The Tax Court is a court of limited jurisdiction, which means it can only hear cases that the Internal Revenue Code provides that it can hear. In Chief Counsel Advice 201735021 the issue was whether a payroll tax examination was a worker classification exam, as the Tax Court has the right to hear cases regarding employee classification under IRC §7436(a), but does not have jurisdiction to hear a case where the issue is whether certain payments represented disguised compensation to employees.

In this case, the IRS was examining an S corporation which, for some years in question, had used a professional employer organization (PEO) for its payroll. Under the agreement with the PEO, all individuals working for the taxpayer, including the officers of the corporation, were treated as employees of the PEO and received paychecks from that organization.

In the exam, the IRS decided that the salary taken by the officer, either directly or via the PEO depending on the year, was not adequate and that other distributions should be treated as payroll paid to the officer. Now the key question was, since the S corporation itself did not pay payroll in the years that it used the PEO, was the IRS reclassifying the officers as employees of the S corporation to the extent of the amount the IRS believed represented disguised payments of compensation?

The memorandum describes the agreement with the PEO as follows:

The duties of the PEO under the contract include: 1) administering Taxpayer payroll, designated benefits, and personnel policies and procedures related to the Assigned Employees; 2) providing human resource administration and payroll administration with respect to the Assigned Employees; 3) furnishing and keeping workers compensation insurance covering the Assigned Employees; 4) processing and paying wages from its own accounts to the Assigned Employees based on the hours and wage information reported by the Taxpayer; and 5) filing all employment tax returns (i.e., Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return, and Form 941, Employer's Quarterly Federal Tax Return) with the Government and furnishing information returns to the workers.

The PEO’s duties under the contract, however, were limited to only those wages that were reported and verified by the Taxpayer to the PEO for each pay period. In the event the Taxpayer paid wages to the Assigned Employees that were not reported to the PEO, the contract provides that the Taxpayer will be “solely responsible for damages of any nature out of the Client’s failure to report payment of unreported wages to any of the Assigned Employees”.

The memorandum concludes that the fact that a PEO is involved does not change the fact that this case does not involve a question of whether the officers were employees. The memorandum notes:

For * * *, the corporate officer also received a Form W-2 reporting wages for services rendered to the Taxpayer, and the wages were also reported on Forms 940 and 941, however, the Forms were filed under the PEO’s EIN and not the Taxpayer’s. The use of a PEO by the Taxpayer as a conduit for paying wages to its corporate officer, however, does not affect whether the audit for * * * with respect to the distribution made by the Taxpayer to its corporate officer is considered a worker classification audit. The contractual arrangement demonstrates that no underlying issue of employment tax classification status exists because the Taxpayer specifically contracted with the PEO to fulfill its obligations as an employer with respect to the treatment of the corporate officer as its employee. Thus, the dispute is not whether the corporate officer performed more than minor services for the Taxpayer and received compensation for those services, i.e., whether the corporate officer was an employee. Rather, the dispute is limited to the amount of compensation required to be treated as "wages" paid to the corporate officer — including distributions paid directly by the Taxpayer that did not flow through the PEO — for employment tax purposes, i.e. whether the additional payments constitute wages, rather than distributions.