Professional employer organizations (PEOs) provide services to tens, if not hundreds, of thousands of small businesses across the nation. And many of those small businesses are eligible for important payroll tax relief that Congress implemented in the form of a fully refundable tax credit known as the Employee Retention Credit (ERC). However, although convenience and cost savings are usually the motivating factors behind a business’s decision to engage a PEO, the unique PEO/business client relationship has created significant areas of confusion where the ERC is concerned.
Certainly, one of the biggest areas of confusion is whether the IRS may offset the amount of an ERC claim made by the PEO on behalf of its business client (commonly via an aggregate Form 941) due to outstanding tax liabilities owed by the PEO (but not owed by the client). In the middle of May 2023, internal IRS email correspondence was released, expressing the current IRS view on Internal Revenue Code (IRC) §6402 refund offsets where ERC and third-party payors are in play.1 According to the IRS, it has the authority to satisfy a PEO’s own tax liabilities with the amount of the PEO client’s ERC.
While the IRS email correspondence appearing in Chief Counsel Advice (CCA) 2023031609200704 is not authoritative guidance, the IRS position described therein is not a welcome discovery for those who have repeatedly petitioned the IRS to take measures to ensure that “small businesses working with third-party payers are not inequitably denied timely receipt of their [ERC] due to an inappropriate application of the refund offset provisions.”2 In fact, the IRS’s position should be on the radar of all ERC-eligible businesses that work with a PEO. Let’s take a closer look at the issues involved, the recent IRS assertion, and what employers may do to avoid potential problems.
PEOs are companies that offer HR services, including tax compliance services, which help their clients stay focused on business operations. These types of third-party payor arrangements are governed by the terms of the parties’ contract, or “service agreement.” Commonly, a service agreement between a PEO and its business client will task the PEO with the responsibility to file the client’s employment tax returns and remit employment tax liabilities to the IRS on behalf of the client. Sometimes an arrangement is a bit more involved such that the business contracting with a PEO “purports to fire its employees, who are allegedly then hired by the PEO and leased back to the [the PEO’s client].”3 Of course, PEOs make payments to employees and/or employment taxes using funds the client’s funds. Moreover, it’s not unusual for a PEO to file employment tax returns using its own EIN. And since a PEO may have multiple clients, the PEO’s EIN appears on the aggregate filings made on behalf of its clients.
Note that a particular type of PEO merits an introduction here. Internal Revenue Code §7705(a) defines a “certified professional employer organization” (CPEO) as a person that applies to be certified as a CPEO and that the IRS has certified as meeting the applicable requirements. Thus, CPEOs have achieved an accreditation which confirms their operations are conducted according to certain ethical standards. The IRS publishes the CPEO Public Listings so that PEO clients, or potential clients, can verify a CPEO’s certification status.
It’s also important here to understand that CPEOs are held responsible for employment tax responsibilities they assume on behalf of their client. This means that a CPEO’s client is shielded from a CPEO’s filing mistakes or even failure pay payroll taxes. Rather, the IRS goes after the CPEO.
On March 27, 2020, Congress launched the ERC as part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). From the beginning, and throughout subsequent legislative extensions and expansions, Congress fully intended for the ERC to be a valuable relief measure available to eligible businesses that retained their employees and were negatively impacted by the pandemic. Unfortunately, PEOs and their clients have confronted a lack of clear guidance about various aspects of the credit which has delayed, or even effectively blocked, many employers from receiving desperately needed relief.
Perhaps topping their list of concerns is the notion that the IRS might “inappropriately” offset a client’s ERC amount claimed via a PEO on an aggregate Form 941. In fact, on April 7, 2022, the National Association of Professional Employer Organizations (NAPEO) sent a letter to IRS Commissioner, Charles P. Rettig, and Treasury Secretary, Janet Yellen, expressing that the IRS needed to “address continuing challenges with processing claims of the employee retention tax credit.”4 Among other listed concerns in that letter, NAPEO emphasized that:
It also appears that the IRS is applying 941 overpayments due to [ERC] to deferral balances due and rolling refunds forward to future tax periods — with no notification. While this has caused even more confusion and delay, we also believe it goes without saying that in no case would it be appropriate to offset the amount of an [ERC] claim made concerning one client employer by a PEO or other third-party payer on an aggregate Form 941 due to any outstanding liabilities. The [ERC] is the client's money.5
In a recently released internal IRS email correspondence, the IRS indicated that it had been asked to consider:
whether the IRS is authorized to offset certain COVID-19 employment tax credits (e.g., employee retention credit (ERC)) to any existing tax liabilities of a Professional Employer Organization (PEO) that pays wages to individuals as part of the services provided to a client employer pursuant to a service agreement, although the credits being claimed on the Form 941 Schedule R are attributable to wages paid to a client employer’s employees.6
The IRS began by noting its IRC §6402 authority to credit any overpayment against “any liability in respect of an internal revenue tax on the part of the person who made the overpayment.” [Emphasis added].
The IRS continued by clarifying the identity of the “person” referenced in IRC §6402 in the specific context of the third-party payor/client relationship. According to the IRS:
the process for claiming credits against employment tax liabilities and liability for erroneously claimed credits differs depending on the type of TPP used. For taxpayers who use [CPEO] or PEO that pays wages to individuals as part of the services provided to a client pursuant to a service agreement, although the credits being claimed on the Form 941 Schedule R are attributable to wages paid to a client’s employees, the 3504 agent, the CPEO or PEO is the taxpayer who is actually claiming the employment tax in an aggregate amount on a single line on a Form 941 filed under its own EIN. If a refund is ultimately issued to the TPP aggregate filer, it is then between the TPP aggregate filer and the client to ensure the TPP remits any portion of the refund it received to the client in the appropriate amount.7
Having determined the “who,” the IRS offered the following rationale:
The IRS is not a party to those agreements and has no legal obligation to refund any portion of the TPP filer’s refund to a client identified on Schedule R. In addition, when the IRS conducts an audit of a Form 941 filed by these types of TPPs, the IRS is examining the aggregate total amount of the line item credit claimed by the TPP on the Form 941, using the client by client allocation information provided on Schedule R as part of the examination. The IRS does not issue refunds or make credit adjustments to the client entities themselves, but rather any credits/refunds are paid to TPP. Any credits claimed against the employment taxes reported on the Form 941, reduce the reported liability of the TPP. Moreover, any adjustment to a credit claimed by a TPP on the Form 941 will affect the total employment tax liability on the TPP aggregate filer’s employment tax return. Schedule R only provides a portion of the information (the allocable share of wages and credits on a client-by-client basis) which was used by the TPP, in part, to determine its own total tax liability on the return. Since the Schedule R information is not itself determinative of the TPP’s ultimate tax liability, the IRS would not be able to determine the appropriate refund to issue to the TPP based solely on the Schedule R information on a client-by-client basis for any particular employment tax credit.8
At this time, employers working with PEOs first need to recognize that, based on this IRS internal email correspondence, the IRS is remaining outside of the PEO/client relationship. With that in mind, employers may consider the following actions:
PEOs add an additional layer of complexity to ERC claims, because in many ways the PEO becomes the taxpayer for the IRS’s purposes. As the IRS clarifies in Notice 2021-20, the ERC may only be claimed for those qualified wages reported for PEO clients on the Form 941 which the PEO files. And as we have seen in this latest internal IRS correspondence, the IRS maintains the “PEO as taxpayer” construct throughout the process, including any offsetting measures.
In our experience, it’s not unusual for PEOs to balk at wanting to do the work to substantiate, qualify and calculate the ERC tax credit. Additionally, some PEOs are over- or under-calculating the credit amount, failing to ensure that IRS-required substantiation is a component of the process, and overcharging their clients for the work involved. We urge employers who have hired PEO’s to work with trusted tax professionals to counter these PEO-related deficiencies and take any appropriate measures to guard against potential offset pitfalls. Contact our team today at (410) 497-5947 or schedule a confidential consultation.