Using an Outside Vendor to Process Payroll Has Risks

By Jeffrey D. Davine

Companies who rely on third-party vendors to make their federal and state payroll tax deposits need to be diligent when selecting the vendor. A bad choice can be very expensive.

Processing payroll and remitting the required federal and state income and employment taxes to the appropriate government authorities is burdensome. As a result, many companies delegate these tasks to a third-party payroll company. In most situations, this arrangement works out well. The payroll company withdraws the required funds from the company’s bank account and ensures that employees and the various government agencies are timely paid. This allows company management to focus on more important things, such as satisfying its customers/clients and making money.

When this arrangement doesn’t work as planned, it has the potential to be disastrous for the business. A case that has been widely reported in the news over the last month provides empirical evidence of this. Approximately 150 businesses recently discovered that the owner of a payroll company that they had engaged to process their payroll taxes stole their funds. It appears that Tovmas Grigoryan, the owner of LA Payroll, withdrew approximately $4 million of funds that LA Payroll was holding on behalf of its customers and left the country. The stolen funds were earmarked to pay the federal and California employment tax obligations of LA Payroll’s customers. Although Grigoryan (and the funds) are gone, the payment obligation of each of LA Payroll’s customers remains.

Handing over payroll taxes to a third party with the expectation that the third party will remit the taxes to the government doesn’t relieve the entity that owes the taxes from its payment obligation. In other words, the company that owes the taxes still owes the taxes because neither the Internal Revenue Service nor the California Employment Development Department cares that the taxes were sent to a third party- the IRS and the EDD take the position that they didn’t get paid and, therefore, are still owed the funds. This means that LA Payroll’s customers will likely be required to pay these taxes twice and some of them are facing tax liabilities of several hundred thousand dollars. In addition, the IRS and the EDD will tack on interest and penalties because the taxes were not timely received. Although in some instances the penalties may be abated, it’s not automatic.

Unfortunately, payroll companies are not subject to strict regulation by the government. As a result, the responsibility for ensuring the reputability of the payroll company being used falls on the client business.

To reduce the chances of becoming a victim, a business should investigate the payroll company that it uses and satisfy itself that the company is trustworthy. They should determine how long it has been in business and its reputation. They should also try to obtain information about its owners. Requesting proof that a liability insurance policy is in effect (and the policy limits) is also a good idea. In addition, a business should avoid the payroll company impounding its taxes. Instead, the taxes should be transferred directly from the business’ account to the appropriate government agency. Doing some detective work now can prevent a lot of grief later.

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