A growing trend among small to medium sized companies is the outsourcing of payroll, and in some cases, other functions such as benefits and human resources. It is estimated that in the range of 180,000 businesses employing over 3.4 million individuals outsource their payroll tax responsibilities. It is further estimated that approximately 6,000 new clients per year are utilizing this service. The company that assumes the obligation to process the payroll and assumes the obligation for the corresponding payroll taxes is called a professional employer organization (PEO) and is also sometimes referred to as an employee leasing company. Typically, the PEO enters into an agreement with a client to perform some or all of the federal employment tax withholding, reporting and payment functions related to employees performing services for the clients. The contract creates a fictional co-employer relationship with the PEO assuming certain responsibilities in connection with the employees and the client retaining the other functions, including day-to-day control. Typically, the PEO is responsible for paying the employees and for the related federal employment tax compliance. As mentioned above, a PEO also may manage human resources, employee benefits, workers’ compensation claims and unemployment insurance claims for the client. The client typically pays the PEO a fee based on payroll cost, plus an additional amount. In almost all cases, however, the employees working in the client’s business are the common law employees of the client for federal tax purposes, and the client is therefore legally responsible for federal employment tax compliance. Thus, while the PEO may contractually agree to withhold and pay federal payroll taxes, the client remains the guarantor of these payments.
As we noted in our February 2016 Tax Monitor article on independent contractors, the IRS uses the common law test in determining whether an individual is an employee and whom his employer is. Under this common law test, it is almost always the client who is deemed to be the actual employer. This has created problems in the qualified plan area since, in the past, the PEO attempted to cover all of its client’s employees in a single employer plan. In Rev. Proc. 2002?21, the Internal Revenue Service made it clear that this was not permissible and required that PEO’s establish multiple employer plans in order to maintain the qualified plan status. In addition to the liability for employment taxes, the common law employee test utilized for employment tax purposes also caused problems when the PEO-client contract was entered into mid-year. There, the PEO was not given credit for any wages paid by the client during the first part of the year. As a result, the PEO would be required to pay and withhold FICA taxes on the entirety of the wages paid to the employee during the balance of the year up to the FICA tax limit for that year. In other words, the PEO received no credit with regard to the FICA tax limit for the wages paid by the client to the employee prior to the PEO-client agreement. Similarly, there are issues with regard to FUTA tax credits when a PEO makes a payment to a state unemployment fund and other special tax credit programs designed for small business clients who arguably were adversely impacted when they leased all or a majority of their common law employees.
In an apparent attempt to encourage the use of PEO’s and to clarify the legal issues surrounding PEO’s, congress adopted the Stephen Beck, Jr., Achieving a Better Life Experience Act of 2014 which added new Sections 3515 and 7705 of the Code. These Code sections introduce the concept of a “certified professional employer organization” which would be a PEO which has been certified by the Internal Revenue Service as meeting the requirements set forth in Section 7705 of the Code. The IRS has recently released final and temporary regulations with regard to certified PEO’s and will be issuing additional guidance in the near future. The IRS has announced that it will begin accepting applications for certified PEO’s effective July 1, 2016. Use of a certified PEO will solve the employment tax issues discussed above. In particular, a client utilizing a certified PEO will not be liable for its worksite employees who are co-employed by the certified PEO. In addition, a certified PEO will be allowed to act as a successor employer regarding employment taxes. FICA and FUTA wage bases will not be reset when a new company joins (or leaves) a certified PEO mid-year. In addition, when a certified PEO makes a payment to any state unemployment fund for its worksite employees in that state, the certified PEO will receive federal tax credit for FUTA. Finally, a client whose worksite employees are co-employed by a certified PEO will not lose any special tax credit programs designed for small business clients.
The use of a certified PEO is optional, and it is not clear that all PEO’s will elect to become certified nor whether their clients will be attracted to certified PEO’s. Certainly, there are many things which would attract a client to a certified PEO, but because of the requirements set forth in Section 7705 of the Code, it would appear that certified PEO’s will be more costly than non-certified PEO’s.
In order to be certified, Section 7705 requires a PEO to pass a background check, to be bonded, to have audited financial statements, to be an accrual basis taxpayer, and to meet certain other administrative regulations which would be promulgated by the IRS. Almost certainly, meeting these requirements will add internal cost to the PEO, and how much of those costs will be absorbed by the PEO or passed on to the client remains to be seen.
Certainly, it would appear that certified PEO’s will have a significant marketing advantage and that clients would look to the certainty of not continuing to be a guarantor on employment taxes on wages which it had paid to the PEO. We certainly would be more comfortable recommending to our clients that desire to outsource these functions to look to a certified PEO, but ultimately it will be a business decision. If you are currently utilizing the services of a PEO, you should determine whether it intends to become certified and, if so, what cost impact that certification will have. If you have been hesitant to utilize the services of a PEO due to the lingering employment tax liabilities, once certification becomes widespread, you might want to relook at the possible benefits of outsourcing.
This article was written by Michael D. Foster, an attorney practicing in the Jackson Kelly PLLC Tax Practice Group. He also serves as Assistant General Counsel to the Firm.