For small business owners, the decisions on how to handle payroll can have long lasting implications for the company. If there are any errors, even small ones, they can accumulate over time. It’s like a small leak in a roof, by the time it is noticed, there can be considerable damage done.
There are many different ways that payroll can be handled. On one end, it can all be done internally, meaning the employer can process all payroll, maintain all records, submit all filings / reports, and handle all disbursements. Rarely is this economical for most businesses.
At the other end of the spectrum, a small business can partner with a firm specializing in outsourced HR, benefits and payroll, technically, the employees receive a paycheck from the outsourcing company. All the company is responsible for is reviewing / approving hours, updating employee records (vacation, pay rates, etc.), and having enough money in their bank account.
What are some of the reasons that companies may decide to do their own payroll?
- Cost Effectiveness – They may view the existing accounting staff (seen as a fixed / sunk cost) as capable of taking on this workload, whereas there would be an extra expense in paying another company to do the processing. Most small business software even comes with a payroll feature built in. The only situation I witnessed where this worked (and it worked well) was a security staffing business that had over 4,000 employees and had 4 people handling payroll. Of course, the payroll for all field personnel (over 95% of employees), was directly tied to billing, which was handled by this same group. They were responsible for all withholdings: federal taxes, state taxes, wage garnishments (child support, alimony, etc.), healthcare plans and retirement plans.
- Managing Cash Flow – Some businesses want to handle their own payroll so they can issue checks (not offer direct deposit), as a means of managing cash flow. This is usually short-sighted for several reasons. The first is that most people end up depositing / cashing their paychecks immediately and a majority clear the bank within 2 days, the gain is usually negligible. Secondly, it creates more work in reconciling bank accounts and re-issuing lost checks. Finally, it can be a hassle to your employees, and is usually not looked up on favorably for those that desire direct deposit.
What can go wrong with managing your own payroll? Lots! Here are some examples:
- Fines and penalties – Besides just making the payments on time, there are forms that need to be submitted quarterly and annually (at federal and state levels), a failure to do so within the correct time frame can lead to fines. If a small business has only one person managing payroll (typical), they may either not understand the requirements, or if there is a personnel change, something can fall through the cracks. If you have missed payroll taxes (for whatever reason), the IRS can demand the amount due, plus penalties, within a very short time frame, which could create a massive liquidity issue.
- Personal Exposure – For any funds withheld from an employee’s paycheck (i.e. everything from gross pay to net pay), those funds are now the responsibility of the company. However, liability can extend to owners and / or management, those deemed to be a fiduciary. Fiduciaries have personal exposure if trust fund taxes are not paid timely.
- Business Interruption Costs – Even if the company has done everything correctly, or only made minor mistakes, they still might need to hire professionals to assist with an audit. Any potential savings are easily outweighed by having to engage attorneys and or accountants for even small amounts of time. Instead of focusing on winning a new customer or managing operations better, managers / owners can be distracted by threats from the IRS.
Due to the myriad of potential risks, it is almost always better to partner with a specialist who can maintain compliance and avoid a miscue. If your company has poor financial record keeping (or, is not exceptional), there is potential for something to get missed. There are many constituencies involved and some of them can wield an immense amount of power (federal and state governments).
The IRS likes to target small businesses because there have been many that have tried to get away without paying taxes. If an investigation arises, you should operate from the standpoint that you are deemed guilty until proven innocent. The investigator might be under an informal quota where they have to find something. I have witnessed this from the IRS on a routine audit, where the find something minor because they are not allowed to find nothing wrong, even if it’s relatively inconsequential, it still takes up company resources.