IRS Outlines Proactive Steps When Outsourcing Payroll Functions

Author: Rena Pirsos, XpertHR Legal Editor

February 3, 2014

Employers commonly outsource some or all of their payroll functions to a third-party payroll service or reporting agent (RA) in order to alleviate the responsibility of withholding income and employment taxes from employees' pay, and for reporting and remitting the amounts withheld to federal, state and local authorities, among many other payroll tasks. While most such services are reputable, employers that outsource payroll duties remain liable if deposits or filings are made late or incorrectly, or in some cases unscrupulously, by a third-party payer or RA.

Even if the third party compensates the employer for a mistake, the employer is still responsible to pay the penalties to the Internal Revenue Service (IRS) as the owner of the employer identification number (EIN) in question. A number of federal courts (e.g., the Third Circuit Court of Appeals and district courts in North Carolina and New York) have agreed with the IRS's position.

Accordingly, to help employers protect themselves from potential liability when outsourcing payroll functions, the IRS offers the following tips:

  • Enroll in the Electronic Federal Tax Payment System (EFTPS) and do not use a payroll service that does not use EFTPS to make tax deposits. EFTPS allows employers, free of charge, to use their EIN to access their payment history and check on whether their payroll service is complying with all tax deposit responsibilities. In addition, if a tax deposit has not been made, the employer can make the missed deposit itself and pay any other business taxes electronically, online or by phone.
  • Do not substitute the third-party payer's address for the employer's address in dealing with tax agencies, even though employers are permitted to do so. This ensures that the employer will receive bills, notices and other account-related correspondence from the IRS. It also enables the employer to monitor the third-party payer and discover any misuse of the employer's funds.
  • Contact the IRS quickly if any bills or notices are received, especially if it involves a payment the employer believes was made, or should have been made, by the third-party payer.
  • Know the special rules that apply to RAs. RAs are required to use EFTPS and file payroll tax returns electronically. In addition, to ensure that employers are made aware of their continuing liability for depositing their payroll taxes and filing their payroll tax returns, the IRS requires all reporting agents to provide their client-employers with a detailed statement to this effect, at least quarterly, when entering into a contract with the employer.
  • Be aware of key employer tax due dates and use the IRS's Small Business Tax Calendar tool to keep track of them.