Tax & Accounting Blog

IRS Cracks Down on Payroll Service Providers

Payroll May 6, 2015

Improvements are needed to safeguard and protect employers that use payroll providers. This was the basis of a recent report sent to the IRS by the Treasury Inspector General for Tax Administration (TIGTA) [TIGTA Audit Report No. 2015-40-023, Processes Are Needed to Link Third-Party Payers and Employers to Reduce Risks Related to Employment Tax Fraud, 3/2/15].

The TIGTA noted that several payroll providers have not been compliant with payments and filing requirements. This is the polite way of saying that several payroll companies have impounded taxes on behalf of their client and then did not remit them.

The audit report also stated that processes are needed to link third party payers to employers, to reduce risks related to employment tax fraud.

TIGTA has classified four types of third party providers:

  1. Payroll Service Providers (PSP), which have two types:
    1. Basic PSPs that prepare signature-ready paper returns for employers to sign and file
    2. PSPs that also impound and pays taxes
  2. Reporting agents are common payroll service companies that are a type of PSP, but also file an 8655 with the IRS, process tax returns, sign as reporting agents, and impound and pay taxes
  3. Section 3504 agents, which file a 2678 with the IRS, report an aggregate return, and withhold and remit taxes
  4. Professional Employer Organizations (PEO) file a return with the PEO Federal Employer Identification Number (FEIN), and impound and pay taxes with the PEO FEIN

The TIGTA report found that processes have not been established to link employers to third parties. Only the Section 3504 agents can be crosschecked. Also, as many PSPs know, the 8655 process is not completely accurate – and sometimes the IRS does not receive the 8655, and thus the connection is not established between the PSP and the employer. Many PSPs find this out when trying to resolve a notice and the IRS representative will not talk to the PSP since the 8655 has not been recorded by the IRS.

TIGTA has made five recommendations for improvement:

  1. The IRS can partner with the Bureau of the Fiscal Service to develop a plan to use the Electronic Federal Tax Payment System (EFTPS) to link the PSP with an employer. The IRS agrees with this recommendation.
  2. The IRS can establish a program whereby employers can inform the IRS of their PEO relationship and establish a certified PEO system. The IRS partially agrees with this recommendation, but does not have a budget to enforce this program.
  3. PEOs can attach a Schedule R (details of the individual clients) to the 941 filed each quarter. The IRS stated that they do not have the authority to require this with non-certified PEOs.
  4. The Commissioner, Wage and Investment Division, can develop a process to ensure 8655s are captured in the IRS system accurately. The IRS agrees with this recommendation (PSPs, rejoice!).
  5. The IRS can develop a process to ensure Section 3504 agents’ indicators are accurate. The IRS also agrees with this recommendation.

It should be noted that Rev Procedure 2012-32 is in effect, and PSPs are required to clearly state the IRS rules for impounding and remitting taxes in writing every quarter. Employers are also encouraged to check the deposits by enrolling in EFTPS. The language must be exact or similar to the following:

Please be aware that you are responsible for the timely filing of employment tax returns and the timely payment of employment taxes for your employees, even if you have authorized a third party to file the returns and make the payments. Therefore, the Internal Revenue Service recommends that you enroll in the U.S. Treasury Department’s Electronic Federal Tax Payment System (EFTPS) to monitor your account and ensure that timely tax payments are being made for you. You may enroll in the EFTPS online at, or call (800) 555- 4477 for an enrollment form. State tax authorities generally offer similar means to verify tax payments. Contact the appropriate state offices directly for details.

Certain states have chimed in, as well. Today, Maine is the only state that requires PSPs to be licensed and bonded to provide common payroll services. Maryland and, most recently, North Carolina are also considering legislation.

In my opinion, it is significantly better if the federal government embraces this effort, instead of the possibility of having rules from 50 different states in the future. In the meantime, we’ll continue to watch for developments.