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Third-party payroll companies, part 1: what can go wrong

Handling payroll taxes involves a lot of logistical effort for small businesses.

After all, owners of those businesses typically wear many hats. They have a lot of other demands on their time and attention besides tax withholding, the issuance of W-2s and other tax compliance tasks.

It is therefore entirely understandable that many such businesses contract with a third-party provider to handle employment-tax services. This often involves having the third party make payroll tax payments to the state.

What happens, however, when that provider becomes insolvent, commits misconduct or otherwise leaves its clients its clients holding the bag for unpaid payroll taxes? In this two-part post, we will discuss that issue.

The issue is hardly an abstract one. The Los Angeles Times reported earlier this week on how the owner of a Southern California payroll company named LA Payroll has apparently disappeared after draining the firm's accounts.

These accounts - called impound accounts - were supposed to have been used to make tax payments to the state on behalf of client businesses. Instead, many clients are now facing thousands of dollars in losses. At least one client reportedly lost more than $350,000.

A former payroll manager at the company estimated the total amount of the losses is about $4 million.

For small-business owners, obviously losing tens of thousands of dollars in this way is a difficult pill to swallow.

After all, it is not as if a government agency is there to ride to the rescue. Companies that provide payroll services are not closely regulated at either the state or federal level. This stands in contrast to financial institutions such as banks, which are regulated by agencies like the Federal Deposit Insurance Corporation (FDIC).

California, like most other states, does not require that payroll service companies be bonded. And with no bond in place, business owners are on the hook for taxes owed to the IRS and state revenue agencies.

Source: Los Angeles Times, "A payroll company leaves its clients in the lurch," Kim Christenson, Feb. 10, 2014

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