The new way to meet payroll

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(FORTUNE Small Business) -- Paychecks and payroll taxes are hardly the most exciting parts of running a business, so it's not surprising that most owners tend to think about their payroll service only when it fails.

Diane Hagglund, owner of DH Marketing in Sunnyvale, Calif., had to give a lot of thought to the firm she had hired to deal with payroll after it made a series of mistakes that took months to fix.

First, the firm miscalculated employee taxes, then it failed to send paychecks, and finally it sent out the wrong W-2 tax forms. All of which forced Hagglund, who declined to give her age, to devote time to payroll that she would have preferred to spend strategizing for her clients. "That was not good for my business," she says.

Even worse, Hagglund says, when she contacted her payroll service to try to correct the mistakes, she was given few answers and plenty of hold music. Sitting on the phone one day, she idly ran a Google (GOOG, Fortune 500) search for "small business payroll." To her surprise, she found an array of online services that calculate paychecks but also compute business taxes, prompt you to fill out the appropriate paperwork and make electronic tax payments.

For years, small firms like DH Marketing had just two options. The first was to calculate their outgoing checks and taxes by hand or with desktop software, keeping track of every arcane twist in local, state and federal tax law - and risking government fines or a lawsuit if they got something wrong. (Each year, about one in three small businesses is penalized by the IRS, according to surveys done by Intuit (INTU).)

The second option was to outsource the entire process to a payroll firm that would assume legal responsibility for any errors it made but that could also be slow and unresponsive.

Now there's a third option: a do-it-yourself online service. Hagglund chose the latter and says she saved 40% on her payroll costs - not to mention her sanity.

The market for online payroll providers is heating up. Fall 2008 saw the launch of three updated services: Intuit Online Payroll, PayCycle Plus and SurePayroll. Banks such as Bank of America (BAC, Fortune 500), Capital One (COF, Fortune 500) and JP Morgan Chase (JPM, Fortune 500) now offer their own rebranded versions. The leading service, PayCycle, boasts more than 75,000 users, a number that grew an impressive 50% in the first half of 2008.

What's driving this trend? More businesses are getting comfortable with the idea of hosting critical data on another company's servers. About 38% of small business managers now subscribe to some form of online software, up from 33% in 2007, according to Jupiter Research. Plus, payroll is a particularly good candidate for online management. The various services update their software constantly to reflect regulatory changes in the country's 7,000 tax jurisdictions, as well as policy changes in company 401(k) plans, workers' compensation or health benefits.

In addition, the major providers have all tweaked their algorithms to notice patterns in your paychecks, so they're much more likely to spot a transposed number or a missing decimal point than humans are.

Tom Sinton, CEO of Perquest, an Oakland-based online payroll service, says most of his 2,000 customers came onboard because an outsourced payroll company made errors or had service problems. "These mistakes can take weeks to correct," he says. "We cut down the error rate dramatically."

Of course, no online service is perfect. Intuit's software can only file state taxes in some states. SurePayroll is more comprehensive, paying your taxes (including local taxes), filing the returns and taking complete legal responsibility for any mistakes it might make. But SurePayroll charges a host of extra fees, such as $1.85 for each paycheck it cuts and $4.25 for each W-2 form it issues. The service also impounds its clients' funds - taking any taxes an employer owes and holding them until the taxes are due. Because the taxes may not be due for several months, this can cause cash flow problems.

Hagglund opted for PayCycle Plus, which costs $42 a month - compared with $72 a month for outsourced payroll. That's not as cheap as the lowest-price service - Intuit Online Payroll, at $29.95 a month - but PayCycle doesn't charge users for checks or W-2s. It's available in 90% of all U.S. tax jurisdictions, and it works with a wide range of accounting software such as Microsoft Money, Peachtree and QuickBooks. Thanks to an alliance with business insurance giant the Hartford (HIG, Fortune 500), PayCycle also offers pay-as-you-go workers' comp insurance, as opposed to the standard practice of paying premiums months in advance.

PayCycle, based in Palo Alto, claims that its service is so simple that you can set it up and start paying your employees in a single day. It asks a series of tax questions, entering suggestions for the most likely answers for employers located in your zip code.

Every month, when it comes time to pay her two employees and eight contractors, Hagglund gets a reminder e-mail. She visits the PayCycle Website, approves salaries, enters bonuses and adds any overtime hours or vacation days. "I typically get it done in 15 minutes," she says, "and I don't have to wait for business hours to do it."

The software automatically calculates the paychecks and deposits them (there's also an option to print out and hand-sign checks). PayCycle e-mails employees, offering them a link to view their pay stubs online. Paying taxes is even simpler: The software tells her how much she owes the IRS, Hagglund clicks OK, and the money is automatically deducted from her bank account. That feature also makes it easier for Hagglund to pay taxes for her contractors. Previously, she had to buy 1099 forms at $20 a package, print them, go to the post office and send them by certified mail. Spending that much time and money - adding up to hundreds of dollars a year, she says - is no longer necessary.

Switching to online payroll software also paid off for Laurie McNeely, a manager at Grimes Credit Union in Urbana, Ohio. McNeely had tried Vanquest Publishing's Bookkeeper desktop software, but the program did not upgrade its own tax tables and her numbers rarely matched up. So for 12 years, she calculated the checks by hand. Now, she uses Intuit's Online Payroll service to pay the credit union's five employees. Like Hagglund, she completes the weekly payroll in about 15 minutes, saving 50 hours a year.

In fact, says Hagglund, she now gets her payroll done in less time than it used to take just to get her payroll company representative on the phone.

"Payroll went from being this nagging thing that never totally worked to being something I don't have to think about," she says. All of which leaves more time for the more exciting and productive aspects of business.