IRS Issues Final Regulations on Payroll Tax Liability of Third-Party Payors

Author: Rena Pirsos, XpertHR Legal Editor

April 9, 2014

The Internal Revenue Service (IRS) has issued final regulations under § 3504 of the Internal Revenue Code (IRC) describing circumstances that will help determine which party is liable for an employer's employment taxes when an employer has entered into a service agreement with a third-party payor. Obligations often covered in such agreements may include withholding employment taxes from employees' pay, making wage payments to employees, and timely reporting and remitting the employer's employment taxes to the appropriate government agencies. The final regulations, which took effect March 31, adopt the proposed regulations issued in 2013 with a few changes based on public comments.

Liability Under Three-Party Arrangements

Employers may mistakenly believe they are relieved of employment tax liability by entering into an agreement with a third-party payor, e.g., an employee leasing company or professional employer organization (PEO), for help in fulfilling their employment tax obligations. However, an employer remains liable for employment taxes regardless of any type of agreement that attempts to shift liability to a payor. IRC § 3401(d)(1) provides one exception - where the person/entity for whom/which services are performed and the person/entity with control of wage payments for those services are not the same.

The IRS bases status as an employer on all the facts and circumstances under the common law test. Neither claims by a payor that it is the employer or co-employer of a worker, nor the fact that the payor may file employment tax returns under its own employer identification number (EIN), determine the identity of the employer liable for employment taxes. Consequently, the parties to a three-party arrangement may not always understand which party or parties will be liable for any unpaid employment taxes. The IRS has established administrative procedures that allow a payor to request authorization on Form 2678, Employer/Payor Appointment of Agent, to file employment tax returns and perform other acts for the employer.

The Proposed Regulations

The proposed regulations established rules regarding the employment tax obligations under three-party agreements which provide that the payor will be liable for some or all of the employer's payroll tax obligations, even if the payor:

  • Has not obtained an approved Form 2678;
  • Does not qualify as a § 3401(d)(1) employer; and
  • Is not a payroll service provider (PSP) or reporting "agent."

The proposed regulations also provided that if a payor is designated as an agent to perform an employer's obligations, all laws and penalties applicable to the employer are applicable to that payor. However, each employer for whom the payor may act also remains subject to all applicable laws and penalties. The regulations note that the IRS will only collect an employer's employment tax liability once, whether from the employer or the payor.

Under the proposed regulations, a payor qualifies as an "agent" under IRC §3504 to perform the acts of an employer in any case in which the payer entered into a service agreement with an employer. A "service agreement" means a written or oral agreement in which the payor:

  • Asserts it is the employer or co-employer of the workers performing services for the employer;
  • Pays wages or other compensation to the workers for their services performed for the employer; and
  • Assumes responsibility for the collection, reporting, and payment of, or liability for, any employment taxes with respect to those wages or other compensation.

Changes Made by the Final Regulations

The final regulations adopt the proposed regulations with changes based on public comments received by the IRS.

'Agent' of the Employer

The final regulations omit references to the payor as an "agent" of the employer in the description of designated third-party payors. The IRS says that, although the designation of a payor in the proposed regulations has no impact in determining the payor's status for other purposes of the IRC, describing the designated payor as an "agent is unnecessary since IRC § 3504 grants the IRS authority to designate a "fiduciary, agent or other person" to perform the acts of the employer.

Third-Party Sick Pay

The IRS declined to clarify in the final regulations whether, under IRC § 3504, a payor of group disability income benefits (i.e., an insurance company) under an administrative service contract with an employer is an agent that is required to file Form 2678. The IRS stated that "it is beyond the scope of the regulations to address whether a Form 2678 must be filed to report and pay employment taxes in any particular situation."

The IRS noted that § 32.1 of the employment tax regulations already provides specific rules for reporting employment taxes related to payments made by a third party on account of sickness or accident disability. And, while § 32.1 is not affected by IRC § 3504 or the final regulations, the final regulations nevertheless add a clarification of how both sets of rules interact.

Statutory Employer

The final regulations also clarify an exception to the general rules found in the proposed regulations. The exception provides that a payor is not designated to perform the acts required of an employer under the rules for any wages or compensation paid by the payor to an individual performing services for an employer, if the payor is the individual's employer. The final regulations explain that the exception includes an IRC § 3401(d)(1), or statutory, employer.