Courtesy of Tax Guard (http://tax-guard.com)
Professional employer organizations (PEOs) – sometimes referred to as “employee leasing companies” or “co-employers” – have been in existence in a variety of forms for over 20 years. However, all too often, the businesses that work with PEOs (the PEO’s client, which is also the lender’s client, and potentially Tax Guard’s client as well) assume their PEO protects them from employer tax liability and assures payment to the IRS. Unfortunately, this assumption is incorrect.
WHAT DOES A PEO DO?
In the typical contractual agreement between a business and a PEO, the PEO takes over some or all duties of an employer (e.g., employment tax withholding, reporting, and payment functions) under its own name and employer identification number (EIN) instead of the business’s EIN. The business receives the benefit of its workers’ services without the paperwork and headache associated with payroll and taxes (e.g., 941 withholding and 940 unemployment). A PEO may also provide additional benefits based on economies of scale, such as managing human resources, employee benefits, workers’ compensation claims, and unemployment insurance claims.
WHAT’S THE PROBLEM?
The contract between the business and the PEO defines the PEO as the responsible party relative to taxes, which is what leads many business owners to assume (incorrectly) that this contract insulates them from tax liability. The IRS is not bound by any agreement between an employer (the business) and a third party (the PEO). Use of a PEO does not necessarily relieve a business of its employment tax obligations.
SO, WHAT HAPPENS IF A BUSINESS’S PEO FAILS TO PAY EMPLOYMENT TAXES? IS THE BUSINESS OR THE PEO LIABLE FOR EMPLOYMENT TAX?
Generally, in an employment tax case, liability is based on whether the business is considered the “common law employer.” Whether the business is the common law employer depends on several facts and circumstances, e.g., which entity directs and controls the day-to-day performance of the workers’ duties, retains the authority to hire and fire the workers, and/or sets the hourly wage or salary. A PEO may not exhibit the degree of direction and control over the business’s workers that is required to satisfy the common law standard, and thus would not be liable under the Internal Revenue Code as the common law employer – in which case, the business would be considered liable. (And, if the business is a staffing company, the staffing company as well as all of its individual clients could be held liable as common law employers.)
IS THE PEO EVER CONSIDERED LIABLE?
As of 2014, there are two clear situations where the PEO is considered the “employer” and responsible party.
First, a PEO (or payor) could be “designated to perform the acts of an employer.” For a PEO to be the designated employer, it must meet the three-part “service agreement test” set forth in Treas. Reg. 31.3504-2(b), whereby it (1) asserts it is the employer (or “co-employer”); (2) pays wages or compensation to the individual(s) for services the individual(s) perform for the client; and (3) assumes responsibility to collect, report, and pay, or assumes liability for, any taxes paid by the payor to the individual(s) performing services for the client. If a PEO fits all three and is the designated employer, all provisions of the law and the regulations applicable to “the employer” are applicable to the PEO.
In many PEO agreements, the problem lies with the second requirement of the service agreement test. A PEO may refer to itself as a “co-employer,” and file employment returns using its own EIN, which meets the first and third requirements. However, many PEO agreements call for the business to make each wage payment directly from the business-owned account on which the PEO has no signatory authority. In these situations, where the business pays wages directly from its account, the PEO does not meet the requirements of a designated employer and will not be responsible for unpaid employment taxes. Rather, the business is the responsible party (even if the business made the necessary payments to the PEO).
The second situation in which the PEO is considered the responsible party is when the PEO is a “certified PEO” with the IRS (CPEO). This is a new certification created as part of the Tax Increase Prevention Act of 2014 (P.L. 113-295). A business’s CPEO is treated as the sole employer of the worker(s) performing services for the business. The statutory deadline for IRS implementation of the CPEO process was January 1, 2016; however, the IRS did not even release the certification information or begin taking applications until July 1, 2016. So, at this point, there is no way to know how many PEOs, if any, have applied for the certification. There are also a number of issues that have not been resolved, and even if a CPEO applicant submits a complete and accurate application before September 1, 2016 and is certified, the effective date of its certification wouldn’t be until January 1, 2017. In short, this is not a near-term fix.
If a business’s PEO does not meet the service agreement test to be “designated to perform the acts of an employer” and/or has not obtained the IRS certification of “CPEO,” the business will likely be held liable for unpaid employment taxes, even if the business made the necessary payments to the PEO.