Many small and mid-size clients put their staff on a professional employer organization (PEO). The PEO runs payroll, files the payroll tax returns and often provides benefits. When the PEO is a certified professional employer organization (CPEO), section 3511 changes who is the employer for federal employment taxes. The change reaches the client's books, its tax credits and the reconciliations the auditor performs.
The statutory rules
Section 3511(a) says that, for purposes of the taxes and other obligations in subtitle C, a CPEO is treated as the employer, and no other person is treated as the employer, of any work site employee performing services for a customer, but only with respect to remuneration remitted by the CPEO to the work site employee. The exemptions, exclusions and definitions that depend on the type of employer apply as if the CPEO were the employer.
Under section 3511(b), for the wage base rules in sections 3121(a)(1), 3231(e)(2)(C) and 3306(b)(1), a CPEO that enters into a service contract with a customer is treated as a successor employer and the customer as a predecessor employer for the term of the contract. When the contract ends, the roles reverse. The practical effect is that wages the client paid earlier in the year count toward the wage base when the CPEO takes over, so Social Security tax is not charged again on wages above the base.
Section 3511(c) also treats the CPEO as the employer, for its liability under subtitle C, of individuals other than work site employees who perform services covered by a qualifying contract, again only on remuneration it remits. Section 3511 does not apply to a customer that bears a relationship to the CPEO described in section 267(b) or 707(b), with a 10 percent threshold substituted for 50 percent. An individual with net earnings from self-employment from the customer's business, including a partner in a partnership that is a customer, is not a work site employee for these purposes.
Credits stay with the customer
Section 3511(d) provides that for specified credits, the credit with respect to a work site employee performing services for the customer applies to the customer, not the CPEO. The customer takes into account wages and employment taxes paid by the CPEO and paid for by the customer, and the CPEO must furnish the customer and the IRS the information the customer needs. The listed credits include the research credit under section 41 and the credit for employer social security taxes on tips under section 45B. A restaurant on a CPEO still claims its own FICA tip credit, using data the CPEO supplies.
What it means for the client's books and audit
- Payroll tax liability. If the client remits gross pay and taxes to the CPEO, the client's liability is to the CPEO. Because the CPEO is the employer on wages it remits, the payroll tax obligation on them is its own. Obtain the service contract and evidence of the CPEO's certification for the file.
- Reconciliation. The payroll register is a CPEO report, not the client's. Reconcile CPEO invoices (wages, employer taxes, benefits, administrative fees) to the general ledger by component. Administrative fees and employer-tax pass-throughs should not be buried in one expense account.
- Credits and tips. For research and tip credits, obtain the employee-level data the CPEO must furnish.
- Other roles. Section 3511 operates on the taxes and obligations in subtitle C of the Code. Whether a worker is an employee at all is a separate analysis; see worker classification for small business clients.
Worked example
A restaurant owner pays a CPEO $1,260,000 for gross wages and $96,390 of employer FICA at 7.65 percent (assume every employee's wages are below the Social Security wage base). Check: $1,260,000 times 7.65 percent is $96,390. The CPEO invoices an administrative fee of $18,900, which is 1.5 percent of gross wages. Check: $1,260,000 times 1.5 percent is $18,900.
- Wages expense: $1,260,000
- Payroll tax expense: $96,390
- Administrative fee: $18,900
- Total invoice: $1,375,290
The ledger should show three lines, and the tax credit schedule should draw from the $96,390 and employee tip data, not the total invoice.
Who is a work site employee
The term comes from section 7705(e), and the file should show each element.
- The individual performs services for the customer under a written contract between the customer and the CPEO.
- The contract provides that the CPEO assumes responsibility for paying wages, for reporting, withholding and paying subtitle C taxes on those wages, and for any employee benefits the contract requires, in each case without regard to the receipt or adequacy of payment from the customer.
- The contract gives the CPEO responsibility for recruiting, hiring and firing in addition to the customer's responsibility, requires it to maintain employee records, and has it agree to be treated as a CPEO under section 3511.
- At least 85 percent of the individuals performing services for the customer at that work site are subject to one or more such contracts. Excluded employees within the meaning of section 414(q)(5) are not counted.
An owner who has net earnings from self-employment from the customer's business is outside the definition, as noted above.
What certification requires of the CPEO
Section 7705(c) requires a bond for the payment of subtitle C taxes. For the period April 1 through March 31, the amount is the greater of 5 percent of the CPEO's prior-year section 3511 liability (not to exceed $1,000,000) or $50,000. The CPEO also provides an opinion of an independent CPA on its financial statements and, each quarter, an assertion on its federal employment tax deposits with an examination-level attestation. The Secretary can suspend or revoke certification if the requirements are not met. Ask the client for the CPEO's current certification status; the IRS publishes a public listing of CPEOs.
Contract start and end reporting
The CPEO files Form 8973 within 30 days of starting or ending a service contract with a customer. When a contract starts, the customer signs Part 5, and the CPEO gives the customer a copy of the completed form. When a contract ends, only the CPEO's signature is required, though the customer may separately file its own notice. Keep the Form 8973 copy in the permanent file; it dates the point at which the successor and predecessor employer roles in section 3511(b) begin and reverse.
Common errors
- Reading the PEO invoice as a single payroll expense and skipping the split between wages, employer taxes, benefits and fees.
- Assuming an uncertified PEO produces the same result. Section 3511 applies only to a certified organization.
- Letting the CPEO claim credits. Under section 3511(d), the credit applies to the customer, and the CPEO must furnish the information the customer needs.
- Ignoring the mid-year change. Wages the customer paid before the contract started count toward the wage base because of the predecessor rule.
- Treating an owner-operator as a work site employee when the owner has self-employment earnings from the business.
- Missing the related-party exception: a customer that is related to the CPEO under section 267(b) or 707(b), with 10 percent substituted for 50 percent, is outside section 3511.
Frequently asked questions
Is every PEO a CPEO?
No. A CPEO is a person who applied to be treated as one for section 3511 and was certified by the Secretary under section 7705.
Which credits stay with the customer?
The list in section 3511(d)(2) includes sections 41, 45A, 45B, 45C, 45R, 45AA, 51 and 1396, plus any other section the Secretary provides.
Sources
- Legal Information Institute, 26 U.S.C. 3511, Certified professional employer organizations: https://www.law.cornell.edu/uscode/text/26/3511
- Legal Information Institute, 26 U.S.C. 7705, Certified professional employer organizations (certification, bond, work site employee): https://www.law.cornell.edu/uscode/text/26/7705
- Internal Revenue Service, Instructions for Form 8973 (30-day filing, signatures): https://www.irs.gov/instructions/i8973
- Internal Revenue Service, Certified professional employer organizations: https://www.irs.gov/businesses/small-businesses-self-employed/certified-professional-employer-organization
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