable for these responsibilities. You can find a list of CPEO in the IRS’s voluntary certification program for PEOs. Be sure to check the list of revoked CPEOs.
Why outsource payroll responsibilities
Payroll is becoming increasingly complicated. During 2020, for example, there have been:
- Required payments by small businesses to eligible employees for sick leave and family leave
- An option to defer payroll.
- The employee retention credit, which is an offset to employment taxes.
- The Paycheck Protection Program (PPP) loan, which anyone who applied knows how important accurate payroll information needs to be.
Despite complications, outsourcing payroll is a good business practice to give you and your staff more time for operating your business. These payroll services likely are more knowledgeable about how to handle payroll responsibilities and monitor changing rules. The cost of paying a third party to do payroll cannot be ignored, but there may be no savings in DIY if you make mistakes and are subject to penalties.
What to keep in mind
Even if you use a third party to handle payroll to deposit payroll taxes, your business may remain liable for unpaid taxes—either entirely or jointly and severally liable, depending on the third party you use for payroll.
You can protect yourself by taking a few simple steps:
- Use a reliable payroll service. As with any service provider you use, get referrals, check references, and avoid any provider making unreasonable for fraudulent promises (such as hiding payroll expenses). The big two in payroll are ADP and Paychex.
- Be sure to check on payroll deposits for your account. Make your deposits through EFPTS.gov and check your account regularly.
- Look for IRS notices. The Service must tell you if there’s been a change of address for your account. If you didn’t authorize it, this is a heads up that your payroll firm is doing something shady.
If you suspect your payroll service provider is doing something improper or fraudulent with tax deposits, file a complaint with the IRS. Use Form 14157 for this purpose and the IRS will investigate.
The IRS has a fact sheet with more information about third-party payroll providers.