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Payroll Outsourcing, Part 2: Types of Third-Party Arrangements

In the previous post, we laid out the central tax compliance challenge for businesses that outsource payroll services.

Contracting with third-party providers to handle time-consuming withholding and employment tax payment tasks is a sound management decision for many small businesses. But if a payroll processor engages in fraud or experiences financial problems, the business that hired the processor may still be liable for taxes that should have been paid.

In this post, we look at three basic third-party arrangements that are available. Each arrangement grants a somewhat different level of authority to the third party.

Let's start with Reporting Agents (RAs). RAs are agents authorized by employers to make necessary tax deposits and file required information with government agencies. Employers authorize RAs to do this with Form 8655.

The RA makes deposits and pays taxes for its client, using the client's Employer Identification Number (EIN). But the client, not the RA, is ultimately liable if timely and accurate deposits and payments are not made.

Like Revenue Agents, Payroll Services Providers (PSPs) make deposits and pay taxes using their client's EIN. RAs generally file for clients electronically, whereas PSPs prepare paper returns that are filed either by the client or the PSP. As with RAs, it is the client, not the PSP, that is ultimately liable for employment tax compliance.

The liability status is different for another type of third party, called Form 2678 agents. Form 2678 agents essentially act as the employer, taking on liability for the client's employment taxes. This means that both the client and the Form 2678 agent are liable for making proper deposits and payments of employment taxes.

If you are an employer and are unsure about which third-party arrangement you should use, it makes sense to talk with an experienced tax attorney. As this brief survey of the options suggest, there are many nuances that you need to consider when seeking the right arrangement for your particular circumstances.

Source: IRS.gov, "Third Party Arrangement Chart"

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