When an employer decides to use a third party from which to lease employees, the employer does not escape liability for the payroll taxes if they remain unpaid even if the employer makes the payment. This was the issue the IRS was looking at in Chief Counsel Advice 201724025.
In this case the taxpayer had hired an outside professional employer organization (PEO) to manage its payroll. Although the company had paid the PEO for the payroll and the amount that was due on the payroll taxes, the PEO failed to pay the payroll taxes. The corporation discovered this fact on exam.
The corporation did not dispute that it was the common law employer of the individuals in question—it had the right to direct and control “all aspects of the employment relationship between itself and these individuals.”
The corporation had not filed any payroll tax reports, as that was the responsibility of the PEO under its agreement, nor had it verified that payroll tax deposits were begin timely made. While the common law employer generally has the ultimate responsibility for the payroll tax payments, this corporation argued that in this case IRC §3401(d) shifts the responsibility to the PEO.
That provision provides:
For purposes of this chapter, the term “employer” means the person for whom an individual performs or performed any service, of whatever nature, as the employee of such person, except that—
(1) if the person for whom the individual performs or performed the services does not have control of the payment of the wages for such services, the term “employer” (except for purposes of subsection (a)) means the person having control of the payment of such wages…
The corporation’s position was that the PEO was the “person having control of the payment of such wages” in this case.
The memo looked at many cases that applied this provision. The memo notes that, per the applicable regulations, the key issue is which entity had “legal control” of the payment of wages.
First the memo looked at a case where someone other than the common law employer had control of the payment of wages:
In Winstead v. United States, 109 F.2d 989 (4th Cir. 1997), the taxpayer, Winstead, owned land that was farmed by sharecroppers, who were accountable for their hired help. However, the sharecroppers could not pay the hired help until after the crops were sold. Therefore, Winstead paid the help from his checking account, over which the sharecroppers had no authority, then deducted what he paid from the sharecroppers’ share of the crop proceeds. Winstead, who was not the common law employer, was held to have control of the payment of wages to the hired help and thus to be the employer under section 3401(d)(1).
However, the IRS then goes on to look at an employee leasing arrangement case and notes that the Court there found that the common law employer retained control of the payment of wages:
In In re Earthmovers, Inc., 199 B.R. 62 (Bankr. M.D. Fla. 1996), the taxpayer, Earthmovers, a construction company in Chapter 11 bankruptcy, contracted with a leasing company that operated similarly to the PEO in this case. Pursuant to the terms of the contract, Earthmovers leased all of its employees from Sunshine Staff Leasing. The employees were under the direction and control of Earthmovers, but Sunshine was responsible for the payment of wages to the employees, the collection of the appropriate payroll taxes from the paychecks, the payment of all employee withholding taxes due, and the filing of all necessary Federal tax forms. Because Earthmovers had exclusive control of its workers, the court held it to be the common law employer. The court also found that because Earthmovers submitted the information regarding the hours worked each week by each employee, forwarded the amount owed for payroll (including the tax amounts) to Sunshine, and retained the right to hire and fire the employees, Sunshine was not in control of the payment of wages for purposes of section 3401(d)(1). Thus, the court held, Earthmovers bore ultimate responsibility for payment of taxes.
Thus, the IRS concludes:
Based on the provisions contained in the contract, the PEO is not considered to be in control of the payment of wages within the meaning of section 3401(d)(1) because the PEO did not assume legal responsibility for payment of the wages to the employees. Under the terms of the contract, Taxpayer must pay the PEO an amount equal to the wages and salaries with respect to the workers in advance of the next payroll date. To ensure that the PEO will not be responsible for payment of wages to these workers, Taxpayer must provide a security deposit or letter of credit naming the PEO as beneficiary in the amount as determined by the PEO to cover the wages and salaries. Additionally, the PEO may terminate the contract immediately without notice and Taxpayer is “responsible for payment of all wages, salaries and employment related taxes.”
Thus, the PEO acted merely as a conduit for Taxpayer in making payroll and does not meet the standards in section 3401(d)(1) and the regulations thereunder.
Results such as these are the reason why Congress added a “Certified PEO” provision to the law, allowing an employer to enter into arrangements with certain PEOs that obtain IRS certification where the liability does shift to the PEO. Although the rollout of the program moved slower than the law indicated it would, eventually an employer can make use of a CPEO to insure the company does not pay the same payroll taxes twice.
Until then, or if the PEO the taxpayer wants to use does not obtain certification, the taxpayer can best protect itself by checking the payroll tax transcripts regularly to ensure that the taxes are being paid.