Professional Employer Organization Defeats IRS Appeal in FICA Tip Credit Case

(Parker Tax Publishing November 2020)

The Eleventh Circuit held that a professional employer organization (PEO) was allowed to claim credits under Code Sec. 45B based on its payment of Federal Insurance Contributions Act taxes on tip income of its client companies' employees because it controlled the payment of wages subject to withholding under Cod Sec. 3401(d). The court, in rejecting the IRS's argument that the PEO was merely a conduit for its clients' funds, found that the contract between the PEO and its clients established who would claim the tax credits and, under that contract, the PEO would control the payment of wages and would be responsible for the withholding of taxes. Trinet Group, Inc. v. U.S., 2020 PTC 349 (11th Cir. 2020).

Background

Trinet Group, Inc. is a professional employer organization (PEO) that acquired Gevity HR, Inc. in 2009. Gevity provided various employment and human resource services to its clients, including payroll processing, employment tax services, health and welfare benefits, and workers' compensation coverage. Gevity's clients included restaurants and other food and beverage clients where tipping is customary.

Gevity entered into a standardized contract, known as a professional services agreement (PSA), at the start of each relationship with a client. Under the PSAs, Gevity was responsible for, among other things, processing and issuing employee paychecks in accordance with the client's instructions, and managing paperwork, including the client's payroll and payroll processing, tax filing and administration, and W-2 preparation. Gevity's clients were responsible for compensation and benefits, hiring and termination, and managing and supervising employees. Grevity and its clients were deemed co-employers of its clients' employees, who were referred to as worksite employees. The PSAs specified that the client would at all times retain its status as an employer of the worksite employees, but the entirety of an employer's rights and responsibilities were to be shared and allocated between Grevity and the client, so that the worksite employees would be simultaneously employed by both parties.

The PSAs required clients to pay Gevity (1) the gross wages of the worksite employees, including employment taxes; (2) a service fee; (3) employer contributions to any benefit plans; and (4) fees for any other services not covered by the service fee. Gevity provided its clients with invoices for the amounts due each pay period, and the invoices were payable immediately upon receipt. The PSAs specified that payment to Gevity must be made through wire transfer, Automated Clearing House (ACH) transfer, or other method acceptable to Gevity. Under the PSAs, Gevity was responsible for the reporting, collection and payment of employment taxes on wages paid to worksite employees. In addition, some of the PSAs stated that Gevity assumed responsibility for the payment of wages to the worksite employees "without regard to payments by Client to Gevity."

The worksite employees earned wages at least a week before the pay date when they received wage payments from Gevity. On the pay date, Gevity paid the net wages of each worksite employee using a debit against Gevity's own bank accounts. There was a lag in the payroll process between the time when Gevity invoiced the client and the time when Gevity received the client's payment. Most clients paid using ACH transfer. If an ACH debit did not clear, Gevity would learn of this fact within three to five business days through a report from its bank. Consequently, Gevity would not know whether the client's ACH transfer had cleared until at least one day after making the wage payments to the worksite employees. Gevity reported the wages and withholdings with respect to worksite employees on Forms 941, Employer's Federal Quarterly Tax Returns, which were under Gevity's own name, address, and employer identification number (EIN). Gevity's deposits of employment taxes to the IRS were also made under its own name and EIN.

On its 2004 through 2009 income tax returns, Gevity claimed credits under Code Sec. 45B based on its payment of Federal Insurance Contribution Act (FICA) taxes on the tip income of the worksite employees. Under Code Sec. 45B(b)(1), the FICA tip credit is equal to the amount of FICA tax paid by "the employer" on the portion of tips exceeding the amount treated as wages for the purpose of satisfying federal minimal wage requirements. The "employer" for FICA purposes is defined by the definition used in Code Sec. 3401(d). Code Sec. 3401(d) defines the "employer" for withholding purposes as (1) the person for whom an individual performs services, except that (2) if the person for whom the individual performs services does not have control of the payment of the wages for such services, the employer is the person who has control of the payment of the wages. The "person for whom an individual performs service" is referred to as the "common law employer," and the person having control of the payment of wages is referred to as the "statutory employer."

The IRS audited Gevity's 2004 - 2009 returns and determined that it was not eligible for the FICA tip credits on the ground that it was neither the common law employer nor the statutory employer of the worksite employees. Gevity paid the resulting deficiencies and then sued for a refund in a district court. The district court held that Gevity was the statutory employer under Code Sec. 3401(d). It relied on its holding in Paychex Business Solutions, LLC v. U.S., 2017 PTC 295 (M.D. Fl. 2017), a case with nearly identical facts, in which the court held that a PEO was the statutory employer because it had exclusive control of the bank accounts from which its clients' employees were paid, and therefore had control of the payment of wages. The district court rejected the IRS's argument that the PEO was merely a conduit between the employer and the employee, noting that Paychex could not confirm the sufficiency of its clients' funds before paying the employees.

The IRS appealed to the Eleventh Circuit. It argued that Gevity's clients had control of the payment of wages because they provided the funds that Gevity used to pay the wages and provided the information needed to determine the payroll. The IRS further argued that the district court applied an erroneous co-employer theory of Code Sec. 3401(d) under which a common law employer and an asserted statutory employer could both count as an employer, even though the plain language of Code Sec. 3401(d) allows for only one of these to be the employer.

Eleventh Circuit's Analysis

The Eleventh Circuit affirmed the district court's order and held that Gevity was entitled to claim the FICA tax credits as the statutory employer because it, not its client companies, had control of the payment of such wages. First, the court clarified that, under Code Sec. 3401(d), the person entitled to claim the FICA tip credit must be the same person as who is responsible for withholding FICA taxes from wage payments. According to the court, as between the common law employer and a party who is not a common law employer, but purports to be the statutory employer on the basis of having control of the payment of wages, only one of them can be the employer under the statute. That one employer is then expressly both liable for withholding and paying FICA taxes and entitled to claim the FICA tip credit.

Next, the Eleventh Circuit explained that while it was affirming the district court's ruling, it disagreed with the lower court's conclusion that the person with control over the bank account from which wages are paid is the person with control over the payment of wages. The Eleventh Circuit reasoned that, in some cases, the person whose bank account is used to make the payment may not be the one controlling the payment, or even the one genuinely paying the employee. Rather, the court held that control depends on who is actually responsible for the payment of wages, as informed by the parties' understanding of their arrangement.

According to the Eleventh Circuit, control of the payment of wages is something that the parties can allocate between themselves through their agreement. The court reasoned that, because both liability for employment taxes and entitlement to credits follow control, the parties' understanding of who bears the responsibility for withholding or who will be able to claim tax credits is strong evidence of who has control of the payments. Applying this framework, the court found that it was part of the bargain between Gevity and its clients that Gevity would control the payment of wages and would be responsible for the withholding of taxes. Most important, in the court's view, was the fact that Gevity generally issued wage payments before receiving payment from its clients.

The court also found that, while Gevity and its clients could not both qualify as the "employer" under Code Sec. 3401(d), the fact that the agreements envisioned a co-employment relationship was relevant because it supported the idea that the parties conceived of Gevity as having a responsibility of its own to pay the wages and not just acting as a conduit for its clients' funds. The court also noted that under the agreement, Gevity was responsible for reporting and collecting employment taxes and that it reported tax withholdings on its own tax forms under its own name and EIN. In the court's view, these considerations suggested that the parties understood Gevity to be liable for employment taxes and entitled to any tax credits associated with those taxes, absent contractual provisions to the contrary.

For a discussion of the rules for determining who is the employer for payroll tax purposes, see Parker Tax ¶210,105. For a discussion of the credit for employer FICA taxes paid on employee tips, see Parker Tax ¶105,901.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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