Employment Taxes
Professional employer organizations (PEOs) provide comprehensive payroll, benefits, and human resource outsourcing solutions to unrelated third-party employers. PEOs are often also referred to as employee leasing companies or "co-employers." The model for providing those services, which has been relatively consistent for many decades, may change significantly because of recent legislation that will bifurcate PEOs into two categories.
At the end of 2014, Congress added Secs. 3511 and 7705 to the Internal Revenue Code, creating a new type of entity called a "certified professional employer organization" (CPEO), effective with respect to wages for services performed on or after Jan. 1, 2016 (Tax Increase Prevention Act of 2014, P.L. 113-295, §206(a)). To receive IRS certification, an existing PEO must meet certain GAAP and examination-level attestation standards, post a bond with the IRS, and meet certain other requirements.
The statute enacting Sec. 3511 also provides that the IRS will establish a certification process by July 2015. While existing PEOs are not required to seek certification, the new rules may result in a shift in the PEO industry, with larger PEOs becoming CPEOs (or offering CPEO as a distinct service) and citing this status to differentiate themselves from other organizations.
Existing PEO Service Model and "Co-Employment"
For federal employment taxes, the PEO and an employer typically enter into a service agreement whereby the PEO undertakes payroll tax obligations in the name and employer identification number (EIN) of the PEO, including obligations to pay wages; deposit taxes; report wages and taxes quarterly on Form 941, Employer's Quarterly Federal Income Tax Return; provide the employee and government Forms W-2, Wage and Tax Statement; pay and deposit federal unemployment taxes (FUTA); and file Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return. The PEO undertakes similar roles for state and local tax obligations.
According to the typical services agreement, the employer continues to provide daily supervision and direction over the employees, but its payroll tax obligations are transferred to the PEO. The PEO achieves economies of scale by offering this service to many employers and aggregating the payroll taxes onto single Forms 941 and 940. Many PEOs describe this arrangement as co-employment.
The IRS and Co-Employment
The Code does not recognize co-employment as such. For federal employment tax purposes, whether an employer-employee relationship exists is determined under the long-standing common law test based on all the facts and circumstances, of which the most important is the right to direct and control the worker's actions. Thus, a service recipient that supervises and directs workers typically is considered the common law employer. This classification is important because, unless an exception applies, the common law employer is liable for the collection, payment, and reporting of payroll taxes and is subject to tax assessments and penalties for failures. There are two basic exceptions: agents and statutory employers.
The first exception allows the common law employer to designate an agent that undertakes all payroll tax obligations and reports and pays the taxes in its own name and EIN (Sec. 3504). However, if the agent fails to pay the taxes or penalties, the common law employer remains liable in addition to the agent. The second exception provides that if the common law employer does not have control of the payment of wages, the person who has control of the payment of wages is the statutory employer for payroll tax obligation purposes (Sec. 3401(d)(1)). In contrast to an agent, a statutory employer is exclusively liable.
Control of the Payment of Wages
To promote greater efficacy in pursuing third-party payroll providers and their client employers for deficiencies in payroll taxes, the IRS recently issued final regulations creating a deemed agent. These provisions treat most third-party payroll providers, except for statutory employers, as merely agents of the employers. While many PEO service agreements provide that the PEO will be responsible for withholding, depositing, and reporting payroll taxes if the employer meets its obligations, PEOs typically are deemed agents rather than statutory employers. Accordingly, unlike with CPEO service agreements, the employer remains liable for payroll taxes and penalties for PEO failures.
CPEO
Congress enacted the CPEO provisions to enable a CPEO to be solely liable for payroll taxes on wages it pays to its clients' employees. In effect, a CPEO can be the employer for employment tax and payroll obligations, while a client employer providing direction to and control over the employees remains the common law employer for other purposes. This change is designed to make the CPEO solely liable for payroll taxes and penalties. The enacting statute provides that the new CPEO rules shall not be construed as creating any inference as to worker classification for any other federal tax purposes or any nontax purposes (P.L. 113-295, §206(h)).
For CPEO status, the organization must assume responsibility for wage and tax payments of its clients' employees, without regard to the receipt or adequacy of payment from the employer. Effectively, this requirement tracks the IRS requirement for an entity to be treated as a statutory employer. Further, the CPEO must assume responsibility for benefits provided under contract and also assume certain responsibilities for recruiting, hiring and firing, and for maintaining the relevant records. The organization also must notify the IRS of the creation and termination of the CPEO relationship. Finally, the owners and officers must meet fitness requirements regarding their background, experience, tax status, business location, and annual financial audits. The entity must post a bond with respect to employment-tax liabilities (ranging from $50,000 to $1 million) and undertake certain GAAP and examination-level attestation obligations.
Failure to meet these requirements means the entity will not qualify as a CPEO for the attestation period. Since existing entities are not required to seek CPEO status, an existing PEO may continue with its established practices. While it is not clear how many PEOs will want to secure CPEO status, the CPEO offers a new business model that will allow businesses to shift liability for depositing and reporting payroll taxes away from the common law employer.
EditorNotes
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms.
Smith at 202-414-1048
202-414-1048
or annette.smith@us.pwc.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.
