4 Main Payroll Provider Types: Which One is Best for You?

You’ve been in business for a few months or years, and you’ve heard about outsourcing your payroll and taxes to a third party. But what kind of businesses will run your payroll and tax deductions, do an effective, efficient job, and keep that stress off your desk? 

The Internal Revenue Service (yea, that one!) has created four categories of third-party payroll processing and tax reporting businesses:

1. Payroll Service Provider (PSP)
2. Reporting Agents (RA)
3. IRC Section 3504 agent 
4. Certified Professional Employer Organization (CPEO)

Yes, some of these categories sound complicated, and one sounds similar to a famous Star Wars droid, but what can you really expect from the IRS. 

Full disclosure, Whirks falls under the Reporting Agent classification. And while we are well-versed in what a Reporting Agent provides as a payroll processing company, we are also knowledgeable in the other three areas. We want you to have all the information necessary to make the right decision, so we will outline each type in this article. 

Let’s get the obvious out of the way first - yes, it sounds like ALL third-party payroll processing companies fall under the payroll service provider class. And most people refer to the company that processes employee payroll and deducts applicable taxes as their payroll provider. But the IRS wanted to make sure you were paying attention. Plus, they aren’t exactly known for being easy to understand. 

In this article, we will break these payroll processing businesses down to their nuts and bolts, which will allow you to wrap your brain around their concepts. With this information, you will have a solid understanding of the four third-party payroll vendors when deciding what kind of relationship to enter into. 

At a Glance: Responsibilities of Third-Party Payroll Providers

Four Types of Payroll Processing Companies

1. Payroll Service Providers (PSP)

Payroll Service Providers (PSP) perform the essential services that all four business categories do: 

• Calculate payroll
• Deduct federal and state taxes (including Social Security and Medicaid) 
• File and pay quarterly employment taxes with the IRS with employer’s Employer Identification Number (EIN)
• File Federal Unemployment Taxes (FUTA)

PSPs are the foundation that all third-party payroll companies build themselves around. PSPs are a lot like Adam West as Batman in the 1960s as each version of Batman since has been centered on Adam West’s iconic portrayal. West’s Batman drove a Batmobile, answered the Bat Signal, and fought villains in Gotham City. 

The significant differences between a PSP and its cohorts are that the client (aka employer) must sign the completed return, a paper hard copy of the return is filed, and the PSP has zero liability if the employer’s taxes are filed correctly, on time, or in full. 

If you choose a PSP to process your employee payroll, withhold taxes, and file your quarterly returns, keep in mind that you will need to sign each of those returns, and you are responsible should your payroll service provider drop the ball. 

2. Reporting Agent (RA)

Reporting Agents (RA) perform the core functions of a PSP and are authorized to file and pay employment taxes on behalf of employers. This means that RAs can: 

• Calculate payroll
• Deduct federal and state taxes (including Social Security and Medicaid) 
• File and pay quarterly employment taxes with the IRS using the business’ EIN
• File returns electronically with Electronic Federal Tax Payment System
• Exchange information with the IRS on the client’s behalf to resolve any problems

The IRS created Form 8655 to authorize Reporting Agents to file and pay employment taxes on behalf of employers.

Reporting Agents are like Michael Keaton as Batman. Keaton continues fighting Gotham’s villains, but now he has high-tech gadgets and a souped-up Batmobile.  

The big difference between RAs and the following two kinds of payroll companies is that employers have full liability if taxes are not filed or returned. 

But it is important to note that PSPs and RAs may (and most likely do) carry general liability and errors and omissions insurance in case a mistake is made with a client’s filings or payments. 

3. IRC Section 3504 Agent

Section 3504 Agents performs the core payroll, tax, and filing responsibilities of PSPs and RAs. They are so named because Section 3504 of the Internal Revenue Code created this type of payroll processing company, determined its guidelines, and specified that IRS Form 2678 is used by employers to appoint companies to perform these functions:

• Calculate payroll
• Deduct federal and state taxes (including Social Security and Medicaid) 
• Files electronically or via paper hard copies
• File aggregate returns for all clients’ employment taxes using the agent’s EIN
• Cannot file Federal Unemployment Taxes (FUTA)

Unlike RAs and PSPs, Section 3504 Agents share liability along with the small business owner should the correct amount of federal tax not be withheld or paid to the IRS. 

Once an employer appoints a third-party payroll company with Form 2678, the IRS can seek both the employer and its designated payroll agent for unpaid employment taxes. Section 3504 Agents group all of their clients’ tax payments and returns together and file them aggregately using their own EIN. 

Sharing tax liability burdens could be an excellent solution for your company. Keep in mind appointing a Section 3504 Agent is similar to getting married. Mixing a piece of your business’ finances with a third party requires significant trust. 

4. Certified Professional Employer Organization (CPEO)

While Certified Professional Employer Organizations perform the same essential functions as any payroll service provider, they operate more like a corporate overlord who can:

• Calculate payroll
• Deduct federal and state taxes (including Social Security and Medicaid) 
• Files electronically or via paper hard copies
• File aggregate returns for all clients’ employment taxes using the CPEO’s EIN
• File Federal Unemployment Taxes (FUTA)

These businesses are often referred to as employee leasing companies because an employer turns over nearly all employee-related responsibilities to the CPEO. 

CPEOs not only process the payroll and withhold federal taxes from a client’s employees, but they also pay those employees' wages directly. CPEOs are fully responsible for filing returns and paying taxes for each of their clients. Granted, each of those clients pays its CPEO for all wages and taxes paid, in addition to service fees. 

Hiring a CPEO is like co-parenting. The client handles the core business activities like sales, production, and services. 

CPEO’s take care of the human resource services, including:

• Administering payroll
• Withholding and paying taxes
• Providing access to health insurance and retirement plans 

Once a small business owner enters into a contract with a CPEO, the business’ employees must heed each parent’s instructions. Employees receive work responsibilities from the employer, while questions regarding wages, taxes, training, records, health insurance, and retirement plans are handled by the CPEO. 

Unlike the previous three payroll providers, CPEOs maintain full liability to the IRS for tax filings, returns and payments. They file all of their clients’ tax returns together under their EIN, not each individual business they represent. 

Choosing the best third-party payroll company for your business

Once you’ve decided to outsource your payroll and tax payment duties to a third party, there are a ton of factors to weigh and way too much information to process. The key differences in the four main types of payroll providers are tax payment liability, the ability to file unemployment tax returns, and IRS designation. 

A benefit to choosing a reporting agent is when you receive tax notices, your reporting agent will also receive them and handle them on your behalf. If you prefer filing your taxes yourself, choose a payroll service provider who will calculate everything for you, but you still have the final say when filing your returns. In either case, a PSP or a RA do not assume tax liability on behalf of their client.

A larger business might choose to work with a Section 3504 Agent because both the employer and the agent assume liability to withhold, report, and pay taxes. This arrangement also has pros and cons,  and it's best to discuss this option with your certified public accountant or internal finance team.

Small business owners wanting to offer health insurance, retirement plans, and other fringe benefits, but don’t have affordable options, should consider partnering with a CPEO. Keep in mind that choosing a CPEO could interfere with your company culture and you’ll lose control of employee onboarding. 

When you are ready to start shopping for a payroll partner, read this article for the pros and cons of national and independent payroll providers. And check out our rankings of top national companies for small and large employers.