No one likes to collect on debt, except professional collection agencies that profit handsomely from the activity. To avoid the hassle of debt collection, landlords may ask for a tenant’s first and last months’ rent in advance. Lawyers request retainers from clients as security for services to be rendered. Perched far above normal debt collectors, the Internal Revenue Service operates in a favored position because the tax code provides a pay-as-you go system to ensure tax liabilities are timely paid. Employers must withhold federal taxes as employees earn their pay. And, self-employed individuals are required to remit estimated tax payments on a set schedule. Fail to follow the pay-as-you-go system and tax penalties will be imposed. As a taxpayer, you may not like this tax collection system, but you certainly understand the logic if you’ve ever had to collect debt as a landlord or vendor.
What if a professional employer organization (PEO) is liable for federal tax beyond the amount it has remitted through the pay-as-you-go system? The answer may surprise you: the IRS can take a refund of taxes that you’ve paid and use them to satisfy your PEO’s separate tax liabilities. Below, we discuss how the IRS came to that conclusion and describe steps that you can take to protect yourself when working with PEOs.
As an initial matter, what is a PEO? A PEO is a company that provides HR solutions (payroll administration, benefits) for small to mid-size businesses. Employers are obligated to file employment tax returns reporting employment taxes for each employment tax period and liable for the withholding and payment of employment taxes. Some employers may want to offload these HR responsibilities by hiring a PEO so they can focus on their business operations. The National Association of Professional Employer Organization boasts that the return on investment of using a PEO in cost savings alone is 27.3%. https://www.napeo.org/what-is-a-peo
So, your company hires a PEO. Smart move, right? On May 12, 2023, the IRS released a Chief Counsel Advice (CCA) addressing an issue involving a PEO’s federal tax liability that should be a major concern for all companies who have hired a PEO. In CCA 202319015 (https://www.irs.gov/pub/irs-wd/202319015.pdf), the IRS asked its government attorneys whether the IRS could use COVID-19 employment tax credits (employee retention credit, or “ERCs”) attributable to a PEO’s client’s payment of wages to the client’s employees to offset any existing tax liabilities of the PEO. In other words, the IRS asked if it was possible to use your federal tax credit to offset your HR provider’s separate federal tax liability. The answer was – yes. But, we need to drill down a bit to the reasoning that supports the answer in the CCA. The critical fact in the CCA is the type of PEO relationship involved. If the taxpayer’s PEO is authorized under the parties’ contract to file federal tax forms under the PEO’s own EIN, not the client’s EIN, then the IRS is authorized to use the PEO client’s ERC (or any other tax refund) as an offset against the PEO’s own tax liability.
A PEO’s client can rightly protest the IRS’s decision to use the client’s ERC to apply against another taxpayer’s tax liability – the PEO’s separate tax debt. But, in the CCA, the IRS has given the Heisman stiff-arm to PEOs’ clients who may fall into this unenviable situation stating, “The IRS is not a party to those agreements [client service agreements with PEOs] and has no legal obligation to refund any portion of the TPP [third party payors] filer’s refund to a client…..” Some PEO clients have had to take private legal action against their PEO to recover their federal ERCs. https://www.pacermonitor.com/public/case/46374962/Golden_West_Wings_LLC_et_al
If you use a PEO, what can you do to avoid the potential pitfall presented in CCA 202319015? Consider using a certified PEO. A PEO can be certified by the IRS to perform federal employment tax withholding, reporting, and payment functions related to the wages it pays to workers performing services for its customers. To obtain certified status, a PEO must satisfy various requirements that includes submitting an annual audited financial statement and submitting proof of bond to the IRS. A list of certified PEOs is available at https://www.irs.gov/pub/irs-utl/list-of-cpeos.pdf. In the event that a certified PEO fails to carry out its duties properly, they are subject to investigation by the IRS and possible de-certification, thus providing a powerful incentive to act in the best interests of the client.
As an additional safeguard, you should consider inserting special language in any client service agreement with a PEO that requires a strict accounting of the credits attributable to your payment of wages to your employees (regardless of any aggregate reporting) and that contains a clause imposing a draconian penalty should any of the client’s credits be effectively applied to the separate federal tax liability of the PEO. After all, the CCA also explains that if you are unlucky enough to have chosen a PEO with outstanding federal tax liabilities, any “difficulties” you encounter are “a civil matter strictly between” the PEO and you. Fair enough, then, leaving preventive contract drafting as the appropriate salve after getting the IRS’s stiff-arm.
Why not just terminate your relationship with a PEO and file Forms 941-X to get your ERCs? When is tax ever simple? If your PEO filed Form 941 using the PEO’s own EIN and you terminate the relationship with the PEO, you cannot file Form 941-X seeking a refund of ERCs since you would be filing using your own EIN, not the EIN used by the PEO. As far as the IRS is concerned, only the original Form 941 filer (the PEO) who filed using its EIN can amend the original return, not the common law employer – even after the relationship is terminated with the PEO. Our law firm called a senior attorney with the IRS Office of Chief Counsel and expressed frustration with the tax oddities involving PEOs. The IRS official admitted, “Yes, it’s an unfortunate mess.”