Significant Risk may be Associated with the Use of a Third-Party Professional Employer Organization to Remit Employment-Related Tax Payments

Synopsis 

Recently, the IRS issued a Chief Counsel Advice memorandum (CCA 201724025, 6/16/2017) relating to the use of a third-party professional employer organization (“PEO”), and whether the business (“taxpayer”) that engaged the PEO was liable to the IRS where the PEO failed to remit the required employment-related federal taxes. The CCA concludes that the taxpayer was the common law employer of the workers in question and that the PEO was not their “statutory employer” for purposes of IRC Section 3401(d)(1).  Thus, the taxpayer was responsible for the federal employment-related tax obligations (income, FICA and FUTA taxes).  As the taxpayer had provided the PEO with the funds in advance for it to use to remit the taxes and the PEO failed to do so, the taxpayer, in effect, was required to pay these taxes twice (i.e., absent subsequent reimbursement by the PEO).

Issue

The CCA was issued to the taxpayer, an S corporation that hired workers to perform various accounting, administrative and marketing services. The workers were retained by a PEO to work at the taxpayer’s location.  Pursuant to its contract with the PEO, the taxpayer assumed responsibility for the day-to-day supervision and control of the workers and agreed to pay the PEO at least one day before each payroll date an amount equal to all wages, salaries and other charges to be paid to or with respect to such workers.  The taxpayer made the foregoing payments, including amounts to cover employment-related taxes, to the PEO, but the PEO did not remit those amounts to the IRS and did not issue Forms W-2 to the workers.  

The duties of the PEO under its contract with the taxpayer included, among other things, administering the taxpayer’s payroll, designated benefits and personnel policies and procedures relating to the subject workers,  providing human resource and payroll administration, furnishing and keeping workers compensation insurance covering the workers, and processing and paying the workers’ wages from its own accounts.  The contract also provided that the PEO would file all employment tax returns for all of the subject workers of the taxpayer,  remit all employment -related taxes due and provide the subject workers with Forms W-2. 

Consistent with its contract with the PEO, the taxpayer did not remit federal income or employment taxes, file any employment tax returns or issue Forms W-2 with respect to the workers’ wages for any of the relevant years.  The taxpayer also did not attempt to verify that the PEO paid the required employment-related taxes or filed the appropriate employment tax returns.

The first issue considered by the IRS was whether the PEO was the statutory employer pursuant to IRC §3401(d)(1), since it was clear that the taxpayer was the common law employer.  Here, the key inquiry was whether the PEO was in “legal control” of the payment of wages to the workers.   On this issue, the CCA concludes that the PEO was not in control of the payment of wages, since it received information and funds from the taxpayer before delivery of payroll to the workers, and further, because under the terms of the PEO contract, the taxpayer was required to provide a security deposit or letter of credit to the PEO to cover the wages that the PEO was required to pay to the workers.  On this basis, the IRS concluded that the PEO was merely a conduit for the taxpayer, and that the taxpayer was the employer for employment tax purposes.  

The IRS then considered whether the taxpayer was entitled to relief under Section 530 of the Revenue Act of 1978.  Pursuant to that section, a taxpayer is permitted to treat a worker as an independent contractor, rather than as an employee, if three requirements are met—the taxpayer did not treat the individual, or any worker holding a substantially similar position, as an employee for any period for purposes of employment taxes; the taxpayer filed all required federal tax returns on a basis consistent with its treatment of the individual as a nonemployee; and the taxpayer had a reasonable basis for not treating the individual as an employee.  As to this issue, the IRS found that the section was not intended to apply to disputes as to whether a common law employer remains liable for employment taxes that were not paid by a conduit payroll processor.  Rather, the section only applies where the issue is whether the particular individual should be reclassified from independent contractor status to employee status.  Thus, Section 530 was not applicable as the taxpayer’s liability for employment taxes did not involve this issue.

Since the taxpayer was the common law employer and Section 530 did not apply, the taxpayer was held to be liable for the employment-related taxes the PEO failed to remit to the IRS.

What Does CohnReznick Think?

Based on the conclusions in the CCA, businesses that utilize PEOs should be aware that a contractual arrangement with a PEO ordinarily does not result in the PEO having ultimate liability for the remittance of employment-related federal taxes.  Where the business will provide the PEO with the funds to pay wages and remit the related taxes prior to their required payment date, the business should select a PEO based on its strong reputation, and require the PEO to provide copies of draft employment tax returns for review before filing, as well as proof of all required tax payments, to ensure that the PEO is timely filing all employment tax returns and remitting all taxes and other amounts due.

Contact

For more information, please contact Stan Solomon, Director, State and Local Tax Services, at [email protected] or 646-254-7409.