Let’s start with a riddle (of sorts):
Question: What do payroll and police have in common?
Answer: You might be expecting some association with fraud, since that’s the topic of this article, but we are going to turn to grammar instead. Payroll and police are used as both nouns and verbs in the English language.
Examples: I’m payrolled by the State Department to review the embassy payroll.
The police visibly police the public park across the street from the school.
Payroll is one of those versatile words, tricky until befriended and familiar, which can make English challenging for people who are not native speakers.
|*(Curious about a few more such versatile words? Here’s a list of just a few more for you to toy with: light, fish, damage, whistle, promise, and influence).|
A thorough definition of payroll will lay the foundation for understanding payroll tax fraud and how to protect yourself from experiencing it.
Payroll, the noun, can refer to any of the following four definitions. Why not make a mental skip forward and begin considering how tax fraud might be perpetrated in each context?
- A list of employees to be paid, with the amount due to each.
Her job was to publish the payroll before each payday.
- A sum total of these amounts.
The payroll this month is $30,000 more than last month.
- The actual money on hand for distribution.
The bandits got away with the payroll.
- The total number of people employed by a business, firm, or organization.
With the newly-expanded payroll, our business will produce more than the competition.
When payroll is used as a verb, it means “to fund or subsidize,” as in, “I am payrolled by the State Department.”
Now let’s consider some common methods of payroll fraud:
- Misclassifying employees
Whether it’s deliberate or not, the IRS can prosecute your company for payroll fraud if employees are (incorrectly) listed as independent contractors on the payroll. Tax laws require different treatment for employees than for independent contractors. Some fraudsters list their employees as independent contractors in an effort to avoid taxes. In this scenario, payroll fraud involves an incorrect list of the employees to be paid.
Pyramiding refers to a company accumulating a chunk of money by withholding payroll taxes, as required, but then using this sum of money for company purposes instead of sending it directly to the IRS. In other words, the company illegally “borrows” money from the federal government for some amount of time by delaying the payment of payroll taxes. In this scenario, payroll fraud refers to the incorrect use of a lump sum of money resulting from the aggregate taxes from each employee on the payroll.
- Embezzlement of tax money
An employer, employee, or a group of employees who are responsible for paying the company’s payroll taxes may embezzle the money by depositing the money into personal accounts and then covering the crime by making the discrepancy appear as an accounting error or glitch. When an employee or group of employees embezzles payroll tax money, the owner/employer is still liable to the IRS.
- Miscalculations of payroll tax
Oops! A company makes some errors in calculations and underpays their payroll tax. The IRS doesn’t care if the miscalculations were deliberate or accidental: underpaying payroll tax is considered fraud. Many small businesses don’t have the resources to stay up to date with complex payroll tax calculations, including multi-jurisdiction taxes and rapid changes in IRS requirements and exceptions. When a company, small or big, underpays the IRS because of miscalculations, this is considered fraud, and penalties apply.
What’s the worst that can happen, you might be asking yourself? IRS penalties for payroll tax fraud or evasion are serious. The IRS penalizes payroll tax fraud using both financial penalties and criminal prosecution. The penalties apply even if the fraud was not deliberate and even if a third-party payroll company was involved.
To penalize tax evaders and dissuade potential tax evaders, the IRS can penalize companies that are delinquent in their taxes or have committed tax fraud. The IRS can order an audit, impose tax liens on property held by an employer, and hold the employer responsible for full restitution of payroll taxes along with interest and penalty fines. In addition, the IRS can file civil action lawsuits in the criminal court system.
There are several steps you can take to protect yourself from payroll tax fraud. The following suggestions amount to a system of checks and balances that provide accountability around the payroll tax.
- Use the tracking options in computerized payroll systems to flag any suspicious transactions.
- Restrict access to the payroll records and the payroll system to authorized personnel only.
- Compartmentalize payroll duties into separate employee roles to reduce the access that any single employee would otherwise receive to the payroll. Employee roles could be separated into authorization, record-keeping, disbursements, and review.
- Automate the time-keeping and withholding systems to prevent data entry errors or embezzlement.
- Use high-quality and current encryption within your company and require that a third-party payroll company also maintain the highest standards of data security.
- Hire only third-party payroll providers with robust auditing of their internal, IT, and business processes.
- If a third-party payroll company processes your payroll taxes, make sure that the IRS sends correspondence to you instead of the third-party payroll company. This will ensure that you stay informed in case the IRS is investigating the third-party company.
- Require that the third-party payroll provider use the EFTPS (Electronic Federal Tax Payment System). This system is designed to ensure that the required tax payments are being made on behalf of your company.
Mixing up the different uses of payroll is one thing but failing to be educated about this important tax is another. Understanding the different definitions of payroll will help you protect your company from faulty or illegal payroll practices.
Protecting your company from payroll tax fraud requires sound business sense and some technical acumen. Payroll tax fraud is heavily penalized even if it’s accidental and even if it is only perpetrated by one or two employees within a larger firm. If you feel that your company is at risk or if your company has already been compromised, we suggest that you call an experienced tax resolution law firm for a professional analysis of your legal options moving forward.