Common Professional Employer Organization Tax Issues

A Professional Employer Organization (PEO) provides outsourced human resources services, including payroll processing, benefits administration, and tax remittance. Businesses enter a “co-employment” relationship, where the PEO contractually shares certain employer responsibilities. The PEO becomes the administrative employer, handling tasks like payroll and tax filings, while the client company retains control over its daily operations and employee management. While this can streamline operations, it also introduces specific tax-related complexities and potential liabilities that business owners must understand.

The Co-Employment Model and Tax Responsibility

The co-employment model reassigns the execution of payroll tax duties. In this arrangement, the PEO assumes the role of the “employer of record” for tax purposes, meaning it is responsible for processing payroll, withholding the correct amounts for federal and state income taxes, and handling Social Security and Medicare (FICA) taxes. The PEO also manages federal unemployment (FUTA) tax obligations on behalf of its client.

While the PEO manages the administrative functions, the client company provides the funds for wages and the associated taxes. The PEO collects these funds from the client with each payroll cycle and is then tasked with remitting them to the IRS and state agencies in a timely manner.

A significant issue within this model is the question of ultimate liability for the payment of these taxes. Unless the PEO has a specific IRS certification, the client business retains the ultimate legal responsibility for the employment taxes. If a non-certified PEO collects tax funds from a client but fails to pay the IRS, the IRS can legally pursue the client business for the full amount of the unpaid taxes.

This potential for double payment—once to the delinquent PEO and again to the IRS—represents a substantial financial risk. This liability exists because the IRS views the client company as the common-law employer that directs and controls the work of the employees.

Certified PEOs vs. Non-Certified PEOs

The Internal Revenue Service established a formal certification program for PEOs to address the issue of tax liability. This program created the Certified PEO (CPEO) designation, which provides a distinction from non-certified PEOs. To become certified, a PEO must meet stringent requirements regarding its financial health, background, and tax compliance history, including posting a bond of up to $1 million to guarantee its federal employment tax payments.

The most significant difference between a CPEO and a non-certified PEO is the allocation of federal tax responsibility. When a business partners with a CPEO and remits the necessary tax funds, the CPEO becomes solely liable for the payment of federal employment taxes for the wages it pays to the client’s employees. If the CPEO were to fail to remit those taxes, the IRS would pursue the CPEO directly, and the client business would be shielded from that liability.

In contrast, a business using a non-certified PEO retains ultimate liability for federal employment taxes. Consider a scenario where a business pays its non-certified PEO for payroll, including $50,000 in federal taxes. If the PEO declares bankruptcy before forwarding that money to the IRS, the client business is still legally obligated to pay that $50,000 to the government.

This distinction is a central point of risk management for any company considering a PEO relationship. The CPEO program was created to provide this layer of protection for business owners. Although only a small percentage of PEOs have achieved this certification, it offers a clear advantage for businesses concerned about the financial stability of their payroll partner.

State Unemployment Tax Complications

Beyond federal tax liabilities, the PEO relationship introduces unique challenges related to State Unemployment Tax Act (SUTA) obligations. These issues primarily revolve around wage base restarts and the management of unemployment experience ratings. SUTA taxes are paid on employee wages up to a certain annual limit, which varies by state.

A common and costly problem is the “wage base restart.” If a company joins or leaves a PEO mid-year, the change in the employer of record for tax purposes can trigger a reset of the SUTA wage base for each employee. For example, if a state has a SUTA wage base of $10,000 and an employee earns $30,000 by June, joining a PEO in July means the PEO must start paying SUTA taxes on that employee’s wages from zero, up to the $10,000 limit again.

Another complication involves SUTA experience ratings. States assign each employer an experience rating based on its history of unemployment claims; fewer claims result in a lower tax rate. When a business joins a PEO, it is typically moved under the PEO’s SUTA account and its experience rating, which can be beneficial for a company with a poor claims history if the PEO’s pooled rate is lower.

Conversely, a business with an excellent experience rating could see its unemployment tax costs increase if the PEO’s pooled rate is higher. This system can be abused through illegal schemes known as “SUTA dumping,” where an employer with a high SUTA rate attempts to shift payroll to an entity with a lower rate to evade its tax obligation. Businesses can be held liable if their PEO engages in such illegal activities.

Federal Tax Credits and PEOs

The co-employment structure can create ambiguity regarding which entity is entitled to claim federal business tax credits. Many of these credits, such as the Work Opportunity Tax Credit (WOTC) and certain Research and Development (R&D) credits, are calculated based on qualified employee wages. Since the PEO pays and reports wages under its own Federal Employer Identification Number (FEIN), a question arises as to who can claim the credits.

The WOTC provides a credit to employers for hiring individuals from targeted groups, while the R&D tax credit allows businesses to claim a credit for expenses related to qualified research activities. The issue is that if the PEO is the employer of record for payroll tax purposes, it could potentially claim these credits for itself.

Entitlement to these credits often depends on the specific language of the tax law and the PEO service agreement. For most credits, the entity that is the common-law employer—the one that directs and controls the employees’ work—is the one entitled to the credit. A well-drafted PEO contract should explicitly state that the client company retains the right to all tax credits.

The IRS’s Certified PEO program helps to clarify this issue, as the rules governing CPEOs expressly state that clients retain the right to claim tax credits. For businesses using non-certified PEOs, it is important to address this matter directly in the service agreement.

Tax Compliance Due Diligence and Monitoring

Mitigating the tax risks associated with a PEO relationship requires proactive due diligence before signing a contract and continuous monitoring afterward. These steps are necessary to protect the business from significant financial and legal exposure. The focus should be on verifying the PEO’s compliance and financial stability from the outset.

Before engaging a PEO, a business owner should request specific tax-related documentation. A primary request should be for proof of CPEO status, which can be independently verified on the IRS’s public CPEO listing. For any PEO, certified or not, the business should ask for redacted copies of their recent Form 941 filings and evidence of timely tax deposits, such as Electronic Federal Tax Payment System (EFTPS) confirmations.

Once the relationship is established, ongoing monitoring is just as important. A business should periodically request proof that its specific payroll taxes are being paid on time and in the correct amounts. Open communication and a contractual right to audit these records are key components of a safe PEO arrangement.