Third-Party Liability for Repaying Employee Retention Credits

Published Categorized as Employment Tax, IRS Audits, Tax Procedure
employee retention credit IRS audit

Many businesses outsource their human resources to third parties called Professional Employer Organizations (“PEOs”). PEOs are particularly popular with small businesses.

The benefits of using a PEO include allowing the business to focus on its business operations rather than HR activities and giving employees access to better employee benefits. This is achieved by having the employees for each business be employees of the PEO, even though they work for the individual client businesses that are the clients of the PEO.

This means that the PEO pays the employees and runs payroll for the employees on behalf of the individual businesses.

This brings us to the subject of this article. The employee retention credit (“ERC”) has been in the news for several years. Specifically, fraudulent ERCs have been in the news. These credits are reported on payroll tax returns. Thus, with PEOs, it is the PEO that reports the ERCs for their client businesses.

This leads to the question of whether the PEO is liable for fraudulent ERCs filed for its clients’ businesses. The IRS addresses this in Generic Legal Advice Memorandum (“GLAM”), AM 2024-001.

About Professional Employer Organizations (PEOs)

PEOs are companies that provide a wide range of employment-related services to their client businesses. They typically handle tasks such as payroll processing, employee benefits administration, workers’ compensation insurance, and compliance with various employment laws and regulations.

As noted above, by outsourcing these functions to a PEO, client businesses can focus on their core operations while ensuring that their employment-related responsibilities are being met.

As for payroll taxes, the PEO files a combined payroll tax return using Form 941, Employer’s Quarterly Federal Tax Return, as would the individual businesses. To break down the taxes for each business on this form, the PEO uses the Schedule R (Form 941) form, Allocation Schedule for Aggregate Form 941 Filers. This schedule allows the PEO to allocate the taxes reported on Form 941 among the various clients or businesses it serves.

The Schedule R form provides a detailed breakdown of each client’s portion of the total taxes reported, including federal income tax withholding, FICA taxes, and any other applicable taxes, such as additional Medicare tax or the employer portion of the FICA taxes.

Payroll tax credits are not reported on Schedule R. Payroll tax credits are reported on specific lines of Form 941, such as Line 11 for the Employee Retention Credit and Line 13 for the credits for paid sick and family leave. Instead of being reported on Schedule R, the employer must provide detailed information about the credits claimed, including the number of employees for whom the credits are claimed and the wages qualifying for the credits.

CPEOs vs. Non-CPEOs

The IRS established the Certified Professional Employer Organization (“CPEO”) program to help regulate the PEO industry. The CPEO is a voluntary certification program. To become certified, a PEO must meet various minimal requirements, including background checks, bonding, and annual audits.

CPEOs are held to a higher standard of compliance and are subject to specific regulations outlined in the tax code. Non-certified PEOs, on the other hand, are governed by the regulations in Treas. Reg. § 31.3504-2. These PEOs are referred to as “Section 3504 Agents.”

While both certified and non-certified PEOs share similar responsibilities in terms of employment tax obligations, there are notable differences. For example, a CPEO is generally treated as the sole employer for employment tax purposes, whereas a non-certified PEO and its clients may share joint liability for certain employment tax obligations.

To complicate matters, PEOs may operate on other arrangements that may not subject them to these regulations. So there are other PEOs that are not CPEOs or Section 3504 Agents. This includes traditional payroll companies and PEOs who do not contractually assume responsibility as the employer of record for their clients’ employees.

Employee Retention Credits

This brings us to the ERC payroll tax credit that has been in the news as of late. The ERC has been a significant focus for PEOs and other third-party payers, such as PEOs and payroll processors.

The ERC is a refundable tax credit, which was created by Congress to encourage businesses to retain their employees during the economic downturn caused by the COVID-19 pandemic.

The IRS has implemented various programs to address the issue of improperly claimed ERCs. One such program is the voluntary disclosure program, which allows businesses that have claimed the ERC incorrectly to come forward and rectify their mistakes without facing severe penalties. This program encourages transparency and helps businesses to correct their ERC claims while minimizing the potential consequences of non-compliance.

In addition to the voluntary disclosure program, the IRS has also initiated outreach efforts to ERC providers, including PEOs and other third-party payers. The IRS’s Criminal Investigation division has been contacting these providers to gather information and investigate potential instances of fraud or abuse related to ERC claims. This outreach serves as a warning to ERC providers that the IRS is actively monitoring the situation and is prepared to take action against those who engage in fraudulent or improper practices.

This is in addition to the IRS’s ability to recover the trust fund portion of payroll taxes (i.e., the employee withholding portion) directly from the business owners. The trust fund recovery penalty allows for this. Thus, if the PEO is liable, then the owners of the PEO may also be liable by way of the trust fund recovery penalty. This can put the personal assets of the PEO owner on the hook for repayment.

PEOs and section 3504 agents, have been instrumental in helping their clients claim the ERC. Now that the IRS is taking steps to recover wrongfully claimed ERCs and is auditing ERC claims, the question is whether the PEO can be on the hook for wrongfully claimed ERCs.

Are PEOs on the Hook for ERCs?

This is where GLAM AM 2024-001 comes in. It clarifies that, according to the IRS, third-party payers, such as PEOs, are liable for any underpayment resulting from an improperly claimed ERC.

GLAM AM 2024-001 provides a detailed explanation of the IRS’s position on the liability of PEOs and other third-party payers for improperly claimed ERCs. The memorandum emphasizes that the existing statutory and regulatory framework governing the responsibilities and liabilities of these entities applies to the ERC just as it would to any other employment tax credit.

The IRS notes that both CPEOs and non-certified PEOs (including Section 3504 Agents) are liable for any underpayment of employment taxes resulting from improperly claimed credits. This liability stems from the fact that these entities are responsible for filing employment tax returns and paying the associated taxes on behalf of their clients.

The memorandum also addresses the specific provisions in the CARES Act and subsequent legislation that discuss the allocation of ERC-related responsibilities between PEOs and their clients. While these provisions do require clients to provide accurate information to their PEOs and hold clients accountable for improperly claimed credits, they do not absolve PEOs of their own liability in cases where they claim the credit based on the information provided by their clients.

In essence, GLAM AM 2024-001 reinforces the concept that PEOs and other third-party payers cannot rely solely on the information provided by their clients when claiming the ERC. They must exercise due diligence and maintain accurate records to ensure compliance with all applicable regulations. According to the memorandum, failure to do so may result in significant financial consequences for these entities.

The Takeaway

The question of whether improperly claimed ERCs could spell the end for PEOs is a serious one. As the IRS ramps up its audits of ERC claims, PEOs find themselves at significant risk for adjustments related to credits claimed incorrectly on tax returns on behalf of their clients. GLAM AM 2024-001 makes it clear that PEOs, regardless of their certification status or specific arrangement, can be held liable for underpayments resulting from improperly claimed ERCs.

To mitigate this risk, PEOs may need to take proactive steps, such as implementing more stringent compliance measures, enhancing their due diligence processes, and improving communication and transparency with their clients. Some PEOs might even consider modifying their service offerings or reassessing their business models to minimize their exposure to potential liabilities. It is likely that we will see significant tax litigation involving PEOs and the IRS involving these issues in the near future.

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