Protecting Yourself from Payroll Tax Fraud
By Jagruti Solanki, assurance senior manager
As an employer, your company has the vital role of managing payroll tax responsibilities, including things like withholding and remitting payroll taxes to federal, state and local authorities. But where there is access to money, there is motive, and this combined with collusion can lead to fraud. So how does payroll tax fraud happen? And what can you do to prevent it?
The why and the how of payroll tax fraud
Companies processing payroll internally are usually more vulnerable to payroll tax fraud than companies using outsourced payroll service providers. A lack of proper controls over payroll functions and the segregation of duties among personnel managing these functions are two of the biggest reasons companies become vulnerable to payroll fraud.
Here are just a few examples of ways that payroll fraud can happen to companies processing payroll in-house:
- Pyramiding – In a pyramiding scenario, employers do not remit the payroll tax withheld from employees and continue to accumulate (or pyramid) withheld taxes, with the intent of using government funds as “borrowed money” for a short while. In such cases, the IRS can make personal assessments against all persons responsible who have ownership in the company. The IRS can also assess a Trust Fund Recovery Assessment, where the owner is liable for a penalty that equals 100 percent of the unpaid taxes. Once assessed, these trust fund penalties cannot be discharged into bankruptcy.
- Misclassification of employee status – Employees sometimes get listed as independent contractors, either erroneously or intentionally, which indicates payroll tax evasion. In such cases, the employer does not get tax relief for not treating an individual as an employee and is considered liable for payroll taxes and penalties.
- Lack of technical expertise of payroll tax laws in-house – Most small businesses lack the technical expertise to deal with complex payroll tax calculations, including multijurisdiction taxes. With their limited resources, it can be a challenge to acquaint themselves with the plethora of changes that sweep the payroll field. For example, some S-corporations treat officer compensation as corporate distribution and do not pay payroll taxes.
Companies that use a third-party payroll provider can still reap the consequences of payroll tax fraud. If the employer’s third-party payroll provider fails to make the federal tax payments, the IRS may assess penalties and interest on the employer’s account and can even hold the employer personally liable for certain unpaid federal taxes.
Failure to pay employment taxes, whether intentionally or erroneously, has serious financial and criminal consequences. The IRS can impose an audit, file tax liens on employer property and levy significant restitution for the taxes evaded (or construed to have been evaded), plus interest and penalties. The IRS can also file civil action lawsuits that could result in criminal convictions. In cases of employee embezzlement of payroll funds where payroll taxes have not been remitted, owners are still held liable.
How you can protect yourself from payroll tax fraud
If your company is processing payroll in-house, then consider implementing a system of checks and balances designed to curb payroll fraud. Here are some suggestions:
- Restrict access to the payroll system and payroll records to authorized personnel in appropriate departments only.
- Activate the tracking option in a computerized payroll system to track any invalid or suspicious transactions.
- Segregate payroll duties between authorization, record-keeping, disbursements and review roles to reduce risk of fraud due to collusion. Have another person review payroll and payroll tax withholdings.
- Automate the time-keeping system to prevent data entry errors in calculating payroll and payroll tax withholdings.
Even if your company is using a third-party payroll provider, there are still controls you can put in place to mitigate your payroll fraud risk. For example:
- Do not use the address of the payroll service provider as the mailing address for the IRS to send correspondence, as it may limit your ability to stay informed on tax issues pertaining to the business.
- Ensure that the payroll service provider is using an EFTPS (Electronic Federal Tax Payment System), as it helps the employers like you confirm that payments are being made on your behalf.
- Ensure the provider uses the highest encryption standards available for data security.
- Hire a reliable third-party payroll provider; ask if the company undergoes an audit of their internal, IT and business process controls.
While there’s no surefire way to guarantee that your company won’t be a victim of payroll fraud, a well-designed system of checks and balances can drastically reduce your company’s risk.
Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.