Generally, an employer is required to deduct and withhold Federal Insurance Contribution Act taxes (“FICA”), Federal Unemployment Tax Act taxes (“FUTA”), and income tax withholding from its employee’s wages and is separately liable for the employer’s share of FICA and FUTA. However, in some cases, an employer will use a third party to perform some or all of the employer’s federal employment tax withholding, reporting, and payment obligations.
Common third-party payer arrangements include: a payroll service provider (“PSP”), a reporting agent (“RA”), a professional employer organization (“PEO”), and a certified professional employer organization (“CPEO”). As in other areas of tax law, the employment tax area is populated with defined terms and acronyms (described below).
Generally, a PSP is a third party that acts on behalf of an employer with respect to the employer’s payroll administration (including wage payments, income tax withholding and employment taxes). A RA is a type of PSP, but a RA’s duties are typically limited to filing certain tax returns (i.e., Forms 940 and 941), making federal tax payments and/or submitting federal tax payment information. In contrast, a PEO is an employee leasing company that enters into an agreement with a client to perform wage payments, employment tax withholding, reporting, and payment functions related to workers performing services to the client. A PEO may also manage human resources, employee benefits, workers compensation claims, and unemployment insurance claims for the client. Finally, a CPEO is a PEO that has been certified by the Internal Revenue Service (the “IRS”).
A significant difference between a PSP, RA, PEO, and CPEO is who is liable for employment taxes when such taxes are not timely paid. As described in my earlier article “Benefits of Hiring a Certified Professional Employer Organization (“CPEO”)”, June 2, 2016, a CPEO is treated as the employer of the covered employees for employer-tax liability purposes and the client is relieved from liability for these employment taxes.
In contrast, when an employer retains a PSP or RA to perform payroll, employment tax withholdings, reporting, or payment obligations, the employer remains liable for any employment tax liability with respect to the services provided by the PSP or RA. In the case of a PEO, depending on the nature of the services provided under the contract between the PEO and the client, the liability for unpaid employment taxes may reside with the client, the PEO or the client and the PEO may be concurrently liable for such employment taxes.
Unfortunately, there are situations where a PSP, RA, or PEO undergoes fiscal stress and fails to perform under the contract with the client/employer or an employee of the PSP, RA, or PEO commits fraud and the employer’s/client’s employment tax liabilities are not timely paid. As described above, in the case of a PSP or RA, the employer/client retains liability for unpaid employment taxes. In the case of a PEO, the client may retain the sole or concurrent liability for the unpaid employment taxes. Thus, when a failure to fully pay employment taxes is discovered, the IRS may also look to the employer/client for the payment of the unpaid employment taxes.
In cases where the IRS seeks payment of employment taxes resulting from a third party paying arrangement, the employer/client may attempt to resolve the controversy via an offer in compromise. In such cases, an offer in compromise is an offer by the client/employer to pay less than the total amount of unpaid employment taxes on the theory that the partial payment promotes efficient tax administration and is supported by equity and/or public policy factors.
On May 25, 2018, the Director, Collection Policy of the IRS issued an interim guidance memorandum that clarifies the authority for IRS collection employees to accept offers in compromise from clients of RAs and PEOs. This guidance will be incorporated into the Internal Revenue Manual (“IRM”) 184.108.40.206.2.1 in the next revision to IRM 5.8.11.
Prior to this guidance, the IRM only addressed the acceptance of offers in compromise from clients of a PSP. The prior IRM also required the existence of sufficient documentation to verify that the PSP was the cause of the delinquency and that the employer/client acted in a reasonable manner. Generally, an employer/client acted in a reasonable manner if the employer/client: (1) verified the PSP’s references, checked to see if the PSP’s state required bonding and corporate filings/licenses were up to date; (2) monitored the federal tax deposits; and (3) took immediate steps to remedy the problem after learning of the PSP’s Fraudulent Acts.
The May 25, 2018 guidance clarifies that collection employees may also accept offers in compromise from the clients of RAs and PEOs. Similar to the prior guidance, the collection employee must “verify the steps taken by the client to act in a prudent and responsible business manner with respect to the employment tax liabilities which the client has submitted an offer in compromise”.
In the case of an offer in compromise submitted by a client of a PEO, the client may also claim that the contract between the client and the PEO relieves the client of its liability for employment tax obligations. Significantly, the guidance notes that contract provisions, by the themselves, cannot contractually assign liability for employment taxes.
While the guidance (and revised IRM section) has limited application, the guidance provides a potential method for resolving a difficult situation (e.g., a PEO or RA failed to pay employment tax liabilities with the IRS looking to the client/employer for the payment of such liabilities). For clients of a RA or PEO and where the RA or PEO failed to pay the required taxes under the engagement, this new IRS guidance indicates that an offer in compromise may be a viable option now to the client to resolve taxes that may be owed.
Please note that the use of a CPEO (referenced above and described in my June 2, 2016 article) avoids the issues addressed in the guidance because the CPEO (and not the client) is treated as the employer for employment tax liability purposes and the CPEO is liable for the taxes in these instances.
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