Payroll Service: What It Means for Employers

What it means in practice

What a payroll service does. The IRS says many employers outsource some or all of their payroll and related tax duties to third-party payroll service providers, which can administer payroll and employment taxes and report, collect and deposit employment taxes with state and federal authorities. The IRS lists the acts an employer may authorize a payroll service provider (PSP) to perform: prepare paychecks; prepare Forms 940 and 941 using the client's employer identification number (EIN); file Forms 940 and 941 that the client has signed; make federal tax deposits and payments for the taxes on those returns; and prepare Forms W-2 that carry the client's EIN.

The core rule: outsourcing does not move the liability. Publication 15 (2026) says an employer who outsources withholding, reporting and paying over Social Security, Medicare, FUTA and income taxes to a third-party payer "will generally remain responsible for those duties, including liability for the taxes." If the third party fails to pay, the IRS may assess penalties and interest on the employer's account, and the employer "may also be held personally liable for certain unpaid federal taxes." Withheld taxes and the employer share of FICA remain the employer's payroll liabilities until they reach the Treasury.

Why the type of arrangement matters. The IRS says that, depending on the facts and the type of arrangement, an employer "may remain solely liable for Federal employment taxes, may become jointly and severally liable for such taxes or may be relieved of liability for such taxes." The IRS form on file, not a provider's marketing label, places an arrangement in one of the categories below.

1. Payroll service provider (PSP). No IRS form is required. Publication 15 says a PSP may prepare paychecks, prepare and file employment tax returns, prepare Forms W-2 and make federal tax deposits and payments, all using the employer's EIN. The IRS chart says the PSP prepares a separate return for each client, which the client signs, and deposits each client's taxes under the client's EIN according to that client's own deposit schedule. A PSP "isn't liable as either an employer or an agent of the employer" for the employer's employment taxes (Pub 15).

2. Reporting agent (Form 8655). Publication 15 calls a reporting agent "a type of PSP" that the employer authorizes on Form 8655 to electronically sign and file the returns listed on that form. The IRS says reporting agents are companies, not individuals. Form 8655 can authorize the agent to sign and file returns, make deposits and payments, generally through EFTPS, and receive duplicate copies of IRS notices. A reporting agent uses the employer's EIN and is not liable for its employment taxes. The authorization agreement the employer signs states that it "does not relieve me, as the taxpayer, of the responsibility to ensure that all tax returns are filed and that all deposits and payments are made."

3. Section 3504 agent (Form 2678). Under 26 U.S.C. 3504, the IRS may designate an agent that pays an employer's employees to perform the employer's acts, while the employer "shall remain subject to" the law, including penalties. The IRS says a section 3504 agent "agrees to assume liability along with the employer" for Social Security, Medicare and federal income tax withholding, files aggregate returns under its own EIN with Schedule R, and that the IRS can collect unpaid taxes from both. The designation generally does not cover FUTA tax, so the employer still files its own Form 940. The Instructions for Form 2678 say processing generally takes 30 days and that until the IRS approves the request "the agent isn't liable for filing any tax returns or making any deposits or payments."

4. PEOs and certified PEOs (CPEOs). The IRS says professional employer organizations (PEOs) "handle various payroll administration and tax reporting responsibilities for their business clients and are typically paid a fee based on payroll costs." Certification is voluntary. Under 26 U.S.C. 3511, a CPEO is treated as the employer, "and no other person shall be treated as the employer," of any work site employee performing services for a customer, but only for remuneration the CPEO remits to that employee. The IRS chart says the CPEO and customer may both be liable for wages paid to non-work-site employees. CPEOs file aggregate Forms 940 and 941 under their own EIN and use Form 8973 to tell the IRS a customer contract has started or ended. Publication 15 lists "non-certified PEOs" among other third-party payers; section 3511 applies only to certified organizations.

What makes someone a work site employee. Under 26 U.S.C. 7705(e), the worker must be covered by a written contract in which the CPEO assumes responsibility for paying wages and for reporting, withholding and paying employment taxes "without regard to the receipt or adequacy of payment from the customer," shares responsibility for hiring and firing, and maintains employee records. At least 85 percent of the individuals working for the customer at that work site must be covered by such contracts, not counting excluded employees under section 414(q)(5). Under section 3511(f), an individual with net earnings from self-employment from the customer's business, such as a partner, is not a work site employee.

Example: the 85 percent test. This is a Remindax illustration with assumed headcounts. A customer has 20 people working at one site, none of them excluded employees. If 17 are covered by qualifying CPEO contracts, 17 / 20 = 85 percent, which meets the threshold. If only 16 are covered, 16 / 20 = 80 percent, so the workers at that site are not work site employees and the sole-employer rule in section 3511(a) does not apply to them.

What CPEO certification involves. Under 26 U.S.C. 7705, a CPEO must meet requirements on tax status, background, experience, business location and annual financial audits, and post a bond for employment taxes equal to the greater of 5 percent of its prior-year section 3511 liability (capped at $1,000,000) or $50,000. It must also give the IRS an independent CPA's opinion on its financial statements and a quarterly CPA attestation that it withheld and deposited the required taxes.

Checking a CPEO's status. The IRS publishes lists of certified, suspended and revoked CPEOs, updated by the 15th day of the first month of each calendar quarter. If a certification is suspended, section 3511 does not apply to new contracts signed during the suspension, and the CPEO must notify customers in writing within 10 days. If it is revoked, the CPEO must tell customers that section 3511 no longer applies and that they "may also be liable" for employment taxes on wages it remits under their contracts (IRS CPEO public listings).

How the IRS says to monitor a provider. The IRS Outsourcing payroll duties page and Publication 15 (2026) list these steps. Make sure the provider uses EFTPS, so payments can be confirmed. Register on EFTPS for the employer's own PIN and use it to periodically verify payments; when a third party enrolls an employer, the employer receives an Inquiry PIN that it should activate to monitor its account. Treat the first missed or late payment as a red flag. Keep the business's own address as its IRS address of record, because IRS correspondence goes there; Form 8822-B updates it. The IRS notes there "have been prosecutions of individuals and companies, who acting under the appearance of a payroll service provider, have stolen funds intended for payment of employment taxes."

What EFTPS shows. EFTPS is a free Treasury service for federal tax payments. IRS Publication 966 says users can check the status and history of EFTPS payments from the last sixteen months, and that even an employer whose payroll company pays all of its taxes may want to enroll separately to confirm payments and keep flexibility if it changes providers. An employer whose provider makes only some payments must enroll and make the rest itself. Publication 15 notes a third party may have different deposit cutoff times than EFTPS.

If something goes wrong. The IRS says an employer that believes a bill or notice results from a problem with its payroll service provider should contact the IRS as soon as possible, including by calling 800-829-4933. Suspected improper or fraudulent activity by a provider can be reported on Form 14157, which the IRS says receives expedited handling. Publication 15 says an error on a previously filed Form 941 is corrected on Form 941-X, the usual route for a payroll prior period adjustment.

Changing an arrangement. Form 8655 authority continues until the taxpayer or reporting agent ends it, and a new Form 8655 naming a new agent terminates the prior agent's authority from the period shown. A Form 2678 appointment can be revoked with one signature, effective on the date in the IRS confirmation letter.

Recordkeeping stays with the employer. DOL Fact Sheet #21 says "Every covered employer must keep certain records for each non-exempt worker," including hours worked each day and week, the regular hourly rate, straight-time and overtime earnings, additions and deductions, total wages each pay period, and the pay date and period covered. Payroll records must be kept at least three years and wage computation records for two. Publication 15 (2026) says to keep employment tax records for at least 4 years. A provider's payroll register can hold this data, but these duties are written as the employer's.

Where states differ. The arrangements above are federal tax categories. States run their own unemployment insurance and withholding accounts and set their own PEO rules. As one example, Texas requires a license from the Texas Department of Licensing and Regulation (TDLR) for anyone offering professional employer services through a coemployment relationship, even with a single covered employee in the state. TDLR says a company "only providing payroll services" does not need a PEO license, and it directs PEO unemployment tax questions to the Texas Workforce Commission. Other states have different rules, so the relevant state agency is the place to check.

Questions employers ask. Does the IRS approve payroll service providers? The IRS certifies CPEOs and approves section 3504 agents on Form 2678; a basic PSP needs no IRS form (IRS chart).

Can a reporting agent see our IRS notices? Yes, if the employer checks the duplicate-notices box on Form 8655; the IRS then sends the agent copies of notices about returns it filed and deposits it made (Form 8655). The originals still go to the employer's address of record.

Is a payroll service the same as a PEO? Not under IRS rules. A PSP works under the employer's EIN and assumes no liability, while a CPEO pays work site employees under its own EIN as the employer for federal employment tax purposes. Whether workers are employees at all is a separate question; see independent contractor.

Why it matters and common mistakes

How Remindax helps

Related terms

See all terms in Payroll & Compensation Basics or browse the full HR Glossary.