Court Decision Underscores Need for Due Diligence When Using Payroll Service Providers

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August 24, 2016

A recent decision of the U.S. District Court for the Central District of California should remind employers to regularly verify the actions of payroll service providers regardless of the provider’s reputation and the longevity of the relationship.  In particular, employers should open an e-Services account with the IRS and verify that all deposits are in fact hitting their payroll accounts timely.  This check should be performed weekly.  If deposits are not timely reflected on accounts, it is incumbent on employers to promptly determine the nature of the problem.  The IRS does not police payroll service companies, and the Department of Justice has prosecuted a number of people for embezzlement of payroll taxes over the years.

In Kimdun Inc. et al. v. United States, four McDonald’s franchises (the “Employer”) under common ownership used an outside payroll company for 30 years to process all aspects of their payroll, including the remittance of payroll taxes to the U.S. Treasury and the California Employment Development Department.  However, during the last several years of the relationship (2008-2011), the payroll company or its related bank embezzled the Employer’s payroll taxes.  To make matters worse, the Employer learned of the failure to deposit its taxes in 2009 but neglected to take any action until mid-2011 and continued to use the payroll company through 2012.  The IRS subsequently assessed approximately $425,000 in failure-to-pay penalties under Section 6651(a), failure-to-deposit penalties under Section 6656, and related interest.  Note that the penalties and interest were in addition to the payroll taxes that the Employer had to pay to the U.S. Treasury above and beyond the funds that were embezzled.

The Employer filed refund claims with respect to the penalties and related interest, which were denied by the IRS.  The Employer then sued for a refund in U.S. District Court arguing that the penalties should be abated on the grounds that the failures occurred due to reasonable cause and not due to willful neglect.  The District Court granted the government’s motion to dismiss, holding that the Employer failed to show that it had acted with ordinary business care and prudence.  In its analysis, the court considered the typical authorities that arise in reasonable cause determinations and concluded that the Employer’s reliance on the payroll company, an agent, did not establish reasonable cause.  The fact that the Employer seemed to wait passively for such a protracted period of time was a particularly bad fact.  The result may well have been different if the Employer had identified the theft within a matter of weeks, made good on the late taxes, and pursued legal action against the payroll company.

The key takeaway from this case, however, is that employers will not simply be absolved of their tax obligations based upon illegal acts committed by third-party agents.  With the tools available from the IRS through e-Services, employers should independently verify that their payroll service providers perform the tasks they agree to perform.