Common law employer remains liable when payroll company fails to remit taxes

Plain-English summary

An S corporation used a professional employer organization to administer payroll and employment-tax filings, but the organization failed to remit the taxes. Chief Counsel advised that the professional employer organization was not the statutory employer under IRC § 3401(d)(1) because it received payroll funds in advance, could require security, and did not assume legal responsibility for paying wages. The organization acted only as a conduit, so the corporation remained liable as the common law employer for income-tax withholding, FICA, and FUTA taxes. Section 530 of the Revenue Act of 1978 did not apply because the dispute concerned responsibility for unpaid taxes, not whether the workers were employees or independent contractors.

Ruling snapshot

• Question: Did the payroll company become the statutory employer, or could the common law employer obtain Section 530 relief from the unpaid employment taxes?
• Outcome: Advice given. The payroll company was not the statutory employer, the common law employer remained liable, and Section 530 relief was unavailable.
• Key authorities: IRC §§ 3121, 3306, 3401(d)(1); Section 530 of the Revenue Act of 1978; Treas. Reg. § 31.3401(d)-1(f)

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201724025
       Release Date: 6/16/2017
       CC:TEGE:EMRogers
       POSTN-103272-17

UILC: 3121.10-01

date: February 01, 2017

 to:   Linda Azmon
       Senior Counsel (Northeast Area Long Island)
       (Tax Exempt & Government Entities Division Counsel)

from: Paul J. Carlino
Branch Chief, Employment Tax Branch 1 (Exempt Organizations/Employment
Tax/Government Entities)
(Tax Exempt & Government Entities)

subject: Application of Section 530 of the Revenue Act of 1978

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.

       ISSUES

       1. Whether a third party that Taxpayer contracted with to perform its employment tax
       obligations is the “statutory employer” under Internal Revenue Code section 3401(d)(1)1
       with the result that Taxpayer is relieved of federal employment taxes, including taxes
       under the Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act
       (FUTA), and Federal income tax withholding (ITW) (collectively, employment taxes).

       2. Is Taxpayer entitled to relief treatment under Section 530 of the Revenue Act of 1978
       (Section 530)?2




       1
         All references to “section” are to the Internal Revenue Code of 1986, as amended, unless otherwise
       noted.
       2
         Section 530 has never been codified in Title 26 of the U.S. Code, but many publishers of the Internal
       Revenue Code include the text of section 530 in the notes following Code section 3401(a).

POSTU-134565-16 2

CONCLUSIONS

1. The third party is not a “statutory employer” under section 3401(d)(1) and Taxpayer is
   not relieved of the employment taxes at issue.

2. Taxpayer is not entitled to relief under Section 530, because Section 530 is not
   applicable to the present dispute.

FACTS

Taxpayer is an S Corporation which operates a -------------- ------------------- business.
In conducting its operations during the years in issue, Taxpayer hired workers to
perform services in various capacities including accounting, administrative, marketing,
-------------------------------------------------------------. Taxpayer filed Form 1120S, U.S.
Income Tax Return for an S Corporation, for the years in issue and did not claim any
deductions for officer compensation or salaries and wages. Instead, Taxpayer claimed
deductions for “Employee Leasing” for its entire workforce.

Prior to the years in issue Taxpayer entered into a contract entitled “PEO SERVICES
AGREEMENT” with a third party.3 Under the contract: 1) Taxpayer assumes “the
responsibility for the day-to-day supervision and control of the individuals who the PEO
retains to work at Taxpayer’s location” and the PEO “does not and shall not have any
liability, obligation or responsibility therefore whatsoever”; 2) Taxpayer must pay “at
least one (1) business day before each payroll date, an amount equal to all wages,
salaries and any all other charges or payments to be paid to or with respect to the
individuals who the PEO retains to work at Taxpayer’s location”; 3) Taxpayer must
provide a security deposit or procure a letter of credit naming PEO beneficiary in the
amount as determined by the PEO to cover wages, salaries, contributions, premiums
and any and all other charges or payments to be paid to or with respect to the
individuals who the PEO retains to work at Taxpayer’s location; and 4) PEO may
terminate the contract, immediately without notice, upon the occurrence of the
Taxpayer’s failure to pay any invoice in full in the amount and at the time specified
when due or any breach or default of the contract by Taxpayer. In the event of
termination for any reason whatsoever, the contract provides that Taxpayer is
“responsible for payment of all wages, salaries and employment related taxes.”

The duties of the PEO under the contract include: 1) administering Taxpayer payroll,
designated benefits, and personnel policies and procedures related to the individuals
who the PEO retains to work at Taxpayer’s location; 2) providing human resource
administration and payroll administration; 3) furnishing and keeping workers
compensation insurance covering the individuals who the PEO retains to work at

3
The third party was part of an industry that, among other things, markets its ability to assist employers
with ministerial tasks associated with the reporting and payment of employment taxes. A professional
employer organization (PEO) is the name commonly used to reference entities in this industry and we will
reference the third party as such for the duration of this memo.

POSTU-134565-16 3

Taxpayer’s location in force; 4) processing and paying wages from its own accounts to
the individuals who the PEO retains to work at Taxpayer’s location based on the hours
reported by the Taxpayer; and 5) filing all employment tax returns (i.e., Form 940,
Employer's Annual Federal Unemployment (FUTA) Tax Return, and Form 941,
Employer's Quarterly Federal Tax Return,) with the Government and furnishing
information returns (i.e., Forms W-2, Wage and Tax Statement) to the individuals who
the PEO retains to work at Taxpayer’s location.

Although the contract generally refers to the individuals who the PEO retains to work at
Taxpayer’s location as “Co-Employees,” Taxpayer does not dispute that at all times
during the years at issue it was the common law employer of the “Co-Employees” and
had the right to direct and control all aspects of the employment relationship between
itself and these individuals.4

Taxpayer did not file any Forms 940 or Forms 941, or issue or file Forms W-2 with
respect to any employees for any of the years at issue based on its contract with the
PEO and took no steps to verify that the PEO filed and paid the employment taxes due
or filed the appropriate returns. Taxpayer learned on audit that the PEO failed to remit
applicable employment taxes to the Government, and now asserts that it paid the
amount in question in full to the PEO and is not liable for the unpaid employment taxes
that the PEO failed to remit to the Government.

LAW AND ANALYSIS

ISSUE l

For employment taxes to apply, an employer-employee relationship must exist. The
existence of an employer-employee relationship generally is determined using the
common law control test. See §§ 31.3121(d)-1(c)(1); 31.3306(i)-1(a); and 31.3401(c)-
1(a) of the Employment Tax Regulations.

In the present case, Taxpayer does not dispute it was the common law employer of the
workers at issue. Thus, there is no question about the employment status of the
workers. Taxpayer also acknowledges that the common law employer has the
responsibility to pay the underlying tax liabilities on wages it pays to employees.
Taxpayer alleges, however, that it paid the requisite amount of wages, the employer
share of FICA and the proper amount of FUTA taxes to the PEO, and that a PEO is
“obligated by statute” under section 3401(d)(1) to withhold employment taxes from
those wages, and pay such taxes over to the government, making the PEO solely
responsible for the payment of the employment taxes at issue.

Pursuant to section 3401(d)(1), if the common law employer does not have control of the
payment of wages, the term employer means the person having control of the payment

4
The individuals referenced as “Co-employees” in the contract are referred to as employees or workers
for the duration of this memo.

POSTU-134565-16 4

of wages. Although the Code imposes only Federal income tax withholding obligations
upon the section 3401(d)(1) employer, case law has extended the section 3401(d)(1)
employer’s obligations to include withholding and payment of FICA and FUTA taxes.
See: Otte v. United States, 419 U.S. 43 (1974); In re: Armadillo Corp. v. United States,
561 F.2d 1362 (10th Cir. 1977); The Lane Processing Trust v. United States, 25 F.3d
662 (8th Cir. 1994).

The key inquiry to make in determining whether the PEO is a section 3401(d)(1)
employer of the Taxpayer’s employees is to establish whether the PEO was in control of
the payment of wages to those employees. When determining whether a person has
control of the payment of wages, the focus is on the “legal control” of the payment of
such wages. See §31.3401(d)-1(f) of the Employment Tax Regulations. Several cases
have dealt with the issue of what constitutes “control of the payment of wages” for
purposes of determining if a taxpayer is a section 3401(d)(1) employer.

In Winstead v. United States, 109 F.2d 989 (4th Cir. 1997), the taxpayer, Winstead,
owned land that was farmed by sharecroppers, who were accountable for their hired
help. However, the sharecroppers could not pay the hired help until after the crops
were sold. Therefore, Winstead paid the help from his checking account, over which
the sharecroppers had no authority, then deducted what he paid from the
sharecroppers’ share of the crop proceeds. Winstead, who was not the common law
employer, was held to have control of the payment of wages to the hired help and thus
to be the employer under section 3401(d)(1).

In In re Earthmovers, Inc., 199 B.R. 62 (Bankr. M.D. Fla. 1996), the taxpayer,
Earthmovers, a construction company in Chapter 11 bankruptcy, contracted with a
leasing company that operated similarly to the PEO in this case. Pursuant to the terms
of the contract, Earthmovers leased all of its employees from Sunshine Staff Leasing.
The employees were under the direction and control of Earthmovers, but Sunshine was
responsible for the payment of wages to the employees, the collection of the
appropriate payroll taxes from the paychecks, the payment of all employee withholding
taxes due, and the filing of all necessary Federal tax forms. Because Earthmovers had
exclusive control of its workers, the court held it to be the common law employer. The
court also found that because Earthmovers submitted the information regarding the
hours worked each week by each employee, forwarded the amount owed for payroll
(including the tax amounts) to Sunshine, and retained the right to hire and fire the
employees, Sunshine was not in control of the payment of wages for purposes of
section 3401(d)(1). Thus, the court held, Earthmovers bore ultimate responsibility for
payment of taxes.

Other cases have also held a taxpayer to not be a section 3401(d)(1) employer if the
taxpayer received payroll information and funds from its client prior to the delivery of
payroll to the client employees. See, United States v. Garami, 184 B.R. 834 (D.C. Fla.
1995) (leasing company not the section 3401 (d)(1) employer of cleaners because it
generated payroll checks based on information submitted to it by the common law

POSTU-134565-16 5

employer and no evidence that leasing company would pay wages without first
receiving funds to do so from common law employer); In re Professional Security
Services, Inc., 162 B.R. 901 (Bankr. M.D.FIa. 1993) (leasing company not the section
3401(d)(1) employer of security guards because leasing company did not issue checks
to the guards unless it received payment from the client company).5 Our office has also
issued memorandums based on similar facts advising that a taxpayer is not in control of
the payment of wages if the payment of wages is contingent upon, or proximately
related to, the taxpayer having first received funds from its clients.6

Based on the provisions contained in the contract, the PEO is not considered to be in
control of the payment of wages within the meaning of section 3401(d)(1) because the
PEO did not assume legal responsibility for payment of the wages to the employees.
Under the terms of the contract, Taxpayer must pay the PEO an amount equal to the
wages and salaries with respect to the workers in advance of the next payroll date. To
ensure that the PEO will not be responsible for payment of wages to these workers,
Taxpayer must provide a security deposit or letter of credit naming the PEO as
beneficiary in the amount as determined by the PEO to cover the wages and salaries.
Additionally, the PEO may terminate the contract immediately without notice and
Taxpayer is “responsible for payment of all wages, salaries and employment related
taxes.”

Thus, the PEO acted merely as a conduit for Taxpayer in making payroll and does not
meet the standards in section 3401(d)(1) and the regulations thereunder.

ISSUE 2

Section 530 provides that if certain requirements (discussed below) are met, workers
shall be deemed not to be employees of a taxpayer for employment taxes, unless the
taxpayer had no reasonable basis for treating the worker as other than an employee.
As explained more fully below, Section 530 is not applicable in this case because the
Taxpayer’s liability for the employment taxes does not involve a question of whether the
workers are employees or nonemployees. Rather, the issue is solely whether the
Taxpayer remains liable for employment taxes on wages paid to common law
employees which the PEO failed to pay over to the government.

There are three requirements for a taxpayer to obtain section 530 relief from
employment taxes. First, the taxpayer did not treat an individual, or any worker holding
a substantially similar position, as an employee for any period for purposes of
employment taxes. Second, the taxpayer must have filed all required Federal returns
(including information returns) on a basis consistent with the taxpayer’s “treatment of

5
By contrast, in United States v. Total Employment Company, 305 B.R. 333 (M.D. Fla. 2004), the court
held that an employee leasing company was, in fact, a section 3401(d)(1) employer because it advanced
payroll on behalf of its client. Notwithstanding, the court held both the leasing company and the common
law employer equally responsible to the IRS for employment taxes.
6
See, for example, FSA 1998-14, CCA 200415008, TAM 201347020.

POSTU-134565-16 6

such individual” as not being an employee. Third, the taxpayer must have had a
reasonable basis for not “treating the individual as an employee.”

If all the requirements are met, the flush language of section 530(a)(1) provides that for
purposes of applying employment taxes for a particular tax period with respect to the
taxpayer, “the individual shall be deemed not to be an employee.” If the worker is
deemed not to be an employee, then the taxpayer has no employment tax liability with
respect to remuneration paid to that worker for that period.

Section 530(a) focuses on the taxpayer’s treatment of the worker as an employee and
not the taxpayer’s treatment of certain payments or services, the taxpayer’s payment of
its liability, or the determination of which party is liable for employment taxes on
payments made to the taxpayer’s employees.

Congressional intent that Section 530 apply only to employee or nonemployee status
determinations is reflected in the language found in section 530(a)(1)(A) that the
taxpayer “did not treat an individual as an employee” for purposes of employment
taxes.” Further, Section 530(b) prohibits the Service from publishing regulations or
revenue rulings clarifying the “employment status” of individuals for purposes of
employment taxes prior to the effective date of any law clarifying the same.

Similarly, the legislative history of Section 530 shows that Congress was providing a
relief provision limited to controversies regarding whether a worker was or was not an
employee of a service recipient. It explains that in the late 1960s the Service increased
its enforcement of the employment tax laws, causing significant controversies between
taxpayers and the Service about whether individuals treated as independent contractors
should be reclassified as employees. H.R. Rep. No. 95-1748, 95th Cong., 2d Sess. 3-7
(1978), 1978-3 C.B. 629, 631-632. See also S. Rep. No. 95-1263, 95th Cong., 2d Sess.
209-211 (1978), 1978-3 C.B. 315, 507-508. Until Congress had adequate time to study
the matter, it provided relief for taxpayers who were involved in controversies with the
Service “involving whether certain individuals are employees for purposes of the
employment taxes.” Joint Committee on Taxation Staff, General Explanation of the
Revenue Act of 1978, 95 Cong., at 301 (1979).

Neither the statute nor the legislative history indicates that Congress intended Section
530 to apply to disputes regarding whether a common law employer remains liable for
employment taxes that were never paid over to the government by a conduit payroll
processor. Rather, the legislative history reflects Congressional intent to limit the
application of Section 530 relief to only controversies regarding whether an individual
should be reclassified from independent contractor status (or other nonemployee status
such as partner) to employee status. S. Rept. No. 95-1263, at 210.

In the current examination, there is no question regarding the proper classification
status of the workers as Taxpayer’s employees. In fact, the contractual arrangement
between the Taxpayer and the PEO is predicated upon the treatment of the Taxpayer’s

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workers as Taxpayer’s employees for employment tax purposes. Specifically, under the
terms of the contractual agreement Taxpayer entered into with the PEO, Taxpayer was
required to remit an amount equal to the wages paid to employees, along with the
employer’s share of FICA and the requisite amount of FUTA taxes prior to the end of
the payroll period, so that the PEO could meet the payroll requirements and pay the
workers while withholding the corresponding amount of employment taxes. Thereafter,
the PEO would issue Forms W-2 to the workers and report and pay employment tax on
the appropriate tax returns.

Although Taxpayer did not directly pay the wages to its employees, withhold taxes from
the wages paid to its employees or file Federal employment and information returns
reporting the amount of wages and taxes to its employees, Taxpayer specifically
contracted with a third party for purposes of fulfilling these obligations with respect to
the treatment of the workers as its employees.7 Thus, the contractual arrangement, in
and of itself, demonstrates that no underlying issue of employment tax classification
status exists regarding those who received wage payments. Rather, since Taxpayer
treated all of these workers as employees for purposes of taxes imposed by subtitle C,
but contracted with a third party for purposes of fulfilling its payroll obligations, the
dispute is unrelated to the proper employment tax classification of the workers. Rather,
the dispute is limited to whether Taxpayer, as the common law employer, remains
ultimately liable for the unpaid employment taxes at issue. As such, Section 530 is not
applicable to the present dispute.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

7
Rev. Proc. 85-18, 1985-1 C.B. 518 provides some guidelines in determining whether a taxpayer did not
“treat” an individual as an employee, but does not provide an exhaustive list. See section 3.03.

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