The identification of which of two (or more) entities is the employer of a worker is important beyond the question of which party has employment tax liability. When multiple entities have a relationship with a worker, the determination of which entity is the "employer" is fact-intensive and can have significant additional tax consequences. Many tax credits, deductions, exclusions, and reporting requirements rest with the common law employer.
An employer is defined in Sec. 3401(d) as the person for whom an individual performs any service, of whatever nature, as the employee of that person. Whether a person is an employer for federal employment tax purposes is determined under the common law—the same standard used to determine whether a service provider is an employee or independent contractor. Determining whether an employer-employee relationship exists requires an evaluation of all the facts and circumstances (see Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318 (1992); Sec. 3121(d)(2)).
Following the common law standard, the employment tax regulations provide that a person for whom the services are performed is a common law employer if the person has the right to direct and control the worker who performs the services (see Regs. Secs. 31.3121(d)-1(c), 31.3306(i)-1(b), and 31.3401(c)-1(b)). In Professional and Executive Leasing, Inc., 89 T.C. 225 (1987),the Tax Court found that an employment relationship did not exist between a leasing company and the workers because the leasing company exercised minimal, if any, control over the workers. In contrast, the client companies controlled the details of the work and the selection of assignments, and provided the office space, tools, and equipment. The client companies therefore were held to be the common law employers even though a separate entity administered the payroll functions.
Federal employment taxes
An employer that pays wages has the obligation to withhold federal income tax, Social Security, Medicare, and Additional Medicare (Federal Insurance Contributions Act, FICA) taxes and to pay Federal Unemployment Tax Act (FUTA) tax and the employer's share of FICA taxes. Employers also must make timely deposits of taxes and report the relevant payroll information as provided in Secs. 3402(a) and 3102(a) and the regulations thereunder. Under Sec.3401(d)(1), if the person for whom the employee performs the services—i.e., the common law employer—does not have control of the payment of the wages for those services, the term employer means the person having control of the payment of those wages.
Thus, the requirement to withhold income tax is imposed on the Sec.3401(d)(1) employer (also referred to as a "statutory employer") that controls the wage payment. The IRS extended the statutory employer definition to include withholding of FICA and FUTA taxes, and the Supreme Court agreed with that interpretation (see Otte, 419 U.S. 43 (1974); see also In re Armadillo Corp.,561 F.2d 1382 (10th Cir. 1977)).
Designating an entity in control of a wage payment as a statutory employer is significant because it shifts the employment tax obligations for withholding, paying, and reporting obligations from the common law employer to the statutory employer. Under Regs. Sec. 31.3401(d)-1(f), a third party must have "legal"control of the payment of wages to be a statutory employer. In this context, legal control has been viewed quite narrowly by several courts and the IRS (see General Motors Corp., No. 89-CV-73046-DT (E.D. Mich. 1990); Earthmovers, Inc., 199 Bankr. 62 (M.D. Fla. 1996); Technical Advice Memorandum (TAM) 201347020). The IRS has taken the position that if an entity requires the common law employer to pay that entity prior to the entity making wage and tax payments, the entity is not in control of the payment of wages as defined in Sec. 3401(d)(1).
In addition to common law and statutory employers, many other payroll arrangements are routinely used and may affect which party has the obligation to withhold, deposit, and report payroll taxes, including agency relationships, such as Sec. 3504 designated agents, deemed agents or engagements with reporting agents, professional employer organizations (PEOs), and shared-service entities. None of these relationships, even when formally recognized by the IRS, alters the determination of which party is the common law employer. Accordingly, while these third parties may share some employment tax liability with the common law employer, the common law employer ultimately remains responsible for employment taxes and reporting relative to its common law employees.
Beyond federal employment taxes
The determination of which entity is the employer can be relevant to many other tax issues. In many instances, determining which party is entitled to a credit, deduction, or exclusion, or has compliance responsibilities, first requires the identification of the employer under the common law.
Compensation deduction: Under Sec. 162, compensation paid for services is deductible only by the employer for whom the services are performed. Parent entities, subsidiaries, and other members of a controlled group are separate corporate entities, and, with narrow exceptions, may not deduct expenses attributable to another (Legal Advice Issued by Field Attorneys20032902F).
Employer responsibility under PPACA: Applicable large employers (ALEs) are subject to the Patient Protection and Affordable Care Act's (PPACA's) employer shared-responsibility provisions under Sec. 4980H and information-reporting requirements under Sec. 6056. Common law employers must report certain information on full-time employees using their own employer identification number (EIN) to assist the IRS in determining whether an employer is subject to the Sec. 4980H excise tax. Any excise tax assessed under Sec. 4980H will be assessed against the common law employer.
Domestic manufacturing deduction: In general, the amount of the deduction allowable under Sec. 199(a) for any tax year shall not exceed 50% of the W-2 wages of the taxpayer for the tax year. Under Regs. Sec. 1.199-2, the Forms W-2, Wage and Tax Statement, used in determining the amount of W-2 wages are those issued for the calendar year ending during the taxpayer's tax year for wages paid to current or former employees of the taxpayer for employment by the taxpayer. For these purposes, the taxpayer's employees are limited to employees as defined in Secs. 3121(d)(1) and (d)(2), including common law employees and corporate officers.
Foreign base company income: Under the substantial-contribution test in Regs. Sec. 1.954-3(a)(4)(iv), a controlled foreign corporation (CFC) may qualify for the manufacturing exception if it makes a substantial contribution through the activities of its employees to the manufacture, production, or construction of personal property. For these purposes, only the activities performed by the CFC's employees are considered; the regulations provide that the term employee means any individual who, under Regs. Sec. 31.3121(d)-1(c), has the status of a common law employee of the CFC.
Employee secondment: A secondment arrangement often is used when an employee is temporarily assigned to work in a different office of his or her employer or for another entity within an organization. A formal agreement typically identifies one of the parties (i.e., either the home-country entity or host-country entity) as the employer during the secondment. However, if a common law employer-employee relationship exists, the designation or description of the relationship by the parties is immaterial (see Regs. Sec. 31.3121(d)-1(a)(3)). The IRS has concluded that taxpayers may not contractually designate one party to be an employer when that party fails to meet the federal criteria for status as an employer (Chief Counsel Advice 200017041). Thus, an employee's continued employment relationship with the home-country entity during the secondment could cause an undesired outcome, such as a permanent establishment (or taxable presence) triggering new or additional income taxes and reporting responsibilities for both the employer and employees in the host country.
FICA tip credit: The Sec. 45B credit allows certain employers to claim a general business credit for the FICA taxes employers pay on their employees' tip income. The entity entitled to the Sec. 45B credit is the taxpayer that incurs the tax imposed by Sec. 3111 (the employer portion of the FICA tax). In TAM 201347020, the IRS held that a PEO was not entitled to claim the Sec. 45B credit because it was neither the common law employer nor a statutory employer under Sec. 3401(d)(1) and did not incur the employer portion of FICA taxes under Sec. 3111 on the employees' tips. The IRS indicated that, generally, the taxpayer that incurs the employer portion of FICA taxes is the common law employer, and left open the question of whether another entity could be a statutory employer with regard to the employer FICA tax on the tips.
The foregoing illustrates the broad implications of the determination of which of two (or more) entities is the common law employer beyond employment tax obligations. Taxpayers should consider the potential ramifications of this assessment in light of all the facts and circumstances to avoid unintended and far-reaching consequences.
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 or email@example.com.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.