IRS Bill Clarifies Who Pays When Your Payroll Service Messes Up Your Taxes

If you run a small business or manage a mid-sized company, you probably use a payroll service or a PEO (Professional Employer Organization) to handle the headache of payroll taxes. This new legislation is all about drawing a clearer line in the sand regarding who is responsible—you, the employer, or the service provider—when the IRS finds an error in your payroll tax filings.

The Fine Print: Who’s on the Hook?

This bill amends the Internal Revenue Code to establish new rules for assigning liability (tax, interest, and penalties) when a third-party payor, like your PEO, files your taxes. Currently, when things go wrong, the blame game can get messy. This bill introduces the concept of “constructive knowledge.”

Here’s the breakdown: If you, the employer, certify information to your payroll service, the service can generally rely on that certification. However, if the payor knew or reasonably should have known that the information you provided was wrong (that’s the constructive knowledge part), then the payor is responsible for the resulting tax liability. But if the error was purely based on the certification you gave them, and they had no reason to suspect it, then you are solely responsible.

For a small business owner, this means your payroll service has a stronger incentive to double-check anything that looks fishy, but it also means you can’t completely offload responsibility by providing inaccurate data. It forces both parties to be diligent. The challenge here is that “constructive knowledge” is a subjective legal standard, which means we might see some disputes over what a payor should have known.

Protection from Other People’s Mistakes

One of the most practical provisions in this bill is a shield for employers. If your payroll service handles dozens of other companies, and they make a mistake on Client A’s return—a mistake that the IRS flags—the IRS is prohibited from delaying the processing of your payroll tax credit or starting an audit on your business just because your shared payor messed up on someone else’s account. This is a huge win for administrative fairness, ensuring that one client’s error doesn't become a domino effect that drags down every other business using the same service.

New Rules for Tax Credits

Many businesses rely on their PEOs to claim specific payroll tax credits. To ensure the payor isn't held liable for an employer's false claim, the bill sets out specific verification steps. A third-party payor is assumed not to have constructive knowledge of an error in a tax credit claim if three things happen: 1) The employer certified they qualify for the credit; 2) the payor accurately reported the credit exactly as certified; and 3) the payor verified the total wages the employer used to calculate that credit amount. This forces the payroll service to perform a basic check on the numbers, making sure the math adds up before they submit the claim to the IRS.

Finally, the bill gives the IRS the power to demand any records from the third-party payor that the IRS could normally demand directly from the employer. This streamlines the audit process but also increases the administrative burden and access rights the IRS has over the payor’s files.