How to Prevent Tax Fraud By 3rd-Party Payroll Tax Services

Collecting and remitting payroll taxes is no fun. For decades the dominant third-party providers were ADT and Paychex. In the last 20 or so years thousands of small independents have emerged.  Some do a great job, some don’t.

The payroll tax industry is very competitive; the work is fairly complex and the exposure to errors is great. Even if a payroll tax provider does a fantastic job they can be at the mercy of state and federal taxing authorities that can miss post a payment or misplace a return, creating havoc for the payroll service and its customers.

Many of our clients use third-party services, or even employee leasing companies, and most process thousands of paychecks, tax returns, reports, and informational returns without a hitch.  When there is an error, it is usually resolved with letters and phone calls.

Beware: Mismanagement of Client Funds

There is an issue that isn’t so easy to resolve — the mismanagement of client funds by third-party providers. As any business owner is aware, employment taxes are paid to taxing authorities on a regular basis depending upon the type of tax, size of payroll and other factors.

The IRS, for example requires that these deposits be made on line utilizing the Electronic Federal Tax Payment System (EFTPS). Most third parties draft the entire amount of a payroll (including taxes) from an employer’s bank account on payday, and deposit the funds back into employees’ bank accounts and transfer taxes and withholding to taxing authorities, etc.

This works very well until it doesn’t. We have seen several instances in which the payroll service transferred the funds from our clients’ bank accounts, and then under deposited (or failed to deposit) the funds with the taxing authorities, namely the IRS.

We are currently dealing with a very elaborate Ponzi-type scheme in which the service moved payments from period to period and taxpayer to taxpayer in an attempt to cover up the malfeasance. We caught it early and are working with the IRS to help our client resolve the situation, but unfortunately there is case law that holds an employer liable for payroll taxes, even if they were paid to a payroll service.

The IRS is also concerned about this. A dishonest payroll service can bilk taxpayers, and the IRS, out of millions before anyone suspects anything. What can you do to lower your exposure? Make your tax professional know that you are using a third-party payroll service.

Most professionals can show you how to set up dual notice reporting letting you know about tax deposit activity or lack thereof. We work with our clients to set up Failure to Deposit (FTD) alerts with the IRS so that they are immediately aware of issues with deposits, as opposed to finding out about it a year or two after the fact when a revenue officer drops by to see why you haven’t been making deposits.

Your tax professional should help you fill out forms and make reports that will ensure that your case gets expedited and that the fraud taskforces become aware of it. Also beneficial is a tax professional with a line of communication with IRS enforcement personnel so that they can quickly investigate these situations and attempt to recovery undeposited funds.

If noting else, giving a heads up to the IRS may help to mitigate or even eliminate penalties, which could be as much as 100% of the taxes that you have already paid or reemitted.

Getting into trouble with the IRS collections department is no fun. Doing everything right, yet still getting into trouble is a nightmare.


Mitch Reitman is Management Principal of Reitman Consulting Group and is a member of the SSI Industry Hall of Fame

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