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Third-Party Payroll Services Are Not Always the Best Option

Managing the many aspects of a small business is a lot to keep up with. For many small business owners, the answer is to use outside service providers to handle aspects such as bookkeeping, information technology, and payroll. According to the National Small Business Association, approximately 40% of small businesses now use third-party payroll services.

What these small businesses usually don't know is that, while they can delegate the authority to handle federal payroll taxes to a third-party, they cannot delegate the duty to do so. In other words, if the third-party fails to properly withhold or pay taxes to the federal government on your behalf, the IRS will not only come to you for payment of those taxes, but you will also be the one responsible for any applicable late filing and late payment penalties. These liabilities, which often span several quarters or even years, can be devastating.

While you can request abatement of the penalties, the grounds for such relief can be confusing and difficult to meet. The courts have long held that failure on the part of an employee or third party to timely comply with tax obligations does not constitute reasonable cause. United States v. Boyle, 469 U.S. 241 (1985). Essentially, the courts hold that "misplaced reliance" is generally not an excuse for failure to meet one's obligations. In order to prevail, the business must show that it exercised "ordinary business care and prudence" to ensure that its obligations were timely met.

It gets worse. If you are a business owner, you could be personally liable for 100% of the owed taxes under the dreaded Trust Fund Recovery Penalty (TFRP), regardless of the protections generally offered by your entity structure. This penalty, contained in Section 6672 of the Internal Revenue Code, makes any "responsible person" who willfully fails to pay withheld taxes to the IRS personally responsible for the entire amount of the owed taxes. If you are an owner or manager of a business, or otherwise have check-signing authority, the IRS will likely consider you to be a "responsible person." Authorizing payments to other creditors, while knowing that payroll taxes are overdue - including payments to employees or to yourself - can be enough for a finding of willfulness.

To combat this growing problem, there have been proposals to more strictly regulate third-party payroll service providers. As of now, these providers are subject to little, if any, licensing requirements. Some of the proposed new rules include requiring payroll service providers to post a bond that would cover any lost tax payments, and requiring that all providers file a record of tax payments that is available for all clients to see.

For more information on relief from employment tax penalties, as well as options for paying employment tax liabilities, please visit our web site section on business and employment tax matters.

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