In an email response (ECC 201319015[1]), the Internal Revenue Service (IRS) conducted an examination of the scenario where a Professional Employer Organization (PEO) submits a claim for refund on behalf of one of its clients regarding the Employee Retention Credit (ERC). This examination specifically explored the implications when the PEO possesses outstanding tax liabilities. The conclusion reached in the response asserts that the IRS holds the authority to allocate the refund towards the PEO’s outstanding tax obligations.

The email articulated the precise question as follows:

You asked whether the IRS is authorized to offset certain COVID-19 employment tax credits (e.g., employee retention credit (ERC)) to any existing tax liabilities of a Professional Employer Organization (PEO) that pays wages to individuals as part of the services provided to a client employer pursuant to a service agreement, although the credits being claimed on the Form 941 Schedule R are attributable to wages paid to a client employer’s employees.[2]

The discussion begins by looking at the IRS’s authority to apply a taxpayer’s overpayments of tax against other outstanding liabilities of that taxpayer under IRC §6402(a):

IRC §6402(a) grants the IRS discretion to credit any overpayment against “any liability in respect of an internal revenue tax on the part of the person who made the overpayment.” With respect to the COVID-19 employment tax credits, the IRS made the business decision to offset excess refundable COVID-19 employment tax credits to any existing tax liabilities on the employer’s account (see COVID-19-Related Employee Retention Credits: General Information FAQs, FAQ #12 and COVID-19-Related Tax Credits: Basic FAQs, FAQ #14). This decision applies to all types of refundable COVID-19 employment tax credits including the ERC, the credit for paid sick and family leave wages, and the COBRA credit.[3]

IRC §6402(a) states the following:

(a) General rule. In the case of any overpayment, the Secretary, within the applicable period of limitations, may credit the amount of such overpayment, including any interest allowed thereon, against any liability in respect of an internal revenue tax on the part of the person who made the overpayment and shall, subject to subsections (c), (d), (e), and (f), refund any balance to such person.

However, the determination of who the “person” refers to in this particular scenario requires clarification. While it may be assumed that the overpayment, pertaining to the PEO’s client, would mean the client should be considered the person in this context, the IRS takes the position that the PEO itself should be regarded as the person in this case. The IRS commences by providing an explanation of the relationship between the parties involved in a PEO arrangement concerning payroll taxes:

For taxpayers who use third-party payors (TPPs), the process for claiming credits against employment tax liabilities and liability for erroneously claimed credits differs depending on the type of TPP used. For taxpayers who use a section 3504 agent, Certified Professional Employer Organization (CPEO) or PEO that pays wages to individuals as part of the services provided to a client pursuant to a service agreement, although the credits being claimed on the Form 941 Schedule R are attributable to wages paid to a client’s employees, the 3504 agent, the CPEO or PEO is the taxpayer who is actually claiming the employment tax in an aggregate amount on a single line on a Form 941 filed under its own EIN. If a refund is ultimately issued to the TPP aggregate filer, it is then between the TPP aggregate filer and the client to ensure the TPP remits any portion of the refund it received to the client in the appropriate amount.[4]

Therefore, according to the IRS, the “person” referred to in this particular case is the PEO itself, rather than the client on whose behalf the overpayment is made.

Continuing from the previous explanation, the email further elaborates on the IRS’s interaction with PEOs regarding payroll tax filings and tax refunds, emphasizing that the IRS does not engage directly with the PEO’s clients. The email states:

The IRS is not a party to those agreements and has no legal obligation to refund any portion of the TPP filer’s refund to a client identified on Schedule R. In addition, when the IRS conducts an audit of a Form 941 filed by these types of TPPs, the IRS is examining the aggregate total amount of the line item credit claimed by the TPP on the Form 941, using the client by client allocation information provided on Schedule R as part of the examination. The IRS does not issue refunds or make credit adjustments to the client entities themselves, but rather any credits/refunds are paid to TPP. Any credits claimed against the employment taxes reported on the Form 941, reduce the reported liability of the TPP. Moreover, any adjustment to a credit claimed by a TPP on the Form 941 will affect the total employment tax liability on the TPP aggregate filer’s employment tax return. Schedule R only provides a portion of the information (the allocable share of wages and credits on a client-by-client basis) which was used by the TPP, in part, to determine its own total tax liability on the return. Since the Schedule R information is not itself determinative of the TPP’s ultimate tax liability, the IRS would not be able to determine the appropriate refund to issue to the TPP based solely on the Schedule R information on a client-by-client basis for any particular employment tax credit. Rather, until the IRS determines entitlement to the entire line item amount claimed on the Form 941, no refunds or credits are paid out to the TPP. Please note that offsetting a TPP’s outstanding tax liability is, in fact, providing the credit to the TPP by way of a reduction in the TPP’s liability.[5]

By providing this explanation, the IRS clarifies that its role in the PEO arrangement is limited to examining the aggregate amount of credits claimed by the TPP and adjusting the overall employment tax liability accordingly. The IRS does not directly issue refunds or credits to the PEO’s clients, and any offsetting of the PEO’s outstanding tax liability effectively functions as a credit provided to the TPP by reducing its overall liability.

In conclusion, the email acknowledges that customers of PEOs may face challenges in receiving payment for the refundable tax credits they are eligible for if the chosen PEO has outstanding federal tax liabilities. The email states:

Although employers who utilize TPPs (such as PEOs in the fact pattern examples provided by TAS) may encounter difficulties receiving payment of the refundable tax credits they may be entitled to if the TPP they have chosen has outstanding federal tax liabilities, this is a civil matter strictly between the TPP/PEO and the client employer.[6]

The email concludes the IRS’s role is limited to the application of tax laws and regulations, and it does not intervene in the payment disputes or obligations between the PEO and its client employer.

[1] ECC 202319015, May 12, 2023, https://www.taxnotes.com/research/federal/irs-private-rulings/e-mail-chief-counsel-advice/irs-may-offset-peo-employment-credits-for-client-employees/7gp15 (retrieved May 13, 2023)

[2] ECC 202319015, May 12, 2023

[3] ECC 202319015, May 12, 2023

[4] ECC 202319015, May 12, 2023

[5] ECC 202319015, May 12, 2023

[6] ECC 202319015, May 12, 2023