The 2014 Tax Act and Professional Employer Organizations (PEOs)

We know that Congress passed, and the President signed, the Tax Increase Prevention Act of 2014 at the end of last year. This is the tax bill that retroactively resurrected certain tax deductions that many taxpayers have become used to, such as deducting sales taxes (rather than state income taxes)  should one live in Tennessee, Florida or Texas or deducting (a certain amount of) tuition payments if one’s child is in college.

There is something else this bill did that was not as well publicized.

It has to do with professional employer organizations, known as PEO’s. These are companies that provide human resource (HR) functions, such as the paperwork involved in hiring, as well as running payroll and depositing payroll taxes and other withholdings.

There has long been a hitch with PEOs and payroll taxes: the IRS considered the underlying employer to still be liable for withholdings if the PEO failed to remit or failed to do so timely. The IRS took the position that an employer could not delegate its responsibility for those withholdings. To phrase it differently, the employer could delegate the task but could not delegate the responsibility.

You can guess what happened next. There were cases of PEO’s diverting withholdings for their own use, then going out of business and leaving their employer-clients in the lurch. If you were one of those employer-clients, the experience proved to be very expensive. You had paid payroll taxes a first time to the PEO and then a second time when the IRS held you responsible.

The answer was to watch over the PEO like a hawk. The IRS encouraged employer-clients to routinely go into the electronic payment system (EFTPS), for example, to be certain that payroll taxes were being deposited.

That unfortunately collided with many an employer’s reason to use a PEO in the first place: to have someone else “take care of it.”

Back to the tax bill. Stuck in with the tax extenders was something called the ABLE Act, which is a Section-529-like-plan, but for disabled individuals rather than for college expenses.

Stuck (in turn) onto the ABLE Act was a brand-new Code section just for PEOs. The provision requires the IRS to establish a PEO certification program by July 1, 2015. There will be a $1,000 annual fee to participate, but – once approved – the IRS will allow the PEO to be solely responsible for the employer-client’s payroll taxes.

You have to admit, this is a marketing bonanza if you own a PEO. It will separate you from a non-PEO who is bidding on the same prospective client.

The PEO will have to post a bond in order to participate in the program. In addition the PEO will have to be audited annually by a CPA. The PEO will have to submit that audited financial statement to the IRS.

I do not know the answer as of this writing, but I have a strong suspicion the AICPA was in the room when that audit requirement was included. Why do I say that? Because only CPAs are allowed to render an opinion that financial statements are “presented fairly in accordance with generally accepted accounting principles.” 

NOTE: That would be CPAs who practice as auditors. There are CPAS who do not. For example, I specialize in taxes.

There is – by the way – risk to the PEO. This is not a one way street. The PEO will be responsible for the payroll taxes, even if the employer-client does not pay the PEO.

No Job Is Worth This Penalty

A few years ago someone asked me to “run their payroll.” This particular place had enough issues to fuel multiple seasons of Game of Thrones, among the least of which was an inability or unwillingness to pay their payroll on time.  It was just a matter of time until someone reported them to a government agency. I was to timely process the payroll, transfer funds, make tax deposits and so on.

My answer?

Not a chance.

I have no problem processing a payroll. The one thing I will not do however is involve myself with making payroll tax deposits.

Why?

There is an IRS penalty out there called the “responsible person” penalty, which we have previously referred to as the “big boy” penalty. This is gallows humor, and you want nothing to do with this boy. The IRS becomes very grim when one withholds payroll taxes and fails to remit them to the government. They consider it theft. The IRS roots around to learn who in the company had control over cash – that is, who decides who to pay, who can sign checks, that type of thing. If that person is you, you may be a “responsible person,” meaning that you are also liable for the payroll taxes. The IRS can chase the company, it can chase you, it can chase both of you. You have stepped into someone else’s problem.

Where have I seen this? Mostly it stems from severe cash flow pressures, such as after the 2008 business crash. My last responsible person penalty client was a contractor on the Kentucky side of Cincinnati. What made it frightening was the IRS interviewing the controller/office manager in addition to the owners. Why? Because, once in a blue moon, she would write a check, mostly if there was no one else available to sign. That woman was understandably terrified.

I am reading a District Court decision coming out of Virginia. From 1990 to 2000 Brenda Horne was the office manager for a medical practice. Her duties included:

·       Billing customers

·       Collecting accounts receivable

·       Making bank deposits

·       Writing checks

·       Preparing, signing and filing payroll tax returns

·       Decisions about hiring, firing and employee compensation

The company stopped making payroll tax deposits in 2006.  Brenda continued writing and signing checks to everyone but the IRS.

The IRS came in. The company owed over $2.8 million in back payroll taxes.

And now, so does Ms. Horne.

Perhaps she was part of this. Perhaps she was under-informed and went along in order to keep her job. She wouldn’t be the first. The fatal fact? That she could decide who to pay, who not to pay, and could sign checks accordingly. The IRS did not get paid, and they held her responsible.

Granted, the owners of the company are responsible long before an office manager is, but that is not the way the IRS approaches this. The IRS is happy to have several responsible persons. That increases the odds of collecting from someone. Theoretically, she could sue the medical practice and its owners for restitution if the IRS compelled her to pay. Considering that the company did not – or could not – pay the taxes when due, I am skeptical that it could pay Brenda Horne now.

It does not matter what she was paid for being an office manager. It cannot approach $2.8 million.

And the company’s loyalty to her?

She got fired at the end of 2010.

“Largest Ever” Texas Payroll Tax Fraud Scheme

We prepare payroll for our clients. We do not handle money, mind you, but we do the calculations, observe the deposit schedules and prepare the tax returns. ADP and Paychex do the same thing, but in much larger volume.

Have you ever wondered who is responsible for penalties if these payroll taxes are not prepared correctly: you or me (that is, the provider)? Let’s ramp this up a notch: what if you remit monies trusting the provider to make the deposits … and they don’t? Think about this for a second. Would the IRS really expect you to make the deposit again? After all, you are out the monies remitted to the provider. And, if they did, would the IRS add insult to injury by applying penalties?

Chances are the answer is yes (to the first) and no (to the second).

Let’s review the buzzwords in this area and then let’s discuss a horror story.

Technically there are three types of payroll providers:

(1)   Payroll Service Providers (PSP)

a.     A PSP prepares the payroll tax returns but the client signs and files the paperwork. This is what we do. Under this arrangement, you remain the employer in the eyes of the IRS.

(2)   Reporting Agent (RA)

a.     RA’s prepare and file the paperwork. It is a slight difference, granted, and again you remain the employer in the eyes of the IRS.

(3)   Professional Employer Organization (PEO)

a.     PEO’s are more difficult to pin down.

                                                    i.     PEO’s perform the range of human resource functions: tax filings and administration, benefit design and ERISA, compliance with federal and state workplace regulations, disciplinary actions, unemployment, disability and workers compensation.

b.     It gets tricky on who is the “employer” in this instance. You are paying the PEO as a virtual outsourcing of your personnel and payroll departments. Odds are – for example – that the PEO is issuing W-2s in its name and identification number. Again, odds are that employee benefits – health and other – are also provided under their name.

                                                    i.     That sets up the question: who is the employer – you or the PEO?

c.      The tax law is not as clear as it could be.

                                                    i.     There is a way for the PEO to be the “employer”, but certain requirements must be met and paperwork has to be filed to notify the IRS.

d.     PEO’s commonly use an indemnity provision requiring them to reimburse you in the event of liability attributable to their failure to collect or remit taxes.

                                                    i.     An indemnity provision – by itself – is not enough to have the IRS consider the PEO to be the employer.

                                                  ii.     This means that – if all that happens is an indemnity provision - you remain the employer, and the IRS can act against you for penalties and undeposited taxes. 

What can go wrong?

I am looking at an FBI release dated February 21, 2014.  There is a court in San Antonio that is sending three individuals to jail for participating in what the FBI describes as “the largest real dollar loss fraud and tax related case ever prosecuted in the Western District of Texas.” At the core of this case were PEOs.

·       John Bean, owner of Synergy Personnel and an officer with several other San Antonio and Austin PEOs, was sentenced to six years in prison and order to repay more than $120 million in restitution.

·       Pat Mire, owner and manager of several San Antonio PEOs (including one with John Bean) was sentenced to three years in prison and order to repay $10 million.

·       Mike Solis, an executive at several San Antonio PEOs, was sentenced to two years in prison.

·       John Walker II owned and managed several San Antonio PEOs. He was sentenced to five years of probation and ordered to repay $450,000.

They had an unusual – but track-proven way - of dealing with the pesky payroll taxes they collected from clients and were supposed to remit to the government: they didn’t. Needless to say, they were extraordinarily profitable. They admitted that between 2002 and 2008 they stole more than $133 million from clients.

Good grief!

That is Nimitz-class payroll taxes, and someone is going to pony up. If you were a client of these PEOs, you would not want the IRS to come knocking, expecting you remit payroll taxes after you already paid these guys to do the same. You would be paying twice.   

The technical lexicon is that you want the PEO to be the “Section 3401” employer. The concept doesn’t apply to a PSP or RA, as their functions are limited. A PEO, on the other hand, performs so many of the employer functions that they practically “are” the employer. You want to be certain that the IRS agrees with that, though, by acknowledging the PEO as the “Section 3401” employer.

BTW, will the IRS go after the San Antonio employers? Truthfully, I cannot tell. I hope that the PEOs involved were the Section 3401 employers. Even if they weren’t, this case is so egregious that I would like to believe the IRS would make exceptional accommodation for the employers affected.

Update as of 3/10/14: Last Friday I had an IRS employment tax specialist in the office. Yes, she is auditing one of our clients (sigh). We spoke about the San Antonio PEO fraud and whether the IRS would accept 3401 status for the underlying employers.

She believes the IRS will act against the underlying employers and not even pause for any 3401 argument. Her observation: "it is a risk you take when you hire a PEO."

Be informed.