IRS Implements New Voluntary Certification Program for PEOs

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August 15, 2016

Through a flurry of guidance this summer, the IRS has finally implemented the long-anticipated voluntary certification program for professional employer organizations (PEOs).  In 2014, Congress enacted Code Sections 3511 and 7705, which brought about a sea-change in the payroll tax world by creating a new statutory employer: An IRS‑certified PEO (CPEO).  This change is significant because a common law employer (customer) who is otherwise liable for payroll taxes on wages that its PEO pays its employees may shift this payroll tax liability to a CPEO.  In May 2016, the IRS released temporary and proposed Treasury Regulations and Revenue Procedure 2016-33, providing tax and CPEO-certification rules under Sections 3511 and 7705.  After launching the online CPEO application in early July, the IRS proposed to create a new CPEO records system and last week, loosened certain certification rules by issuing interim guidance (Notice 2016-49), on which taxpayers may rely pending final regulations.  Importantly, Notice 2016-49 extended the application deadline from August 31, 2016, to September 30, 2016, for PEOs seeking to have the earliest possible effective certification date of January 1, 2017.

Although the CPEO program is welcomed by PEOs and their customers, applicants and CPEOs must carefully comply with numerous certification rules established under the recent IRS guidance.  Moreover, customers should be aware of limitations on their ability to shift payroll tax liabilities to their CPEOs.  Further, CPEOs and their customers should keep in mind that the CPEO program primarily assists payroll tax administration, and leaves difficult questions regarding CPEO sponsorship of qualified employee benefit plans and compliance with the Affordable Care Act (discussed in a separate blog post).

Background

PEOs provide customer-employers with payroll and employment services.  Before Congress enacted Sections 3511 and 7705 in late 2014, however, customers had remained liable for payroll taxes on wages paid to their employees.  Because there was no rule allowing the tacking of wages, PEOs would have to restart the applicable wage base limitations (e.g., FICA and FUTA limitations) upon moving the customers’ employees to the PEOs’ payrolls.  Under Section 3511, a CPEO is solely responsible for its customers’ payroll tax—i.e., FICA, FUTA, and RRTA taxes, and Federal income tax withholding—liabilities, and is a “successor employer” who may tack onto the wages it pays to the employees to those already paid by the customers earlier in the year.  The customers, on the other hand, remain eligible for certain wage-related credits as if they were still the common law employers of the employees.  Section 7705 called for the IRS to establish certification requirements.  It also provided a critical enforcement tool:  The IRS will publish every quarter a list of all CPEOs.

On May 5, 2016, the IRS released temporary Treasury regulations establishing certification rules under Section 7705 (temporary regulations).  These temporary regulations became effective on July 1, 2016 and will remain effective for three years thereafter.  Simultaneously, the IRS released proposed Treasury regulations under Section 3511 (proposed regulations) that establish rules on the payroll tax liabilities of CPEOs and their customers.  These rules are likely in proposed form because the IRS intends to revisit numerous issues, such as the treatment of specified tax credits.  Shortly after releasing these regulations, the IRS published Revenue Procedure 2016-33, which provides additional certification and application rules.  Although these rules do not affect an existing PEO’s established practices, a PEO must satisfy the requirements to become certified and thereby attract customers wishing to shift their payroll tax liabilities.

New Certification Requirements

The new IRS guidance establishes a robust set of certification requirements—e.g., proof of suitability, annual financial reporting and positive working capital, bonding requirements, etc.—aimed at ensuring the IRS’s collection of payroll taxes from CPEOs.

Suitability.  The temporary regulations add “suitability” requirements designed to ensure that the PEO has the capability, experience, and integrity to properly withhold and remit payroll taxes.  Showing that it has mulled over the PEO industry and its potential tax pitfalls, the IRS decided to apply many of these suitability requirements not only to the PEOs themselves, but also to certain “responsible individuals,” “related entities,” and “precursor entities” of the PEO.  Thus, for example, the IRS will not certify a PEO solely because its responsible individuals (e.g., certain owners, the CEO, or CFO) have failed to pay applicable Federal or state income taxes or have been professionally sanctioned for misconducts.  Nor can a PEO that is otherwise unsuitable for certification cleanse the taint of prior tax wrongdoings by transferring its assets to a new PEO that applies for certification.

Positive Working Capital & Transition Relief.  The temporary regulations add a positive-working capital rule—tweaked by Notice 2016-49—to ensure that the PEO is financially capable of fulfilling its tax obligations.  Under the temporary regulations, applicants and CPEOs must file annual audited financial statements accompanied by an independent CPA’s opinion that the financial statements (1) are fairly presented under GAAP, (2) reflect positive working capital, and (3) show that the PEO uses an accrual method of accounting.  Addressing comments that CPAs may be professionally prevented from including the last two items in a CPA opinion, Notice 2016-49 provides that, in lieu of doing so, a PEO must include in its annual filing a Note to the Financial Statements stating that the financial statements reflect positive working capital and providing detailed calculations.  Further, Notice 2016-49 provides transition relief for applicants required to submit a copy of its annual audited financial statements and CPA opinion for a fiscal year ending before September 30, 2016.

To allow reasonable fluctuation in working capital, an exception to the positive-working capital rule is available if: (1) the working capital of two consecutive fiscal quarters that year were positive; (2) the PEO explains the reason for the negative working capital; and (3) the negative working capital does not present a material risk to the IRS’s collection of payroll taxes.  The third element hinges on whether the PEO has identified facts and circumstances that will result in positive working capital in the near future.  A similar positive working-capital rule and a similar exception apply to quarterly financial statements.

Bond and Surety.  Under Section 7705(c)(2), an applicant or CPEO must post a bond (ranging from $50,000 to $1 million) with respect to its employment tax liabilities.  The temporary regulations clarified that the bond cannot be substituted with collateral, and that the bond must be issued by a qualified surety, i.e., one that holds a certificate of authority from the IRS.  Accordingly, a CPEO application must include a signed surety letter confirming that the surety agrees to issue a bond pursuant to terms set forth in Form 14751 and in the required amount to the applicant, if and when the applicant is certified.

Business Entity.  The temporary regulations provide that a CPEO must be a “business entity” organized in the United States, but may not be a disregarded entity.  Addressing concerns that PEOs may choose to be disregarded entities for legitimate business reasons, Notice 2016-49 provides that a CPEO may be a wholly domestic disregarded entity.  The Treasury and the IRS sought comments on whether they should allow partly or fully foreign disregarded entity to apply for certification.  Additionally, Notice 2016-49 provides that a sole proprietorship, which is not included in the definition of “business entity,” may apply for certification.

Consent to Disclosure.  Consistent with Section 7705(f), which requires the IRS to publish the names and addresses of all CPEOs, the temporary regulations add that the IRS will also publish the fact of the suspension or revocation of a PEO’s certification and may notify the PEO’s customers of this fact.  Accordingly, the temporary regulations also require an applicant or CPEO to provide the consents for the IRS to disclose confidential tax information to the customers and to other persons as necessary to carry out the purposes of the CPEO rules.

Functional Application of Rule.  The IRS will likely take a functional rather than a mechanical approach to applying the certification rules.  The temporary regulations permit the IRS to suspend or revoke a PEO’s certification if the PEO violates a certification requirement, but require the IRS to do so only if the violation presents a material risk to the IRS’s collection of Federal payroll taxes.  If the IRS suspends or revokes a PEO’s certification, the benefits—e.g., shifting of payroll tax liability and tacking of wages—under Section 3511 will not apply and the PEO must notify its customers of its suspension or revocation.

Employment Tax Treatment of CPEOs and Their Customers

The proposed regulations implement rules under Section 3511 pertaining to the employment tax treatment of CPEOs and their customers.

Work Site Employee.  Section 3511 shifts a customer’s payroll tax liability with respect to wages paid to a “work site employee,” and the proposed regulations apply a quarterly test.  Specifically, a covered employee is a work site employee for a calendar quarter, if at any time during that quarter, at least 85 percent of the service providers at the same work site are subject to one or more CPEO contracts between the CPEO and the customer.

Specified Tax Credits.  The proposed regulations also indicate that the IRS may change its treatment of specified tax credits under Section 3511(d)(1), for which the customer—not the CPEO—is eligible, provided that the wages at issue are paid to a work site employee.  In the preambles to the proposed regulations, the Treasury and the IRS sought comments as to whether they should expand the list of specified tax credits, and how the tax credits should apply with respect to non-work site covered employees.

Continuing Reporting Obligations.  Most significantly, the proposed regulations add three categories of reporting requirements that a CPEO must meet in order to remain certified: (1) reporting to the IRS by CPEOs, including any Form 940 (Employer’s Annual FUTA Tax Return) or Form 941 (Employer’s Quarterly Federal Tax Return) and their applicable schedules, periodic verification of compliance, notice of material changes to information provided, and independent financial review documents, such as the annual audited financial statements along with the CPA opinion; (2) reporting to customers by CPEOs, including notification of suspension or revocation of certification and notification regarding transfer of CPEO contract; and (3) inclusion of certain information in the CPEO contract.

CPEO System of Records

To ensure that an applicant or CPEO complies with the new certification rules, the Treasury and the IRS proposed to establish a records system that covers a myriad of groups of individuals involved in the certification process or administration of the applicant or CPEO.  The proposed records system keeps administrative, investigative, and tax records, which the IRS will only use and disclose consistent with the confidentiality rules under Code Section 6103.  Like the detailed certification rules, the proposed records system signals the IRS’s commitment to enforce the CPEO suitability requirements by weeding out PEOs managed by individuals with a history of tax wrongdoings.  The proposed system became effective on August 10, 2016.

Other Issues

Groundbreaking in the payroll tax world, the CPEO rulemaking project is still in its infancy, and the IRS will continue to issue new rules and clarifications as to a CPEO’s certification and reporting obligations, as well as the new CPEO records system.  Additionally, the IRS will likely address whether to expand the list of specified tax credits applicable to a customer with respect to its work site employees, and how these credits may apply in the case of non-work site covered employees.

One crucial issue the IRS has yet to address is the scope of the liability of CPEOs’ customers.  Although the new rules are intended to shift payroll tax liability to the CPEO, the customer, as the common law employer, may be liable if the IRS retroactively revokes or suspends a CPEO’s certification.  This liability may be significant, as it includes the payroll taxes that should have been but were not properly withheld and/or remitted, and may also include Trust Fund Recovery Penalties.  It is unclear if a customer can avoid this liability when its CPEO failed to withhold or remit payroll taxes properly, solely by showing that it relied on the IRS’s quarterly CPEO list.  Thus, it remains to be seen if the IRS clarifies whether customers must verify their CPEOs’ ongoing compliance with certification requirements.

Wellness Program Cash Rewards and Salary-Reduction Premium Reimbursements Taxable

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May 27, 2016

Recently, the IRS clarified whether employees are taxed for receiving cash rewards and reimbursements from their employers for participating in wellness programs.  In CCA 201622031, the IRS ruled that an employee must include in gross income (1) employer-provided cash rewards and non-medical care benefits for participating in a wellness program and (2) reimbursements of premiums for participating in a wellness program if the premiums were originally made by salary reduction through a Section 125 cafeteria plan.

In CCA 201622031, the taxpayer inquired whether an employee’s income includes (a) employer-provided cash rewards or non-medical care benefits, such as gym membership fees, for participating in a wellness program; and (b) reimbursements of premiums for participating in a wellness program if the premiums were originally made by salary reduction through a cafeteria plan.  The IRS ruled that Sections 105 and 106 do not apply to these rewards and reimbursements, which are includible in the employee’s gross income and are also subject to employment taxation.

Tax Court Lacks Jurisdiction to Review IRS Employment Classification Determination

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April 5, 2016

Today, the U.S. Tax Court held that it lacked jurisdiction to review a Form SS-8 determination that a father was an employee, not an independent contractor, of his son. In B G Painting, Inc. v. Commissioner, the son, a painting contractor, issued Forms 1099-MISC to his workers, including the father. The father filed a Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding), requesting that the IRS determine his employment status. In response, the IRS SS-8 Unit notified the parties that the father is the son’s “employee.” The son petitioned the court to review this determination.

The Tax Court held that it lacked statutory jurisdiction to review this determination because the Form SS-8 process is not an “examination.” Section 7436(a) of the Internal Revenue Code grants the Tax Court jurisdiction over employment status if “in connection with an audit of any person, there is an actual controversy involving a determination by the Secretary as part of an examination.” But the Form SS-8 process is not an “audit” or “examination”; rather, it is a voluntary compliance process involving no specific tax liabilities or assessments. Therefore, the Tax Court dismissed the case for lack of jurisdiction.

Once the IRS rules that an individual is an employee on the basis of a Form SS-8 submission, the employer has no right to appeal the determination. The IRS will send a follow-up letter to the employer asking whether the employer has filed Forms 941-x to pay the applicable FICA taxes based on the determination, whether the employer is eligible for Section 530 relief, and whether the employer has reasons for believing the IRS determination is incorrect. Given the obligation to provide health insurance to employees or face a potential tax penalty, the employer should expect an increased number of Form SS-8 submissions by independent contractors and increased focus on worker classification issues by the government.

If the employer fails to treat the individual as an employee following a Form SS-8 determination, the individual may file Form 8919 to report his or her share of FICA taxes. The same form can be used while a Form SS-8 is pending for the individual or if the individual was provided both a Form 1099-MISC and a Form W-2 and believes the income reported on the Form 1099 should have been included on Form W-2.