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Professional employer organization denied credit for tips received by clients’ employees

In a National Office Technical Advice Memorandum (TAM), PLR 201347020, IRS has concluded that a professional employer organization (PEO) may not claim the Code Sec. 45B income tax credit for Federal Insurance Contributions Act (FICA) tax paid on tips received by its clients’ employees in connection with the providing, delivering, or serving of food or beverages for consumption.

Background on tips in general.  In general, Code Sec. 3101(a) requires employers to deduct and pay over the employee portion of the FICA tax. However, under the special rule of Code Sec. 3102(c)(1), the withholding requirement applies only to the tips included in a written statement furnished by the employee to the employer under Code Sec. 6053(a), and only to the extent that collection can be made by the employer by deducting the amount of the tax from wages paid to the employee (excluding tips).  Under Code Sec. 3121(q), tips received by an employee in the course of employment are considered remuneration for that employment and are deemed to have been paid by the employer for purposes of the employer portion of the FICA taxes.  The remuneration is deemed to be paid when a written statement including the tips is furnished to the employer by the employee under Code Sec. 6053(a). However, if the employee either did not furnish the statement or if the statement furnished was inaccurate or incomplete, in determining the employer’s FICA tax liability for the tips, the remuneration is treated as paid on the date on which notice and demand for the taxes is made to the employer by IRS.

Under Code Sec. 45B(a), for purposes of the Code Sec. 38 general business credit, the credit for employer social security and Medicare taxes paid on certain employee tips is an amount equal to the excess employer social security tax paid or incurred by the employer. Excess employer social security tax means any tax paid by an employer under Code Sec. 3111 (both social security tax and Medicare tax) on its employees’ tip income without regard to whether the employees reported the tips to the employer. Thus, the Code Sec. 45B(a) credit is available for unreported tips in an amount equal to the excess employer social security tax paid or incurred by the employer. No credit, however, is allowed to the extent tips are used to meet the federal minimum wage rate that was in effect on Jan. 1, 2007 ($5.15 an hour). The credit is available with respect to FICA taxes paid on tips received from customers in connection with the providing, delivering, or serving of food or beverages for consumption, if it is customary for customers to tip the employees.

Code Sec. 3401(d)(1) defines the term “employer” for income tax withholding purposes as the person for whom the individual performs or performed any service, of whatever nature, as the employee of such person, except that if the person for whom the individual performs or performed services does not have control of the payment of wages for such services, the term “employer” means the person having control of the payment of such wages.

The FICA does not contain a definition of employer similar to the definition contained in Code Sec. 3401(d)(1) relating to income tax withholding. However, the U.S. Supreme Court ruled in Otte v. U.S. (S Ct 11/19/74), 34 AFTR 2d 74-6194 that a person who is an employer under Code Sec. 3401(d)(1) is also an employer for purposes of FICA withholding. The Otte decision has been interpreted to mean that the person having control of the payment of wages is also an employer for purposes of employer FICA.

IRS’s Office of Chief Counsel has consistently stated that a PEO or similar employee leasing company is not in control of the payment of wages if the payment of wages is contingent upon, or proximately related to, the PEO having first received funds from its clients.

Facts.  A company we’ll call ABC was licensed as a PEO in Florida. Some of its clients were small food and beverage establishments. ABC performed certain human resource and employment related activities for these and other clients. ABC contractually agreed with its clients to comply with all laws and regs governing the reporting, collection, and payment of federal and state payroll taxes on the wages of clients’ employees. ABC also assumed responsibility to process payroll, pay wages, and report and pay federal taxes, including Federal income tax withholding, FICA tax, and tax under the Federal Unemployment Tax Act (FUTA), under its own employer identification number (EIN).

Consistent with the contracts, ABC filed Forms 941, Employer’s Quarterly Federal Tax Return (FICA taxes and Federal income tax withholding), for all of its clients on an aggregate basis, entering ABC’s name, address, and EIN in the blocks designated on the Form 941 for the name, address, and EIN of the employer. ABC also furnished to all client employees and filed with the Social Security Administration Forms W-2, Wage and Tax Statement. ABC’s name, address, and EIN were entered in the blocks designated as for the employer on the Forms W-2 and Form W-3, Transmittal of Wage and Tax Statements.

ABC’s clients were responsible for determining and reporting to ABC how much was to be paid to the employees and for transferring the payroll amounts to ABC for processing.

For federal income tax purposes, ABC reported the total wage transfers received from clients in its gross receipts on its Form 1120, U.S. Corporate Income Tax Return, and took a deduction for payroll as a cost of goods sold. With respect to amounts paid to employees of its food and beverage establishment clients, ABC filed a Form 3800, General Business Credit, and a Form 8846, Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips, with its Forms 1120. The Forms 8846 filed by ABC claimed a Code Sec. 45B credit in the aggregate for employer FICA tax paid on employee tips with regard to all of ABC’s food and beverage clients.

ABC agreed that it was not the common law employer of the workers performing services for its clients.

Credit denied. The TAM concluded that ABC was not entitled to claim the Code Sec. 45B credit. It said that Code Sec. 45B’s language provides that the person entitled to the credit is the taxpayer who incurs the tax imposed by Code Sec. 3111 (the employer portion of the FICA tax). Generally, the taxpayer who incurs the employer portion of FICA tax is the common law employer. Even if another entity could be a Code Sec. 3401(d)(1) employer with regard to the employer FICA tax on the tips, under the facts and circumstances presented in the TAM, IRS concluded that ABC was not theCode Sec. 3401(d)(1) employer of its’ clients employees. The client/common law employer had control of the payment of wages. Because ABC’s payments of wages to its clients’ employees were contingent upon, or proximately related to, ABC having first received funds from its clients, the amounts did not come under the control of ABC and it acted only as a conduit to deliver payroll. Thus, because ABC was neither the common law employer nor the Code Sec. 3401(d)(1) employer of its clients employees, it did not incur the employer portion of the FICA tax under Code Sec. 3111 with regard to the tips received by those employees and was not entitled to claim the Code Sec. 45B credit.

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Meet Paul Raymond

Meet Paul Raymond

Mr. Raymond is a sought after speaker in tax controversy law by many attorney, accountant, and business groups and at the request of the Internal Revenue Service, has presented programs at the IRS Nationwide Tax Forum, attended by tax professionals throughout the United States.

Additionally, he continues to be an active member in the Section of Taxation, American Bar Association, where he was the Past Chair of the Employment Taxes Committee.

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