Poor Design and Poor Defense Sink Employee Discount Plan

A recent IRS Field Attorney Advice (FAA) memorandum highlights the risk of poorly designed employee discount plans.  In FAA 20171202F, the IRS Office of Chief Counsel determined that an employer was liable for failing to pay and withhold employment taxes on employee discounts provided under an employee discount plan that failed to satisfy the requirements for qualified employee discounts under Code section 132(c).  The FAA also suggests that had the employer either kept or provided better records of the prices at which it provided services to select groups of customers, the result may have been different.  In the FAA, the IRS applied the fringe benefit exclusion for qualified employee discounts to an employer whose business information was largely redacted.  Under the employee discount program considered, an employee and a set number of participants designated by each employee (including the employee’s family members and friends) were eligible for discounts on certain services provided by the employer.  The Treasury Regulations under section 132(c) permit employers to offer employees and their spouses and dependent children non-taxable discounts of 20 percent on services sold to customers.

The employer argued that, although the discounts provided under the program exceeded the 20 percent limit applicable to discounted services when compared to published rates, they were in most cases less than the discount rates the employer offered to its corporate customers and members of certain programs.   The Treasury Regulations provide that an employee discount is measured against the price at which goods or services are sold to the employer’s customers.  However, if a company sells a significant portion of its goods or services at a discount to discrete customers or consumer groups—at least 35 percent—the discounted price is used to determine the amount of the employee discount.  Despite the employer’s argument that the determination of the amount of the employee discounts should not be based on the published rates, the IRS refused to apply this special discount rule for lack of adequate substantiation.  Although the employer provided the IRS with bar graphs showing the discounts it gave to various customers, the employer did not substantiate the information on the graphs or provide the IRS with evidence showing what percentage of its total sales were made from each of the customers allegedly receiving discounted rates.  Had the employer shown that it sold at least 35 percent of its services at a discount, then at least some, if not most of the employee discounts in excess of the published rates less 20 percent, may not have been taxable.

Having determined that the discounts offered exceeded the 20 percent limit applicable to services, the IRS ruled that the employer must withhold and remit employment taxes on any employee discount to the extent it exceeded 20 percent of the published rate.  Correspondingly, the employer must report the taxable amount as additional wages on the employee’s Form W-2.  Perhaps even more costly for the employer, the IRS determined that the entire value of the discount (and not just the amount in excess of 20 percent) provided to someone designated by an employee constitutes taxable wages paid to the employee unless the person is the employee’s spouse or dependent child.  Accordingly, if an employee designates a friend under the program who uses the discount, the entire discount must be included in the employee’s wages and subjected to appropriate payroll taxation.

Offering employee discounts on property and services sold to customers can make for a valuable employee reward program, but the technical requirements to avoid tax consequences for these programs can be overlooked.  The FAA’s analysis is consistent with the regulations under Code sections 61 and 132, and should not be surprising to anyone familiar with the rules.  Given the recent interest in employee discount programs by IRS examiners conducting employment tax examinations, it would be prudent for employers to review their employee discount programs and consider whether the programs are properly designed to avoid the potentially expensive payroll tax consequences that could be triggered by discounts that do not qualify for the income exclusion under section 132(c).

Employers Likely Need to Update Their Processes Based on New Requirements for Employer Refund Claims of FICA and RRTA Taxes

On March 20, the IRS released Rev. Proc. 2017-28, providing guidance to employers on employee consents used to support a claim for credit or refund of overpaid taxes under the Federal Insurance Contributions Act (FICA) and the Railroad Retirement Tax Act (RRTA). The revenue procedure requires the employee consent to contain, among other information, the basis for the refund claim and a penalties of perjury statement. In addition, it permits employers to request, receive, and retain employee consent electronically, and clarifies the “reasonable efforts” an employer must make, if it fails to secure employee consent, to claim a refund of the employer’s share of overpaid FICA or RRTA taxes. Many of the requirements in the revenue procedure were included in a proposed revenue procedure contained in Notice 2015-15. Rev. Proc. 2017-28 also provides the circumstances under which an employee consent may use a truncated taxpayer identification number (TTIN).  Employers will need to review the new requirements and update their existing FICA refund process to ensure that process satisfies the new requirements.

Background

Treasury Regulation section 31.6402(a)-2 provides general rules for employers to claim refunds of overpaid FICA and RRTA taxes. An employer must file the refund claim on the form prescribed by the IRS (e.g., Form 941-X) and designate the return period to which the claim relates, explain the grounds and facts supporting the claim, and meet other requirements under the regulations and the form’s instructions. An employer that is granted a tax refund of FICA or RRTA taxes (including any applicable interest) must give the employee his or her share.

To protect an employee’s interests, the regulations prohibit the refund of the employer share unless the employer (a) has first repaid or reimbursed the employee, or (b) has included a claim for refund of the employee share of FICA or RRTA taxes, along with the employee’s consent. Similarly, to claim refund of the employee share, the employer must certify that the employer has repaid or reimbursed the employee share or has secured the employee’s written consent for the refund claim, except to the extent taxes were not withheld from the employee. But these requirements do not apply, and the employer may claim refund for the employer share, to the extent that either (a) the taxes were not withheld from the employee’s compensation; or (b) the employer cannot locate the employee or the employee will not provide consent after the employer has made reasonable efforts to either secure the employee’s consent or to repay or reimburse the employee.

New Rules on Requesting and Retaining Employee Consent

45-day consent period. A request for consent must give employees a reasonable period of time to respond, not less than 45 days. The request must clearly state: (a) the purpose of the employee consent; (b) that the employer will repay or reimburse the employee share (including allocable interest) to the extent refunded by the IRS; and (c) that an employee cannot authorize the employer to claim a refund on the employee’s behalf for any overpaid Additional Medicare Tax. A request for consent may include an express presumption that if an employee’s response has not been received by the employer during the specified time period, the employee will be considered as having refused to provide the employee consent. However, a failure to respond may not be deemed consent. A request for consent also may include a request that the employee keep the employer informed about any change in the employee’s mailing address or email address.

Electronic Consent. An employer may establish a system to request, furnish, and retain employee consent in an electronic format that ensures the authenticity and integrity of the electronic signature and record. Although an employer may use electronic consent, the employer must provide an employee, upon request, the option to review the consent request and to provide the consent in paper format.

Reasonable Efforts. An employer may claim a refund of the employer share of FICA and RRTA tax without obtaining employee consent only if the employer makes “reasonable efforts” to repay or reimburse the employee or secure the employee’s consent and the employer cannot locate the employee or the employee will not provide consent. The reasonable efforts rule is satisfied if an employer fulfills the following requirements.

  • Request for consent. The employer properly requests the employee’s consent.
  • Email receipt acknowledgement. Any electronic request for consent asks the employee to affirmatively acknowledge the request (e.g., by clicking on a voting button (YES) or by sending a reply message). A read-receipt message is not sufficient.
  • Record retention. The employer retains a record of sending the request for consent, including the mailing or personal delivery record, the email record (including any receipt acknowledgement), or the employee’s reply declining the request.
  • Second delivery attempt. If the employer’s initial request fails to be delivered, the employer must attempt to secure consent a second time, with a 21-day response period from the date of the second request. In particular, if a mailing is undeliverable, the employer must make a good faith attempt to determine the employee’s current address and if a new address is discovered, send the request again by mail or personal delivery. Alternatively, the employer can email the request to the employee. If an email is undeliverable (e.g., due to problems with the employee’s email address) or if the employee does not acknowledge receipt of the email, the employer must send a request in paper to the employee’s last known address by mail or personal delivery.

New Rules on Employee Consent

Required Items. Employee consents are subject to a list of requirements, two of which are noteworthy. First, the employee must identify the specific basis of the refund claim. The revenue procedure provides a detailed example: “request for refund of the social security and Medicare taxes withheld with regard to excess transit benefits provided in 2014 due to a retroactive legislative change.” It is unclear how detailed the basis provided must be to satisfy this requirement. Second, the consent must contain the employee’s signature under a penalties of perjury statement. The penalties of perjury requirement will complicate efforts to obtain employee consents and written statements as employees are often reluctant to sign documents under threat of perjury even when they are certifying true statements. This is particularly true with regard to former employees.

In addition to the two requirements described above, an employee consent must:

  • contain the employee’s name, address, and taxpayer identification number (TIN);
  • contain the employer’s name, address, and employer identification number (EIN);
  • contain the tax period(s), type of tax (e.g., social security and Medicare taxes), and the amount of tax for which the employee consent is provided;
  • state that the employee authorizes the employer to claim a refund for the overpayment of the employee share; and
  • with regard to refund claims for employee tax overcollected in prior years, include the employee’s written statement certifying that the employee has not made previous claims (or that the claims were rejected) and will not make any future claims for refund of the overcollected amount.

Use of TTIN. To address concerns regarding identity theft, the revenue procedure allows the use of a TTIN in place of the employee’s complete social security number (SSN) if the employer prepares the employee consent and prepopulates the TIN field with the TTIN. A TTIN may not be used, however, if the employer requests the SSN as the employee’s TIN or if the employee furnishes the TIN as part of the consent.

As a result of the new guidance, many employers will need to update their employee consent procedures to comply with the new rules, most of which are not specified in the Code or the implementing Treasury regulations. FICA tax overpayments frequently occur, and failure to obtain the proper employee consent, or failure to follow the procedures for requesting consent, can delay the employer’s refund claim. The new requirements apply to employee consents requested on or after June 5, 2017.

IRS Certified PEO Program Leaves Unresolved Qualified Plan and ACA Issues

The IRS recently implemented the voluntary certification program for professional employer organizations (PEOs) (discussed in a separate blog post).  Earlier this summer, the IRS released temporary and proposed Treasury regulations and Revenue Procedure 2016-33 pursuant to Code Sections 3511 and 7705, which created a new statutory employer for payroll-tax purposes: an IRS-certified PEO (CPEO).  Last week, the IRS released Notice 2016-49, which relaxed some of the certification requirements set forth in the regulations and Revenue Procedure 2016-33.

Although a significant change in the payroll tax world, the new CPEO program does not clarify the issue of whether a PEO or its customer, the worksite employer, is the common law employer for other purposes.  Thus, even when properly assisted by CPEOs, customers may still be common law employers and must plan for potential liability accordingly.  Two key areas of potential liability are PEO sponsorship of qualified employee benefit plans and the Affordable Care Act’s employer mandate.

PEO Sponsorship of Qualified Plans

Before the new CPEO program became available, the PEO industry was already expanding, with customers pushing for PEOs to act as the common law employers for all purposes, not just payroll tax administration.  Customers particularly sought PEOs to sponsor qualified benefit plans for the customers’ workers.  This arrangement, however, clashed with a fundamental rule of qualified plans under ERISA and the Code:  Under the exclusive benefit rule, employers can sponsor qualified plans only for their common law employees and not independent contractors.  Many PEOs set up single employer plans, even though customers – not PEOs – usually had the core characteristics of a common law employer:  Exercising control over the worker’s schedule and manner and means of performing services.

In Revenue Procedures 2002-21 and 2003-86, the IRS reiterated its hardline stance on enforcing the exclusive benefit rule against PEO plans, stating that after 2003, PEOs can no longer rely on any determination letter issued to their single employer plans, even if the letter was issued after 2003.  The guidance provided two forms of transition relief available until 2003: (1) a PEO could terminate the plan, or (2) convert the plan into a multiple employer plan (MEP), which is an employee benefit plan maintained and administered as a single plan in which two or more unrelated employers can participate.  This MEP option, however, still treated customers as the common law employers, who are subject to nondiscrimination, funding, and other qualified-plan rules under ERISA and the Code.

The new CPEO program does not affect the exclusive benefit rule or the determination of common law employer status for qualified plan purposes.  Certified or not, a PEO can sponsor MEPs, but properly sponsoring any single-employer plan rests on the argument that the PEO is the common law employer.  Thus, the law still significantly limits a customer from outsourcing its qualified plan to a PEO.

ACA Employer Mandate & PEO-Sponsored Health Plan

The Affordable Care Act (ACA) imposes on employers with 50 or more full-time equivalent (FTE) employees the “employer mandate,” which, in turn, applies a tax penalty if the employer chooses not to provide health care insurance for its workers.  In general, the common law employer is required to offer coverage to its employees.  Under some circumstances, however, the common law employer can take credit for coverage offered by another entity—such as another company within the same controlled group.

The problem for PEO customers stems from a provision in the final regulations on Section 4980H.  The provision allows the PEO’s customer to take credit for the PEO’s offer of coverage to the customer’s workers only if the customer pays an extra fee:

[I]n cases in which the staffing firm is not the common law employer of the individual and the staffing firm makes an offer of coverage to the employee on behalf of the client employer under a plan established or maintained by the staffing firm, the offer is treated as made by the client employer for purposes of section 4980H only if the fee the client employer would pay to the staffing firm for an employee enrolled in health coverage under the plan is higher than the fee the client employer would pay the staffing firm for the same employee if that employee did not enroll in health coverage under the plan.

The preamble to the regulations doubles down by describing a situation in which the staffing firm is not the common law employer as the “usual case.”

This extra-fee rule puts the PEO’s customer in a difficult position.  If it does not pay the extra fee, then the PEO’s offer of health coverage cannot be credited to the customer.  Thus, the customer risks being subject to the tax penalty, if upon audit the customer is determined to be the common law employer (assuming the PEO’s customer is an applicable large employer).  Alternatively, if the customer pays the extra fee to hedge against the risk of the tax penalty, the payment could be taken as an admission that the customer—not the PEO—is the common law employer.  Being the common law employer could expose the PEO’s customer to a host of legal liabilities, including, for example, rules pertaining to qualified plans (e.g., funding, nondiscrimination), workers compensation, and respondeat superior.  This result is unacceptable for many customers, who take the position that they are not the common law employers for any purpose.  Unfortunately, the new CPEO program only allows the customer to shift its payroll tax liabilities, and does not affect whether the customer or the CPEO is the common law employer for other purposes.

Finally, there is also a reporting wrinkle for customers outsourcing their health coverage obligations to PEOs.  The ACA requires the common law employer to report the offer of coverage on Form 1095-C.  If the PEO’s customer is the common law employer, there is no rule allowing it to shift this reporting obligation to the PEO.  Thus, if the PEO, rather than the customer, files the Form 1095-C, the customer may be subject to reporting penalties for failure to file a return.