On May 4, 2016, the IRS announced that it would begin accepting applications for the voluntary certification of professional employer organizations (“PEOs”) beginning July 1, 2016. PEOs are also commonly referred to as employee leasing companies. While the requirements of the certification program may be of interest to the PEO, the designation of a PEO as a certified professional employer organization (“CPEO”) should be of major interest to the employers utilizing the CPEO. This blog will review the beneficial tax treatment resulting from a PEO’s certification as a CPEO.
Under Section 3511 of the Internal Revenue Code, a CPEO is treated as the sole employer of any “work site employee” for purposes of liability for employment taxes. However, the customer continues to be treated as the employer for purposes of determining the exemptions, exclusions, definitions and other rules which are based on the types of employer which are used in computing the employment tax liability.
In effect, Code Section 3511 allows the customer to shift the employment tax liability with respect to “work site employees” to the CPEO (i.e., the CPEO is treated as the employer of these employees for employment-tax liability purposes and the employer is released from liability for those employment taxes). These rules virtually eliminate a CPEO’s customer’s concerns that it will be held liable for employment taxes with respect to work site employees.
For purposes of these rules, a “work site employee” is an individual who: (1) performs services for a customer under a qualifying contract (described below) between the customer and the CPEO; and (2) at least 85% of the individuals performing service for the customer at the work site (excluding certain classes of individuals such as temporary or part-time employees, employees under age 21, etc.) where the individual performs service are subject to one or more qualifying contracts.
Section 7705(e)(2) of the Code provides that a qualifying contract is a written contract that provides that the CPEO will:
- assume responsibility for the payment of wages to such individual, without regard to the receipt or adequacy of payment from the customer for such services;
- assume responsibility for reporting, withholding and paying any applicable employment taxes with respect to such individual’s wages, without regard to the receipt or adequacy of payment from the customer for such services;
- assume responsibility for any employee benefits which the service contract may require the CPEO to provide, without regard to the receipt or adequacy of payment from the customer for such benefits;
- assume responsibility for recruiting, hiring, and firing workers in addition to the customer’s responsibility for recruiting, hiring, and firing workers;
- maintain employee records relating to individuals subject to the contract; and
- agree to be treated as a CPEO for purposes of Code Section 3511 with respect to the individuals subject to the contract.
Individuals with net earnings from self-employment derived from the customer’s trade or business (self-employed individuals) are not work site employees for purposes of these rules. It appears that the customer will remain potentially liable for employment taxes arising with respect to non-work site employees (i.e., Code Section 3511 does not release the customer from employment tax liability with respect to non-work site employees). Thus, the customer should limit their employees to “work-site employees”.
In addition, under Code Section 3511, the CPEO is treated as a successor employer and the customer is treated as a predecessor employer for purposes of computing employment taxes subject to an annual compensation limit (e.g., FICA, Railroad Retirement Tax Act, and FUTA tax). The practical effect of this rule is to eliminate the double counting of compensation subject to the compensation limits which normally occurs with contracts that are entered during a taxable year (i.e., midyear contracts).
Notwithstanding that CPEO is treated as the employer of the work site employee for employment-tax purposes, the customer is treated as the employer for purposes of certain tax credits. These credits include:
- credit for increasing research activity (Code Section 41);
- Indian employment credit (Code Section 45A);
- Credit for portion of employer Social Security taxes paid with respect to employee cash tips (Code Section 45B);
- Clinical testing expense for certain drugs for rare diseases or conditions (Code Section 45C);
- employee health insurance expenses for small employers (Code Section 45R);
- the work opportunity credit (Code Section 51); and
- the empowerment zone employment credit (Code Section 1396).
Treating the customer as the employer, for tax credit purposes, allows the customer that enters into the contract with a CPEO to retain the eligibility for the above-enumerated tax credits to which the customer may otherwise be entitled.
The IRS will publicly disclose PEOs that have been certified and disclose PEOs whose certification has been suspended or revoked. Given the ability to provide certainty to the customer with respect to the shifting of the employment tax liabilities to the CPEO, we expect that PEOs will have a substantial incentive to become CPEOs in order to attract and retain customers. However, we recognize that it may take a significant period of time for the IRS to process the applications and there may not be a substantial number of CPEOs in the near future.
With respect to employers that currently use PEOs, we recommend that the employer initiate a conversation with the PEO to determine whether it intends to become a CPEO. If the PEO intends to become a CPEO, the employer should expect their contract with the PEO to be revised to include the qualifying contract provisions (described above).
If the PEO does not intend to become a CPEO, the employer should monitor the certification of PEOs in their area (along with those PEOs’ ability to service their needs) and consider (as the number of CPEOs increases) the benefits and costs of changing their PEO to another PEO that is a CPEO.