Proposed Regs. Would Govern Employment Tax Liability of Third-Party Agents

On Friday, the IRS released proposed regulations under Sec. 3504 (acts to be performed by agents) that would govern the liability for employment taxes when an employer designates an agent under a “service agreement” to pay its employees and to satisfy all employment tax obligations (REG-102966-10). Such agents include payroll service providers, employee leasing companies, and professional employer organizations.

The proposed rules are intended to assist taxpayers and the IRS in determining the parties’ employment tax obligations in a three-party arrangement in which a payer has represented to the employer that it will pay the employment taxes for wages or compensation it pays to employees for services the employees performed for the employer.

Generally, employment tax liability is determined under the Code and cannot be altered by an agreement between an employer and a third party. In some limited circumstances, a third-party payer may be considered the person responsible for withholding and payment of employment taxes in addition to—or in lieu of—the employer. Under Sec. 3504, if a third party pays wages or compensation to employees who are employed by one or more employers, the IRS can designate that payer to perform acts required of employers under the Code.

Under the Sec. 3504 rules, agents use their own employer identification number (EIN) when filing one aggregate Form 941, Employer’s Quarterly Federal Tax Return, for all the employers for whom they act (or one aggregate Form CT-1, Employer’s Annual Railroad Retirement Tax Return, for all railroad employers for whom they act). The payers file Form 941, Schedule R, Allocation Schedule for Aggregate Form 941 Filers, to provide the breakdown for individual employers. Employment taxes for these purposes include the employer and employee portion of Federal Insurance Contributions Act (FICA) taxes, Federal Unemployment Tax Act (FUTA) taxes, Railroad Retirement Tax Act taxes (RRTA), and federal income taxes withheld from wages.

Under existing rules, payers and employers file Form 2678, Employer/Payer Appointment of Agent, with each Form 941. A payer that undertakes these obligations is liable for any tax or penalty that may apply, but the employer also remains liable.

The proposed regulations provide that, unless certain exceptions apply, a payer can be designated as an agent under Sec. 3504 to perform the acts required of an employer with respect to wages or compensation paid by the payer to any individual performing services for any client pursuant to a “service agreement” between the payer and the client. In that case, the IRS states that it will pursue recovery of unpaid taxes and penalties only once—either from the payer or the employer.

A service agreement is defined in the proposed rules as an agreement between an employer and payer in which the payer asserts it is the employer (or “co-employer”) of the individuals performing services for the employer; pays wages or compensation to the individuals; and assumes responsibility to collect, report, and pay, or assumes liability for, any employment taxes applicable for wages or compensation the payer pays to the individuals performing services for the employer (Prop. Regs. Sec. 31.3504-2(b)(2)).

The rules under the proposed regulations would not apply if the wages are reported on a return filed under the employer’s EIN, the payer is a common paymaster under Secs. 3121(s) or 3231(i), or the payer is the individuals’ employer (Prop. Regs. Sec. 31.3504-2(d)). Eight examples illustrate how these rules would apply.

These rules will apply to wages or compensation a payer pays under a service agreement in quarters beginning on or after the date they are published as final in the Federal Register. In the meantime, the IRS is requesting comments, which must be received by April 29. In particular, the IRS asks for comments on (1) whether the definition of service agreement inappropriately results in a payer’s being designated (or failing to be designated) an agent under Sec. 3504; (2) whether additional exceptions are warranted; and (3) whether additional examples should be given.