Fixing an Oversight

The TCJA as originally passed neglected to address the impact for businesses that are using a Professional Employer Organization (PEO) to handle their employment related administrative responsibilities. For businesses using a PEO, W2 wages are reported under the EIN of the PEO and not the PEO’s client company. This situation created questions among PEOs and PEO clients regarding the admissibility of using worker W2 wages for when calculating QBI when the wages are reported to the IRS by the PEO. That question is being resolved via guidance on Section 199A from the Department of the Treasury – IRS. As drafted, PEO clients will be able to use W2 wages paid (via their PEO) for their worksite employees when calculating their QBI and associated tax deduction

The National Association of Professional Employer Organizations (NAPEO) has communicated that the proposed rule clearly states that eligible pass-through entities that are clients of a PEO can take the 20 percent tax deduction created by Section 199A of tax reform. It also affirms that being the client of a PEO does not affect the eligibility of a pass-through entity for the 20 percent tax deduction in Section 199A of the tax code.

The proposed IRS guidance for 199A-2 (page 17) states:

II. Proposed §1.199A-2: Determination of W-2 Wages and the UBIA of Qualified Property

As described in part I.C. of this Explanation of Provisions, if an individual’s taxable income exceeds the threshold amount, section 199A(b)(2)(B) imposes a limit on the section 199A deduction based on the greater of either (i) the W-2 wages paid, or (ii) the W-2 wages paid and UBIA of qualified property attributable to a trade or business. This part of this Explanation of Provisions describes the rules in proposed §1.199A-2 regarding the determination of W-2 wages and UBIA of qualified property

A. W-2 wages attributable to a trade or business

The W-2 wage rules of proposed §1.199A-2 generally follow the rules under former section 199. Section 199, which was repealed by the TCJA, provided for a deduction with respect to certain domestic production activities and contained a W-2 wage limitation similar to the one in section 199A. The legislative text of the W-2 wage limitation in section 199A is modeled on the text of former section 199, and both taxpayers and the IRS have developed experience in applying those W-2 wage rules for over a decade. The regulations under former section 199 provided rules to determine Doc 2018-32521W-2 wages, which provide a useful starting point in developing the W-2 wage rules under section 199A, including rules on the definition of W-2 wages, wages paid by persons other than the common-law employer, and methods for calculating W-2 wages.

The Treasury Department and the IRS have received comments concerning whether amounts paid to workers who receive Forms W-2 from third party payors (such as professional employer organizations, certified professional employer organizations, or agents under section 3504) that pay these wages to workers on behalf of their clients and report wages on Forms W-2, with the third party payor as the employer listed in Box C of the Forms W-2, may be included in the W-2 wages of the clients of third party payors. In order for wages reported on a Form W-2 to be included in the determination of W-2 wages of a taxpayer, the Form W-2 must be for employment by the taxpayer. The regulations under former section 199, specifically §1.199-2(a)(2), addressed this issue, providing that, since employees of the taxpayer are defined in the regulations as including only common law employees of the taxpayer and officers of a corporate taxpayer, taxpayers may take into account wages reported on Forms W-2 issued by other parties provided that the wages reported on the Forms W-2 were paid to employees of the taxpayer for employment by the taxpayer.

Proposed §1.199A-2(b)(2)(ii) provides a rule for wages paid by a person other than the common law employer that is substantially similar to the rule in §1.199-2(a)(2). Specifically, the proposed regulations provide that, in determining W-2 wages, a person may take into account any W-2 wages paid by another person and reported by the other person on Forms W-2 with the other person as the employer listed in Box c of the Forms W-2, provided that the W-2 wages were paid to common law employees or officers of the person for employment by the person. In such cases, the person paying the W-2 wages and reporting the W-2 wages on Forms W-2 is precluded from taking into account such wages for purposes of determining W-2 wages with respect to that person. Persons that pay and report W-2 wages on behalf of or with respect to others can include certified professional employer organizations under section 7705, statutory employers under section 3401(d)(1), and agents under section 3504. Under this rule, persons who otherwise qualify for the deduction under section 199A are not limited in applying the deduction merely because they use a third party payor to pay and report wages to their employees. However, with respect to individuals who taxpayers assert are their common law employees for purposes of section 199A, taxpayers are reminded of their duty to file returns and apply the tax law on a consistent basis.

Unlike former section 199, the W-2 wage limitation in section 199A applies separately for each trade or business. Accordingly, proposed §1.199A-2 provides that, in the case of W-2 wages that are allocable to more than one trade or business, the portion of the W-2 wages allocable to each trade or business is determined to be in the same proportion to total W-2 wages as the deductions associated with those wages are allocated among the particular trades or businesses. Section 199A(b)(4) also requires that to be taken into account, W-2 wages must be properly allocable to QBI. W-2 wages are properly allocable to QBI if the associated wage expense is taken into account in computing QBI.

Additionally, proposed §1.199A-2(b)(4) restates the rule of section 199A(f)(1)(A)(iii), which provides that, in the case of a trade or business conducted by an RPE, a partner’s or shareholder’s allocable share of wages must be determined in the same manner as the partner’s allocable share or a shareholder’s pro rata share of wage expenses.

Consistent with section 199A(b)(5) and the legislative history of the TCJA, which direct the Secretary to provide rules for applying the W-2 wage limitation in cases in which the taxpayer acquires, or disposes of, a trade or business, the major portion of a trade or business, or the major portion of a separate unit of a trade or business during the year, proposed §1.199A-2(b)(2)(iv)(B) provides rules that apply in the case of an acquisition or disposition of a trade or business. See Joint Explanatory Statement of the Committee of Conference, 38. Specifically, proposed §1.199A-2(b)(2)(iv)(B)(1 )provides that, in the case of an acquisition or disposition of a trade or business, the major portion of a trade or business, or the major portion of a separate unit of a trade or business that causes more than one individual or entity to be an employer of the employees of the acquired or disposed of trade or business during the calendar year, the W-2 wages of the individual or entity for the calendar year of the acquisition or disposition are allocated between each individual or entity based on the period during which the employees of the acquired or disposed of trade or business were employed by the individual or entity, regardless of which permissible method is used for reporting predecessor and successor wages on Form W-2. For this purpose, the period of employment is determined consistently with the principles for determining whether an individual is an employee described in proposed §1.199A-2(b).

A notice of proposed revenue procedure, Notice 2018-64, 2018-35 IRB ____, which provides three methods for calculating W-2 wages is being issued concurrently with this notice of proposed rulemaking. The three methods in the notice are substantially similar to the methods provided in Rev. Proc. 2006-47, 2006- 2C.B. 869, for purposes of calculating “paragraph (e)(1) wages” (that is, wages described in §1.199-2(e)(1) issued under former section 199). The first method (the unmodified Box method) allows for a simplified calculation while the second and third methods (the modified Box 1 method and the tracking wages method) provide for greater accuracy.

Clients and prospective clients of any PEO may need to understand some things about this IRS certification. First of all there is no legal requirement for a PEO to gain IRS certification.  It is entirely up to each PEO to determine if they want to incur the additional cost and administrative burden of obtaining and maintaining IRS certification.

Certified by the IRS

About the IRS Certification Program

The Small Business Efficiency Act (SBEA) modified the Internal Revenue Code, and provided statutory authority for those PEOs that have elected to pursue IRS certification.  IRS certified PEOs (CPEOs) are officially authorized by the IRS to collect and remit federal employment taxes under the PEO’s Employer Identification Number (EIN) for wages paid to worksite employees.  PEOs that choose to participate in the IRS certification program must meet specific requirements regarding tax status, background, industry experience and financial reporting.  The IRS process for a PEO to obtain and maintain IRS certification requires:

• Payment of an annual fee to the IRS
• Background verification and tax compliance history review of PEO owners and stakeholders
• Submission of third party CPA opinion statements and annual audited financial statements
• Independent surety bonding for federal tax liabilities
  The IRS certification program requires a CPEO to post a bond each year guaranteeing payment of its federal employment tax liabilities. Bonding for the PEOs must be set to 5% of their collective annual federal tax liabilities with a minimum of $50K up to a maximum of $1M.Full Rules for CPEOs are available in IRS Internal Revenue Bulletin 2017-3 Rev. Proc 2017-14.

Why did the IRS offer a certification program for PEOs?

It’s really pretty simple; avoiding bad press for the PEO industry.  Over the last twenty years there have been a few PEOs that have gone out of business either through mismanagement or (rarely) outright fraud.   As in every industry with a fiduciary responsibility to customers there will be mistakes and some bad actors; banking, investing and insurance have all had some high-profile failures.   In our twenty years as industry advisors we have seen only a very, very few PEOs fail and the vast majority of client/PEO relationships successfully last for decades.  As for potential tax fraud by a PEO who collects employment related taxes and then fudges on the IRS deposits, the threat of being sentenced to federal prison is a pretty good deterrent.   In the few cases where a PEO has failed, it has gained press attention (Google never forgets) and in turn that tends to tarnish the whole PEO industry.

In response, some PEO industry leaders banded together through the National Association of Professional Employer Organizations (known as NAPEO), to construct a certification program and lobby the US congress for its implementation.  To advocates, this program was viewed as a win-win for both the IRS and the PEO industry.  The IRS gets increased confidence and oversight regarding the payment by the PEO of employment related taxes for the PEOs worksite employees and clients.   In turn, certification advocates in the PEO industry were seeking a way to assure prospective clients that employment related taxes are being handled appropriately.  Like any business, winning new clients is competitive and PEOs touting IRS certification are no doubt considering it will deliver a marketplace advantage.

Potential advantages for clients of a CPEO

• Payroll Tax Liability

  Clients who join a CPEO cannot be held liable for unpaid federal employment related taxes for the duration of their time in a CPEO relationship.  Technically in a standard PEO relationship the IRS can legally hold a PEO client liable for unpaid employment related taxes in the event that the PEO failed to make the required tax deposits. In the very few cases we are aware of where the client payed the PEO and the PEO failed to make those tax deposits, the IRS has most commonly declined to pursue the PEO client for such monies. No matter how uncommon, it has remained a concern for PEO clients for years. Clients of a CPEO are released from that potential liability.

• Wage Base Restarts – Successor Employer Treatment

  The IRS provision for CPOEs allows them to be treated as a successor employer regarding federal employment taxes – FUTA and OASDI – social security taxes. These taxes are subject to annual wage cutoff thresholds.  Some companies joining a PEO late in the calendar year have not been credited for earlier current year employment tax contributions due to the change in federal employer identification number (FEIN) reporting the wages.   In the payroll world this is called a wage base restart. A company (and their worksite employees) that joins a CPEO midyear will not be required to restart wage base calculations for federal employment related taxes.  This advantage will primarily affect PEO clients that have employees with annual wages over $127,200 – the social security tax threshold for 2017.  PEO clients with average annual wages below this amount will not see much financial advantage in joining a CPEO versus a standard PEO in a midyear transition.   This treatment also applies in reverse to any CPEO client that elects to leave the CPEO during the year. Since the CPEO program only covers federal employer taxes, successor employer status for state taxes (SUTA) will not be affected by the new certified PEO regulations.

• Tax Credit Eligibility

  In addition a client’s eligibility for other federal tax credit programs will not be impacted by using a CPEO. Since some tax credits eligibility accrues to the employer of record, some have questioned whether a PEO client can apply for tax credits when technically their PEO is the employer of record since form 941 wages are reported under the EIN of the PEO.   Some of the more common employer based tax credits are:

• IRS Section 45B – Related to cash tip credits (common PEO clients in the hospitality industry)
• IRS Section 45R- Related to employee health insurance expenses for small employers
• IRS Section 51- Related to Work Opportunity Credit
• IRS Section 1396 -Related to Empowerment Zone Employment Credit

Under the new CPEO rules, it is now codified that all of the listed federal tax credits will be eligible to the benefit of the CPEO client and that a CPEO has the obligation to calculate and report the eligible financial amounts to their CPEO clients.For more details refer to Internal Revenue Bulletin:  2016-21, REG–127561–15 Section 6

Will joining a Certified PEO Cost More?

Since the CPEO program is just now getting underway, only time will tell whether PEOs charge their clients more in order to offer a certified PEO service solution.  Each PEO who seeks and obtains IRS certification will have increased costs for maintaining program compliance and surety bonding.  It can be expected that those higher operating costs have to be recovered somehow and might result in slightly higher fees charged to clients seeking an IRS certified services suite.

Potential PEO Industry Impacts

According to the National Association of Professional Employer Organizations there are from 780 to 980 PEOs operating in the USA.  Smaller PEOs, may find the costs associated with certification (surety bonding in particular) to be much more marginally expensive than it will for larger PEOs who have a much higher number of clients to spread those relatively fixed costs.  Over the years the CPEO program has been developing, we have spoken with our StaffMarket member PEOs about their plans for obtaining IRS certification. Many are excited to finally have clarity about lack of potential tax liability they can guarantee to prospective clients. Others have expressed dismay that the associated additional expenses incurred to obtain CPEO status may place them at a price disadvantage to some of the larger PEOs. Furthermore there has been industry grumbling that the larger PEOs have been pushing this program with the Department Of Treasury as a strategy to gain a marketplace price advantage and possibly force industry consolidation.  Another possibility is that some smaller PEO operators will offer both a “certified” CPEO option as well as a standard PEO option to their clients, possibly at different price points. There is no doubt that many PEO clients enjoy the “high-touch” personal service of a smaller PEO. Let’s hope those clients of smaller PEOs who also demand certified PEO services are willing to pay a little more to get it.

Once the IRS names those PEOs who have obtained certified status, StaffMarket will track that information and StaffMarket analysts will be glad to review both standard PEO and CPEO solutions available that also meet your company’s other workers compensation, health insurance and HR needs.

Photo credit to Dave Miller at Flickr. Note this photo is of the IRS agent Frank Hamer- responsible for killing Bonnie Parker and Clyde Barrow.