PEO is statutory employer

The Tax Court allows a refund of overpaid Social Security taxes to professional employer organization Paychex.
By Elizabeth Lyon, J.D., LL.M.

The District Court for the Middle District of Florida granted a motion for judgment in a case from 2017 involving whether a professional employer organization (PEO) was the statutory employer for employment tax purposes for its client's employees and as such was entitled to a refund of Social Security taxes it overpaid.

Facts: Paychex Business Solutions LLC was a PEO that entered into service agreements with client companies in which it would provide employer payroll functions, including payment of wages and withholding and payment of payroll taxes. Under some versions of the service agreements, Paychex assumed responsibility for the payment of wages only if the client company first provided funds to Paychex to cover this obligation. Under other versions, Paychex assumed responsibility for the payment of wages regardless of whether the client companies paid first.

When Paychex began providing PEO services to a client company, Paychex would switch the reporting of payroll taxes from the client company's federal employer identification number (EIN) to Paychex's EIN and would restart each worksite employee's Social Security wage base for the year.

Paychex later determined that each client company was at all times the common law employer of the worksite employees, even after the client company began a PEO relationship with Paychex. As a result, Paychex should not have restarted the Social Security wage base and overpaid more than $4 million in Social Security taxes, for which it filed a refund claim.

The IRS did not contest that the client company was the common law employer or that Social Security taxes had been overpaid, but it denied the refund claim.

Issues: The primary issue before the court was whether Paychex was the statutory employer of its client's employees (worksite employees) and was liable for their Social Security taxes. If Paychex was the statutory employer of the worksite employees, it would have standing to sue for a refund. If, however, as the IRS contended, Paychex was merely a third party that voluntarily paid the Social Security taxes on behalf of the client company, Paychex was not the taxpayer and had no right to a refund.

Sec. 3111(a) imposes a Social Security tax on every employer. Generally, the common law control test determines whether a party is an employer for purposes of Social Security tax liability. Under this test, a party that has control over both the work to be completed and the methods used to complete the work is an employer. In the typical PEO relationship, the client company maintains sufficient control over the results and methods of the work performed by the worksite employees to be considered the common law employer.

However, under Sec. 3401(d)(1), if the common law employer does not control the payment of wages to its employees, then the party that does control the payment of wages to the employees is the employer for income tax and employment tax purposes. This party is commonly referred to as the statutory employer.

Paychex and the IRS agreed that the client companies, not the PEO, were the common law employers of the worksite employees. However, Paychex argued that it was the statutory employer of the worksite employees, since it, not the client companies, paid their wages. The IRS, on the other hand, argued that while Paychex issued wage payments, it was a conduit for its client companies because it debited their accounts before paying the worksite employees, and the client companies were in actual control of the wage payments because Paychex's payment of the wages was contingent on or proximately related to its first receiving funds from the client companies. It further argued that to be the statutory employer, Paychex must have had exclusive control of the wage payments to the worksite employees, but it did not have exclusive control of the payment of wages because Paychex's payment of the wages was contingent on, or proximately related to, its first receiving funds from the client companies.

Holding: The court, in a June 2017 decision, held that Paychex was the statutory employer of the worksite employees and thus was entitled to a refund of the overpaid Social Security taxes.

The court found that the relevant inquiry in determining which party had controlled the payment of wages was which party had exclusive control of the bank account from which wage payments were made. The payments were made from Paychex's bank accounts, which the client companies had no authority over or access to.

The court rejected arguments that Paychex was merely a conduit for payment by the client companies or that the client companies were in actual control of the wage payments because, while Paychex debited client companies' bank accounts prior to paying wages, it had no confirmation that the funds were received before it made the wage payments. It further determined that the IRS was incorrect in arguing that Paychex was required to have exclusive control over the wages paid to the worksite employees. Rather, the court found that Paychex was required to have exclusive control over the bank accounts from which the wage payments were made, and that the undisputed evidence showed that Paychex did have exclusive control over those accounts.

The court rejected the IRS's motion for reconsideration and in May 2018 granted Paychex's motion for judgment and ordered the IRS to pay Paychex a refund of $4,061,784 in tax, plus statutory interest. The IRS has announced it will appeal this decision.

  • Paychex Business Solutions, LLC, No. 8:15-cv-1455-T-24-TGW (M.D. Fla. 5/2/18)

— By Elizabeth Lyon, J.D., LL.M., an assistant professor of accountancy at California State University, Sacramento.

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