S Corporation Liable for Employment Taxes Not Paid by Professional Employer Organization

(Parker Tax Publishing July 2017)

The Chief Counsel's Office advised that an S corporation that hired a professional employer organization (PEO) to fulfill the S corporation's employment tax obligations was liable for the employment taxes that the PEO failed to pay. Had the S corporation used a certified PEO instead, it would not have been liable for the unpaid taxes. CCA 201724025.

Background

An S corporation employed workers that it obtained through a professional employer organization (PEO) in various capacities, including accounting, administrative and marketing positions. The S corporation and the PEO entered into an agreement with respect to those workers. Under the terms of the agreement, the S corporation was responsible for the day to day supervision and control of the workers and, before each payroll date, it was obligated to pay to the PEO the wages and salaries and any other charges or payments to be paid to, or with respect to, the individuals the PEO retained to work in the S corporation's locations. It agreed to provide a security deposit or procure a letter of credit naming the PEO as the beneficiary for the amount necessary to cover the wages and salaries. The PEO was responsible for payroll, benefits, personnel policies and procedures, human resources services, workers' compensation insurance, and processing and paying wages from its own accounts to the workers. The PEO was also obligated under the contract to file all employment tax returns including Form 940, Employer's Annual Federal Unemployment Tax (FUTA) Return and Form 941, Employer's Quarterly Federal Tax Return, as well as all information returns (i.e., Forms W-2).

For the years at issue, the S corporation filed Forms 1120S and took employee leasing deductions for its entire workforce. It did not claim any deductions for officer compensation or salaries and wages. The S corporation did not file any Forms 940 or 941 or issue Forms W-2 with respect to any workers for any of the years at issue; nor did it take any steps to verify that the PEO filed and paid the employment taxes due or filed the appropriate returns. As the result of an IRS audit, the S corporation learned that the PEO had failed to remit the applicable employment taxes to the IRS. According to the IRS, the S corporation was liable for the unpaid employment taxes.

Liability for Employment Taxes

The responsibility for paying employment taxes falls on the statutory employer as defined in Code Sec. 3401(d) and Reg. Sec. 31.3401(d)-1(f). For employment tax purposes, the employer is the person for whom an individual performs a service, unless the person does not have control over the payment of wages for such services. The focus under the regulations is on the legal control of the payment of wages.

Under Sec. 530 of the Revenue Act of 1978 (Sec. 530), workers are deemed not to be employees of a taxpayer for employment tax purposes if certain requirements are met. If Sec. 530 applies, then for employment tax purposes for a particular period, the worker in question is not an employee, and the taxpayer therefore has no employment tax liability for that period.

S Corporation's Arguments

The S corporation did not dispute that it was the common law employer of the workers at issue, and acknowledged that it was responsible for paying the underlying tax liabilities on wages it paid to its workers. The S corporation asserted, however, that it paid the wages plus the required employment taxes to the PEO, and that the PEO was obligated to withhold employment taxes from the wages and pay those taxes over to the IRS. The S corporation argued alternatively that it was entitled to relief under Sec. 530 from its employment tax liabilities.

Chief Counsel's Conclusion

The Chief Counsel's Office advised that the S corporation was not relieved of its employment tax obligations, and was not entitled to relief under Sec. 530. First, the Chief Counsel's Office concluded that the PEO was not the statutory employer under Code Sec. 3401(d)(1) because it did not assume legal responsibility for the payment of the wages to the employees. The contract provided that the S corporation would pay the PEO an amount equal to the wages in advance of the next payroll date. To ensure that the PEO would not be responsible for the payment of wages to the employees, the S corporation was required to provide a security deposit or letter of deposit naming the PEO as the beneficiary in the amount as determined by the PEO to cover the wages. In the view of the Chief Counsel's Office, the PEO therefore did not meet the definition of an employer under Code Sec. 3401(d), but was rather merely a conduit for the S corporation in making payroll.

With respect to the Sec. 530 issue, the Office of Chief Counsel advised that the S corporation was not entitled to relief from its employment tax liabilities under Sec. 530. Reviewing the legislative history, the Chief Counsel's Office concluded that Congress's intent was to limit the application of Sec. 530 relief only to controversies regarding whether an individual should be reclassified as an employee instead of an independent contractor. In this case, there was no question that the workers were properly classified as employees. The Chief Counsel's Office reasoned that the entire contractual arrangement between the S corporation and the PEO was in fact predicated on the treatment of the workers as employees. The dispute was limited to whether the S corporation as the common law employer remained ultimately liable for the unpaid employment taxes, and Sec. 530 was therefore inapplicable to the S corporation's situation.

Certified PEO Program

The IRS has established a certified PEO (CPEO) program. If a company hires a CPEO, and that CPEO fails to fulfill its obligations, the company is not held responsible for the CPEO's failure. In order to become a CPEO, certain certification requirements under Reg. Sec. 301.7705-2T must be met. The procedures for applying to become a CPEO are set forth in Rev. Proc. 2016-33, as modified by Notice 2016-49. Further guidance for the requirements to remain certified as a CPEO, as well as the procedures for suspension and revocation of a CPEO certification, is provided in Rev. Proc. 2017-14.

For a discussion of PEOs and CPEOs, see Parker Tax ¶218.110.

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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