Is Payroll Provider a Statutory Employer?

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By Jamie Rathjen

“I got a letter from the IRS denying our claim for a refund on the Social Security taxes we overpaid for our clients,” Paul, a payroll officer at a professional employer organization, said to his boss, Suzanne.

“Don’t worry,” Suzanne said. “We can prove we’re the employer for tax purposes because we pay their employees.”

Facts: A professional employer organization was denied a refund by the Internal Revenue Service of an overpayment of Federal Insurance Contribution Act taxes on wages it paid to employees of its clients. The organization filed a lawsuit for the refund in federal district court, claiming that it was the statutory employer of its clients’ employees under Internal Revenue Code Section 3401(d)(1).

The organization said it paid employment taxes for its clients as part of an agreement that included the organization handling payroll and some human resources duties for clients, including the payment of wages.

The clients submitted employees’ hours worked and rates of pay, but the organization kept employees’ Forms W-4, Employee’s Withholding Allowance Certificate, and other information needed to calculate wages and income tax withholding.

Some of the professional employer organization’s clients used the Automated Clearing House debit process to send funds needed for the PEO to make payments to employees. However, payments to employees were initiated, and could not be reversed, before the organization received confirmation that clients had sufficient funds for the payments to be made.

The organization was responsible for payments to employees regardless of whether it received the funds needed from clients.

The organization used its own bank accounts to pay clients’ employees and remit employment taxes.

The organization was responsible for collecting, paying, and reporting employment taxes for its clients. The clients stopped paying employment taxes when they entered into an agreement with the organization.

For several quarters from 2009 to 2012, the professional employer organization miscalculated the amount of Social Security taxes owed and overpaid by about $4 million. When the organization entered into a new agreement with a client, it mistakenly reset the Social Security taxable wage base for the client’s employees and overpaid the tax.

The organization filed Forms 941, Employer’s Quarterly Federal Tax Return, for its clients using its own name, address, and employer identification number. When the organization realized it miscalculated Social Security tax owed, it filed Forms 941-X, Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund, but the IRS denied a refund.

Justice Department tax lawyers argued that the organization was not the statutory employer of the clients’ employees because it did not have exclusive control over the payment of wages. Payment was contingent upon the organization first receiving funds from clients, the government said.

The government claimed the organization was voluntarily paying its clients’ tax liabilities, instead of assuming the employer’s duty to pay taxes. Third parties that voluntarily pay the taxes of others may not claim refunds, the government said.

A federal district court found that the organization was the employees’ statutory employer, as it had exclusive control over the bank account used to pay wages to employees. If the common-law employer does not control the payment of wages, the entity that does have control replaces the employer for the purpose of withholding and paying taxes, the court said.

The Justice Department asked the court to reconsider the decision, claiming that the clients’ supplying of funds to the professional employer organization meant the organization was not the statutory employer. Because the organization paid clients’ employees with the clients’ money, the clients maintained some level of control over wage payments, the government said.

Issue: Was the professional employer organization the statutory employer for purposes of paying employment taxes?

Decision: The professional employer organization was the employees’ statutory employer, the district court said, affirming its previous ruling.

The court, in declining to reconsider its earlier decision, rejected the Justice Department’s claim that the clients exercised control over payments to employees. Additionally, the organization could not confirm whether clients using the ACH system had sufficient funds in their accounts when payments were made, the court said.

The evidence showed that the organization had exclusive control over the bank accounts used to make payments. The clients had no access to the accounts used to pay wages and, therefore, exercised no control over payments, the court said.

The case is Paychex Bus. Sols. LLC v. United States, M.D. Fla., No. 8:15-cv-1455-T-24, 4/3/18.

Pointers: Under I.R.C. Section 3401, which provides definitions for federal income tax withholding purposes, an “employer” is one having control of the payment of wages when the business for whom employees perform services does not have control of payments for the services performed.

A professional employer organization provides services for businesses wishing to outsource functions such as payroll, human resources, or tax administration.

According to the case United States v. Total Employment Co. (305 B.R. 333, 2004), the entity in control of the payment is the only one in a position to deduct and withhold taxes, regardless of the business that hires employees or determines employees’ rates of pay.

For more information, see Payroll Administration Guide’s “Federal Income Tax Withholding: Employer Coverage Rules” chapter.

To contact the reporter on this story: Jamie Rathjen in Washington at jrathjen@bloombergtax.com. To contact the editor responsible for this story: Michael Baer at mbaer@bloombergtax.com.

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