Who Gets the Tax Credit When You Outsource Payroll to a PEO?

Many businesses outsource their payroll, human resources, and employment tax responsibilities to professional employer organizations. These arrangements make sense.

The PEO handles the administrative burden of onboarding workers, processing wages, withholding taxes, and managing benefits. The business owner focuses on running the business and directing the workers. But when it comes time to claim employment-related tax credits, a question arises: who is the “employer” entitled to claim them?

This question matters because several tax credits could either go to the PEO or their clients–or both or neither of them. If a PEO pays the wages and reports the employment taxes, does it get to claim those credits? Or do the credits belong to the business that actually hired the worker and directs their day-to-day activities?

The court recently addressed this issue in Barrett Business Services, Inc. v. Commissioner, 166 T.C. No. 7. The case provides an opportunity to consider who qualifies as an “employer” for purposes of these valuable tax credits.

Facts & Procedural History

The taxpayer is a professional employer organization or PEO based in Washington. It provides employment-related services to small and mid-sized businesses throughout the United States. The services include onboarding workers into its payroll system, processing and paying wages, and withholding, paying, and reporting all applicable federal, state, and local employment taxes. The taxpayer may also provide employee benefits, workers’ compensation insurance, human resources advice, and workplace safety guidance.

The taxpayer’s clients are the “worksite employers.” They hire workers who provide services at the clients’ business locations. The clients supervise the day-to-day activities of these workers. The taxpayer does not supervise them.

For tax years 2017 through 2020, the taxpayer claimed both the Work Opportunity Tax Credit (“WOTC”) and the Empowerment Zone Employment Credit (“EZEC”) on its returns with respect to its clients’ workers. When a client hired a new worker, the taxpayer required the client to prepare a new hire packet containing a questionnaire. That questionnaire helped identify whether the worker belonged to a targeted group eligible for the credits.

Roll the clock forward. The IRS reviewed the tax returns and issued a Notice of Deficiency for each year to disallow the claimed credits. The IRS determined that the taxpayer could not claim the WOTC because it was not the common law employer of the workers and was not a statutory employer under Section 3401(d)(1). The taxpayer filed a petition in the U.S. Tax Court challenging the IRS’s determinations. Both sides filed cross-motions for partial summary judgment.

What Are the Work Opportunity Tax Credit and Empowerment Zone Employment Credit?

To understand this case, we have to first start with the underlying tax credits.

The WOTC is found in Section 51. It allows employers to claim a credit equal to 40% of qualified first-year wages paid to individuals who are members of a “targeted group.” Those targeted groups include qualified veterans, ex-felons, individuals with disabilities, designated community residents, vocational rehabilitation referrals, summer youth employees, food stamp recipients, SSI recipients, long-term family assistance recipients, and long-term unemployment recipients. The credit is intended to encourage employers to hire people who face significant barriers to employment.

Congress first enacted a version of this credit in 1977 as the New Jobs Credit. Its purpose was to address high unemployment by giving businesses an incentive to hire disadvantaged workers. When the national unemployment rate declined, Congress narrowed the credit to target specific groups of individuals who continued to struggle finding work even in a stronger economy. In 1996, Congress replaced the targeted jobs credit with the WOTC, focusing on individuals with poor workplace attachments and promoting longer-term employment.

The EZEC under is found in Section 1396. This one allows employers a credit equal to 20% of qualified zone wages. Qualified zone wages are wages paid to a “qualified zone employee” — someone who both lives and performs services within an empowerment zone. Empowerment zones are areas designated by the Secretary of Housing and Urban Development or the Secretary of Agriculture as suffering from high poverty and unemployment. Congress created these zones and the accompanying tax credits in 1993 to revitalize economically distressed areas through expanded business and employment opportunities.

Both credits share a common purpose. They reward the businesses that actually create jobs for disadvantaged individuals and in struggling communities.

Who Is an “Employer” for Purposes of These Credits?

Neither Section 51 nor Section 1396 defines the term “employer.” The term is simply not defined.

When Congress uses a term that has an established meaning under common law without defining it, the courts will often presume Congress intended the common law meaning. The Supreme Court established this principle in Nationwide Mutual Insurance Co. v. Darden, 503 U.S. 318 (1992), explaining that when Congress uses the term “employee” without defining it, courts should apply the conventional master-servant relationship as understood by common law agency doctrine.

Whether a common law employer-employee relationship exists is a question of fact. The tax court has said that it will look at several factors, including: the degree of control the principal exercises over the details of the work, which party invests in the facilities, the worker’s opportunity for profit or loss, whether the principal can discharge the worker, whether the work is part of the principal’s regular business, the permanency of the relationship, and the relationship the parties believe they are creating. No single factor controls.

In this case, the taxpayer’s clients — not the taxpayer — hired the workers, directed their day-to-day activities, and received the benefit of their services. The taxpayer processed payroll and handled tax reporting. Under the common law test, the clients were the employers. The taxpayer was not.

Can a Statutory Employer Claim the Credits?

The taxpayer argued that the definition of “employer” in Seciton 3401(d)(1) should apply. This provision says if the person for whom an individual performs services does not have control of the payment of wages, the term “employer” means the person who does have control of the payment. Since the taxpayer controlled the payment of wages through its payroll processing. It argued it was a “statutory employer” entitled to the credits.

The tax court rejected this argument. Section 3401(d)(1) defines “employer” only “[f]or purposes of this chapter” — chapter 24 of subtitle C, which deals with collection of income tax at the source on wages. It is an employment tax provision. The WOTC and EZEC are in subtitle A, chapter 1, which deals with income taxes. The court saw no reason to import an employment tax definition into income tax credit provisions.

According to the court, the legislative history reinforced this conclusion. Congress enacted these credits to encourage businesses to hire disadvantaged individuals and to create jobs in distressed areas. A PEO that processes payroll is not the entity providing those work opportunities. It is not the intended beneficiary of the credits.

Does Section 3504 Allow an Agent to Claim the Credits?

The taxpayer made a second argument under Section 3504, a fiduciary, agent, or other person who controls, receives, or pays the wages of employees can be designated to perform acts required of employers. The taxpayer argued that as an agent under Section 3504, “all provisions of law” applicable to employers — including the WOTC and EZEC — should apply to it.

The tax court also disagreed with this argument. Section 3504 authorizes an agent to perform acts required of employers and subjects the agent to provisions of law applicable “in respect of an employer.” The court interpreted this phrase to mean provisions applicable to employers acting in their capacity as employers. The WOTC and EZEC are income tax credits. They are not provisions of law applicable to employers in their capacity as such.

The tax court also noted the result that would follow from the taxpayer’s reading. Section 3504 provides that the employer “shall remain subject to the provisions of law” even when an agent is designated. If Section 3504 extended the credits to agents, both the agent and the employer would be eligible for the same credits on the same wages. Nothing in the legislative history suggests Congress intended that result.

Does the Three-Party Arrangement in Section 51(k)(2) Help?

The taxpayer raised one more argument. They argued that Section 51(k)(2) addresses situations where an employer pays an employee who performs services for another person. The taxpayer argued this provision contemplates a three-party arrangement where someone other than the common law employer can claim the credit.

The tax court found the taxpayer’s logic broke down at a key point. The taxpayer argued that because the employee performs services for “another person,” that other person must be the common law employer — leaving the paying entity (the taxpayer) as the “employer” eligible for the credit. But the mere performance of services for a third party does not make that third party the common law employer. The multi-factor common law test determines the employer, and no single factor is dispositive.

The legislative history of Section 51(k)(2) confirmed the court’s reading. Congress added this provision to prevent employers from “lending or donating the services of individuals on their payroll to tax-exempt or other organizations which do not have sufficient tax liability to take advantage of the credit.” The provision ensures the credit is available only when the employer receives compensation from the third party that exceeds what it pays the worker. It does not expand the definition of “employer” beyond the common law meaning.

The Takeaway

The Tax Court made clear that the WOTC and EZEC belong to common law employers — the businesses that hire workers, direct their activities, and create the job opportunities these credits are designed to encourage. A professional employer organization that handles payroll and employment tax reporting cannot claim these credits simply because it controls the payment of wages. Neither the statutory employer definition in 26 U.S.C. §3401(d)(1) nor the agent provisions of §3504 extend these income tax credits beyond the common law employer. For businesses that use PEOs and want to take advantage of these hiring incentives, the message is straightforward: the credit stays with the business that does the hiring.

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