What happens when a PEO fails to remit employment taxes?

The employer is generally liable for the unpaid employment taxes. As the use of professional employer organizations increases, a recent case provides a warning.

How does federal law define employer? This was at the crux of a case from earlier this year. Under the Internal Revenue Code, an employer has the obligation to withhold Federal income tax. Case law extends that requirement to withholding and paying FICA (Social Security and Medicare) and FUTA (unemployment) taxes.

Employee leasing

In Chief Counsel Advice from this summer, the IRS held that the taxpayer is liable if a PEO fails to remit those taxes. The employer did not claim deductions for compensation and salaries; instead it listed the deduction “Employee Leasing” for its entire workforce.

What had happened was the employer entered a PEO contract keeping day-to-day supervision and control of employees, but assigned payroll, designated benefits and personnel policy/procedure issues to a PEO. The PEO agreed to remit employment taxes and file all employment tax returns with the IRS as part of the agreement.

Audit and liability

In a business audit, the employer learned the PEO failed to pay employment taxes to the IRS. To fight a large back tax bill for employment taxes it had already withheld and paid over to the PEO, it argued it was not liable for the taxes that the PEO did not send over.

The IRS, however, concluded that a PEO is not a “statutory employer.” This decision meant the taxpayer was not relieved of its requirement by the intervening fraud of the PEO. After a detailed analysis of prior case law, the IRS found that a PEO acts merely as a conduit for a taxpayer.

The taxpayer next asked for Section 530 relief. This is available relief for an employer who fails to withhold employment taxes because a worker is misclassifies as an independent contractor. This section was found inapplicable to the PEO situation.

Is there any way to get around this predicament? The IRS has established a program that certified PEOs – working with a company on this list of CPEOs offers protection from the liability issue faced by the employer in the above case.