Certified Professional Employer Organization Temporary and Proposed Regulations Issued by IRS

The IRS has issued temporary (TD 9768, Regs. §§301.7705-1T and 301.7705-2) and proposed regulations (REG-127561-15, Proposed Regs. §§31.3511-1, 301.7705-1 and 301.7701-2) that will govern the Certified Professional Employer Organization (CPEO) program that Congress enacted as IRC §7705 at the end of 2014 as part of the ABLE Act of 2014.  The program, which was supposed to begin accepting applicants in the summer of 2015 will actually begin accepting applications on July 1, 2016.

As part of the release of the regulations, the IRS also announced the agency’s intent to release a pair of Revenue Procedures, one outlining the application process to become a PEO and another detailing the ongoing requirements to maintain certification.

The provision is meant to allow businesses to avoid the problem under current law that occurs where the organization uses a professional employer organization to take care of paying its employees if the PEO fails to make the payroll tax payments.  Under the general rule, the business remains liable for the unpaid payroll taxes despite the fact that the business had paid over the amount of the taxes to the PEO.

The failure of the PEO to pay over the tax due may occur because the PEO runs into financial difficulties and decides to hold back on the tax payments in a last ditch attempt to stay in business.  Such a situation, while clearly a severe violation of the customer’s trust, is not the worst case.  In some cases, the business has become involved with an organization that simply had no intent to ever pay over the taxes, but simply pocketed those funds.

For an example, see the situation described in the case of City Wide Transit, Inc. v. Commissioner, CA2, 2013-1 U.S.T.C. ¶50,211, reversing TC Memo 2011-279.  As the result there makes clear, the business now has to come up with the funds to pay the payroll taxes that it reasonably believed had been paid.  Even worse, a good portion of those taxes are trust fund taxes subject to the trust fund recovery penalty—and now that the responsible parties are aware that there are unpaid trust fund taxes, they are at risk of personal liability if they allow any other payments to be made to vendors or employees before the trust fund taxes are paid over to the government.

Section 7705 was meant to provide a method for businesses to avoid being placed in this position by creating a class of PEOs to be known as Certified Professional Employer Organizations.  The organizations would need to meet specific standards (including having an independent CPA audit their annual financial statements and issue a report that the company has positive working capital), post a bond, pay an annual fee and submit an application to the IRS.  The status would be subject to annual renewal, and could be revoked if the organization violated certain rules or became financially “risky” by allowing working capital to go negative.

The temporary regulations govern the application process for those entities that wish to become CPEOs and the requirements to maintain CPEO status.  The details will primarily be of interest to organizations seeking to obtain that status and those with clients who perform that service should certainly study this document.

However, your audit and accounting partners may find the rules regarding the audited financial statement and report on working capital of interest

The preamble to the temporary regulations note the following provisions for submission of these statements

Pursuant to these provisions, the temporary regulations require a CPEO applicant to provide to the IRS, with its application, a copy of its annual audited financial statements for the most recently completed fiscal year as of the date it applies for certification. If a CPEO applicant applies for certification before the last day of the sixth month following its most recently completed fiscal year, and the audit of the financial statements for this fiscal year has not yet been completed at the time of application, a CPEO applicant must also provide to the IRS a copy of its audited financial statements for the immediately preceding fiscal year, if any. The temporary regulations provide that the CPEO applicant must subsequently provide to the IRS the financial statements for the most recently completed fiscal year by the last day of the sixth month after such fiscal year ends.

In addition, for any fiscal year that ends after the CPEO applicant applies for certification and on or before the effective date of certification, if applicable, the CPEO applicant must provide the audited financial statements by the last day of the sixth month after such fiscal year ends. The obligation to provide the audited financial statements described in the preceding sentence continues to apply after the CPEO applicant is certified as a CPEO. Once certified, pursuant to section 7705(b)(1), a CPEO is required by the temporary regulations to provide a copy of its annual audited financial statements to the IRS within six months of the end of each fiscal year (beginning with the first fiscal year that ends after the CPEO’s effective date of certification). For these purposes, a CPEO applicant’s or CPEO’s fiscal year will be considered completed once the last day of that fiscal year has ended, even if the CPEO was not operating or certified for the full fiscal year or the fiscal year was a short year consisting of fewer than 12 months.

In addition to the independent CPA’s audit report, a separate report on the status of working capital will also need to be provided by an independent CPA:

Additionally, the Treasury Department and the IRS believe a CPEO with annual audited financial statements that reflect positive working capital (as determined in accordance with GAAP) presents a materially lower risk to the IRS’s collection of federal employment taxes than a CPEO without such financial statements. Accordingly, pursuant to section 7705(b)(1) and consistent with several state PEO certification and registration laws, the temporary regulations require a CPEO applicant or CPEO to cause to be prepared and provided to the IRS, by the same date it must provide a copy of its annual audited financial statements, an opinion of an independent CPA that such financial statements reflect positive working capital for the fiscal year, unless the exception described in the next paragraph applies. In addition, the temporary regulations require this opinion to set forth in detail a calculation of the CPEO applicant’s or CPEO’s working capital. Consistent with section 7705(c)(3)(A), this CPA opinion must also generally state that the financial statements are presented fairly in accordance with GAAP.

The temporary regulations require the CPA be independent—but the IRS is asking for guidance on whether the AICPA standards (which will be used for now) should be the standards finally used:

In accordance with section 7705(c)(3)(A), the temporary regulations require the opinion regarding a CPEO’s financial statements to be provided by a CPA who is independent of the CPEO. For this purpose, the temporary regulations require a CPA to be independent as prescribed by the American Institute of Certified Public Accountants’ Professional Standards, Code of Professional Conduct, and its interpretations and rulings. The Treasury Department and the IRS request comments regarding whether the CPA independence guidelines or requirements of other governmental agencies or departments or industry self-regulatory bodies, as adapted for a CPA of a CPEO, would better ensure the impartiality of CPAs providing opinions on CPEO’s financial statements, such as: (1) the Department of Labor’s guidelines on the independence of CPAs retained by employee benefit plans under 29 CFR 2509.75-9; (2) the Securities and Exchange Commission’s (SEC) independence guidelines for auditors reporting on financial statements included in SEC filings; and (3) the Government Accountability Office’s auditor independence requirements under Government Auditing Standards that cover federal entities and organizations receiving federal funds.

Obviously, CPA firms looking to take on these engagements should consider the possible implication of meeting the independence provisions of those other possible sets of rules, understanding that regardless of what the IRS rules the CPA will need to meet the requirements of his/her state licensing board (which often reference those same AICPA standards) as well as those contained in these regulations.

To complete the accounting and audit portion of this article, the regulations also generally require that the CPEO use the accrual basis of accounting or another method approved by the Treasury.  Given that the CPA’s audit report must show that the statements are prepared in accordance with U.S. GAAP this requirement seems somewhat superfluous. 

The portion of the proposed regulations that are not simply a duplicate of the temporary regulations deal with the operational issues of the CPEO, including the way in which liability can be transferred to the CPEO.  These regulations, to the extent they are not contained in the temporary regulations, will not be effective until published as final regulations.