IRS Issues Final Regulations on Payroll Tax Liability of PEOs and Other Third-Party Payors
Joshua R. Welsh & Joshua L. Cannon
As a follow-up to proposed regulations issued in January of 2013, the IRS has now published final regulations that increase the circumstances in which the IRS may directly pursue Professional Employer Organizations (PEOs) and other third-party payors for unpaid employment taxes. These finalized regulations give small and medium-sized businesses another reason to consider using PEOs.
Final Regulation § 31.3504–2
On March 31, 2014, the IRS issued final regulations under Section 3504 of the Internal Revenue Code regarding the “Designation of Payor to Perform Acts Required of an Employer.” These regulations generally extend certain third-party payors’ liability for unpaid payroll taxes to circumstances in which the third-party payor has entered into an agreement with an employer under which the payor performs the employment tax obligations of the client with regard to wages or compensation paid by the payor to individuals performing services for the client, even if certain other existing requirements for imposing such liability have not been met.
The final regulations do not materially differ from the proposed regulations. As in the proposed regulations, the final regulations extend the current law, under which a third-party payor generally is liable only if it is: (1) deemed to be a common law employer (i.e., the payor generally has the right to control and direct the work performed by the employee); (2) deemed to be a Code Section 3401(d)(1) employer (i.e., the payor generally controls the wages paid to the employee); or (3) appointed as a Section 3504 agent (i.e., the payor and the employer for whom the payor is acting submit IRS Form 2678, Employer/Payer Appointment of Agent). Now, the IRS may hold a third-party payor liable if it has entered into a “service agreement” meeting certain criteria, even if the payor does not meet one of the above tests.
Employment (Payroll) Taxes
Under the Federal Insurance Contributions Act (FICA), employers generally must withhold 6.2% of an employee’s wages, up to the then-applicable wage base ($117,000 for 2014) which is then contributed to Social Security. Employers are also separately liable for the “employer share” of Social Security, which is also 6.2% of the employee’s wages, up to the then-applicable wage base. Likewise, employers are required to withhold 1.45% of an employee’s wages for Medicare and are separately liable for the employer share of 1.45%. There is no wage base for Medicare, so all of an employee’s wages are subject to such tax. Under the American Taxpayer Relief Act of 2012, the employee share of the Medicare tax increases for 2013 and subsequent years by 0.9%, to a total of 2.35%, for employees whose wages exceed $200,000 for single filers and $250,000 for joint filers.
Under the Federal Unemployment Tax Act (FUTA), employers generally are responsible for paying an amount equal to 6.0% of an employee’s wages, up to the FUTA wage base of$7,000. A credit is given for state unemployment tax paid of up to 5.4%. Thus, an employer’s net FUTA tax rate may be as little as 0.6%.
In addition to FICA and FUTA, employers are generally required to deduct and withhold federal income tax from their employee’s wages.
Tax Return Reporting and Filing Obligations
In connection with the deduction, withholding and payment requirements set forth above, employers are generally required to make periodic tax filings. FICA wages are reported to the IRS quarterly on Form 941, Employer’s Quarterly Federal Tax Return. FUTA wages are reported to the IRS annually on Form 940, Employer’s Annual Federal Unemployment Tax Return. Note, however, that, with limited exceptions, Section 3504 agents, which are the subject of this discussion, are not, according to the preamble to the proposed regulations, “authorized to perform the employment tax obligations of an employer with respect to the FUTA tax” and, consequently, “an employer generally must continue to satisfy its FUTA tax obligations by filing a Form 940 using its own EIN.” Withheld federal income tax is reported to the IRS annually on Form 945, Annual Return of Withheld Federal Income Tax.
Liability for Employment/Withheld Income Taxes
As common sense would dictate, an employer (or, as relevant to these discussions, the employer’s agent) is responsible for paying over to the government all of the taxes that it withholds from its employees’ wages (in addition to the FICA and FUTA taxes which it separately owes). This is important. When an employer withholds taxes it is deemed to be holding those funds “in trust” for the government. When an employer fails to pay these “trust fund” taxes over to the government, the IRS can hold the payor’s owners and other “responsible persons” personally liable for all outstanding amounts.
Third-Party Payor Arrangements
Payroll obligations can be burdensome on small and even medium-sized businesses. Accordingly, employers often turn to third-party payor arrangements in order to relieve these burdens. These arrangements take on various forms, including payroll service providers (PSPs), employee leasing companies (ELCs), and professional employer organizations (PEOs). PSPs typically enter into an agreement whereby they undertake to prepare employment tax returns and process withholding, deposit and payment of taxes, all using the employer’s EIN. Under such arrangements, the PSP is neither an employer under common law or under Section 3401(d), nor an agent under Section 3504, and is therefore not ultimately directly liable for payroll taxes. True ELCs, on the other hand, which hire the employee and temporarily place him or her with a company, are generally responsible for payroll tax liability as either such employees’ common law employer or as a Section 3401(d) employer. PEOs are a bit trickier (since they have characteristics of both PSPs and ELCs) and are the most likely to be impacted by the final regulations.
Professional Employer Organizations
PEOs will typically enter into an agreement with an employer-client to employ or co-employ that employer’s employees. The PEO will handle all of the client’s payroll issues, including the payment of wages, filing of employment tax returns, etc. The co-employment relationship is important inasmuch as it generally allows a PEO to provide the employer-client with a better benefit package, including group insurance, qualified retirement plans, etc., while at the same time allowing the employer-client to control workplace and similar issues directly affecting the employees.
Registration requirements and law governing PEOs in Wisconsin are primarily set forth in Chapter 461 of the Wisconsin statutes. Specifically, a PEO in Wisconsin “means a person that is engaged in the business of entering into written contracts for the provision of nontemporary, ongoing employee workforce of a client and providing services under those contracts and that under those contracts has the obligation to pay the employees providing services for those clients from its own accounts.” Wis. Stat. §461.01(5). Worker’s Compensation issues for PEOs are addressed in Wis. Stat. §102.315. Unemployment Insurance issues for PEOs are generally addressed in Wis. Stat. §§ 108.02(21c), 108.065(2)(b) and 108.067.
Implication of the Final Regulations for PEOs
As noted above, the final regulations expand the circumstances in which the IRS can target a third-party payor for payroll tax liability. This may impact certain PEOs and their clients. Currently, PEOs can knowingly assume liability for payroll taxes by submitting, along with the client, Form 2678 to the IRS. Under the final regulations, a payor can now be liable even without submitting Form 2678, if it has entered into a “service agreement” with an employer to handle payroll tax obligations. Specifically, under the regulations, the “service agreement” at issue is one in which “the payor: (A) asserts it is the employer (or co-employer) of the individual(s) performing services for the client; (B) pays wages or compensation to the individual(s) for services the individual(s) perform for the client; and (C) assumes responsibility to collect, report, and pay, or assumes liability for, any taxes... with respect to the wages or compensation paid by the payor to the individual(s) performing services for the client.” This is typical for most PEO arrangements. Significantly, such a service agreement does not need to be in writing, and an oral agreement meeting the above elements will have the same effect. Furthermore, the payor may implicitly assert that is the employer under (A) by undertaking certain acts on behalf of the client, such as recruiting and hiring employees on the client’s behalf or filing employment tax returns using the payor’s EIN for individuals performing services for the client.
In many respects, the final regulations are straightforward. They essentially apply a substance over form test by saying to PEOs: “If you’re responsible for payroll taxes... well, then... you’re responsible for payroll taxes.”
Importantly, these rules do not take the employer-client completely off the hook. When an employer hires a PEO, it remains liable for the payment of payroll taxes, regardless of whether the PEO and client execute Form 2678 to formally appoint the PEO as agent, or the PEO’s liability is by agreement under the regulations. Certainly, many PEOs, either in their standard contract or by virtue of negotiation with a client, will include a provision that requires the PEO to indemnify the client in the event of payroll tax liability attributable to the PEO’s failure to collect or remit taxes. It appears that the final regulations nevertheless provide a benefit to clients in such situations inasmuch as the IRS will now have authority to pursue the PEO directly in circumstances in which it may have otherwise pursued only the employer-client. While it appears that the final regulations effectively cause the PEO and its client to be jointly and severally liable for the payroll tax obligations, the client is in a much better position by having the IRS pursue the PEO directly. The final regulations are effective for wages or compensation paid by a payor in quarters beginning on or after March 31, 2014.
The information contained herein is not intended as and should not be construed as legal advice. Please consult with legal counsel before taking any action based on this information.
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