Liability for payment of employment taxes when using a PEO

Editor: Mark G. Cook, CPA, CGMA

An organization engages a professional employment organization (PEO) to file its employment taxes, and the taxes are not paid. Whose door is the IRS going to knock on? A recent Chief Counsel Advice (CCA 201724025) was issued regarding who is ultimately liable for payment of employment taxes when using a PEO. A PEO is a company that provides a number of services to another corporation including, but not limited to, the payroll function. The Chief Counsel’s Office answered two questions in the CCA:

1. Is the PEO or the taxpayer liable for remitting “employment taxes”?; and
2. Does the taxpayer qualify for relief under Section 530 of the Revenue Act of 1978?

Background

The taxpayer, an S corporation, hired its own employees, but entered into a contract with a PEO to administer payroll, benefits, HR administration, and various other functions on the taxpayer’s behalf. The taxpayer did not deduct any officer compensation or salaries and wages, but instead deducted an employee lease expense.

In the agreement entered into between the taxpayer and the PEO, the taxpayer was in charge of the day-to-day supervision of the individuals hired by the PEO. Although the PEO paid salaries, wages, and other costs, the contract mandated that the taxpayer had to pay these amounts to the PEO at least one day before the payroll date. The taxpayer was also required to pay a security deposit or establish a line of credit to cover the payments the PEO needed to make on the taxpayer’s behalf.

At any time, the PEO could terminate the contract for the taxpayer’s lack of payment. The contract stated that the PEO would administer payroll, file all required employment tax returns to the government, and provide the employees with their information returns. Due to the terms of the contract, the taxpayer did not file Forms 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, or 941, Employer’s Quarterly Federal Tax Return.

The taxpayer learned upon an IRS audit that the PEO it hired did not make any employment tax payments to the government. The IRS came after the taxpayer for the unpaid employment taxes. The taxpayer argued it was not liable, stating that because it had remitted the employment taxes to the PEO, the PEO and not the taxpayer was liable for the unpaid employment taxes.

Liability for employment taxes

The determination of who is liable for making sure the employment taxes are paid ultimately came down to two factors: (1) Who was the common law employer; and (2) who was in control of the payment of wages? In the associated case, the taxpayer agreed that it was the common law employer and that the common law employer has the responsibility to pay any tax liabilities on the wages it pays to its employees. However, the taxpayer stated that it did pay the required amount of employment taxes to the PEO and that it was ultimately the PEO’s responsibility to remit the employment taxes per Sec. 3401(d).

Sec. 3401(d) determines that the term “employer” shall apply to the person who has control over the payment of wages when the common law employer does not have control of this function. While this Code section only states that it applies to the obligation of federal income tax withholding, case law (see Otte, 419 U.S. 43 (1974); In re Armadillo Corp., 561 F.2d 1362 (10th Cir. 1977); The Lane Processing Trust, 25 F.3d 662 (8th Cir. 1994)) has applied this section to other employment taxes, including Federal Insurance Contributions Act and Federal Unemployment Tax Act taxes.

In the case at hand, the determination must be made whether the PEO or the taxpayer was in control of the payment of wages. The Chief Counsel’s Office noted that a number of cases have dealt with the issue of who is in control of the payment of wages as determined by Sec. 3401(d)(1), including the following:

Winstead, 109 F.2d 989 (4th Cir. 1997): Winstead owned farm land, which was operated by sharecroppers. The sharecroppers were responsible for hiring their own help. The issue was that until the crops were harvested and sold, the sharecroppers did not have the funds to pay their help. Winstead would pay the help from his own checking account, on behalf of the sharecroppers. It was determined that Winstead had control over the payment of wages and was considered the employer under Sec. 3401(d)(1), making him responsible for the payment of the employment taxes.

In re Earthmovers, Inc., 199 B.R. 62 (Bankr. M.D. Fla 1996): Earthmovers contracted with a leasing company, Sunshine Staff Leasing, for its employees. Earthmovers had the day-to-day supervision and control over these employees. Sunshine Staff Leasing was responsible for paying wages to the employees, collecting payroll taxes, paying taxes due, and filing the required federal tax forms. The court found that Earthmovers was the common law employer since it had direct control over the employees. Every week, Earthmovers would send timesheet information and the amount owed for payroll and taxes to Sunshine, and it also retained the right to hire and fire workers. Therefore, the court held that Earthmovers and not Sunshine was in control of the payment of wages as defined in Sec. 3401(d)(1). The court found that Earthmovers was the party responsible for paying employment taxes.

The Chief Counsel’s Office also observed that other cases, such as Garami, 184 B.R. 834 (M.D. Fla. 1995), and In re Professional Security Services, Inc., 162 B.R. 901 (Bankr. M.D. Fla. 1993), concluded that taxpayers who received payroll funds and data from a client company, and would not pay employees if funds were not received from the client company, were not Sec. 3401(d)(1) employers.

Based on this precedent, the Chief Counsel’s Office advised that because the contract required the taxpayer to send funds to the PEO, the taxpayer was legally in control of the payment of wages. The contract was set up in such a way that the PEO would never be responsible to pay wages. If the taxpayer failed to send funds to the PEO, the security deposit or line of credit would cover the amounts due. Thus, the taxpayer was responsible and liable for making sure that all employment taxes were paid.

Relief under Section 530 of the Revenue Act of 1978

The taxpayer in the alternative argued that it should be eligible for relief under Section 530 of the Revenue Act of 1978, which would permit the taxpayer to escape liability for the employment taxes. For Section 530 relief to apply, the taxpayer must meet three requirements: (1) The taxpayer did not treat an individual or others with a substantially similar position as an employee; (2) the taxpayer must have filed all federal tax returns in a manner consistent with the individual not being treated as an employee (i.e., Form 1099-Misc, Miscellaneous Income); and (3) a reasonable basis must exist for the taxpayer to not treat the individual as an employee. If all three of these conditions are met, Section 530(a)(1) states that the individuals are not considered employees and the taxpayer would not be liable for employment taxes.

Ultimately, the Chief Counsel’s Office advised that the taxpayer was not entitled to relief under this section. Examining the legislative history, it found that Section 530 was intended to determine employee or nonemployee status, not to determine whether a common law employer was liable for any employment taxes that were not paid to the government.

No cover for hiring a PEO

Using a PEO can alleviate some of the burdens of a growing business, but ultimately it will be the responsibility of the company that uses the PEO to make sure that the PEO is actually paying the employment taxes to the government. Even if the PEO has the responsibility of payment for wages and employment taxes according to the contract, the company should always verify that the PEO pays all required taxes in a timely fashion.

In June, the IRS approved the first group of certified professional employer organizations (CPEOs), a new type of PEO authorized by the Tax Increase Prevention Act of 2014, P.L. 113-295, that may resolve some of the issues surrounding PEOs. The CPEO provisions in Secs. 3511 and 7705 allow a CPEO to be solely liable for payroll taxes on wages it pays to its clients’ employees.

EditorNotes

Mark G. Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.