Government contractors may be overpaying Social Security taxes
INSIGHT ARTICLE |
It is very common for a government contractor to win a new contract previously held by a competitor. When this happens, the contractor will often hire the employees who had previously worked on the contract and restart their Social Security wage base limits. However, in many cases, it is not necessary to restart the wage base; as a result, some contractors are significantly overpaying the employer’s share of Social Security taxes.
The wage base limit is the maximum wage that is subject to the 6.2 percent Social Security tax imposed on both employees and employers. In 2016, the wage base limit was $118,500. If employees work for more than one employer and receive combined payments over $118,500, resulting in an overpayment of their share of the Social Security tax for the year, they can claim a refund for the overpaid tax on their personal income tax return. There is no such refund opportunity for the employer. If an employer can qualify as a successor employer, it can carry over the employee’s wage base from the previous employer. Thus, the employee will reach the wage base limit faster and both the employer and the employee will pay less Social Security tax.
An employer can qualify as a successor employer and carryover the wage base if the employees brought on board because of a business acquisition. In the case of a government contractor who hires a competitor’s employees after winning the competitor’s government contract, guidance exists that allows the new contractor to receive successor employer treatment as well.
What do the rules say?
Generally, compensation paid by the second employer is subject to Social Security taxes up to the wage base limit, without regard to the taxes paid by the employee’s prior employer. However, Treasury Regulation section 31.3121(a)(1)-1 provides an exception to the general rule. This regulation establish the following specific criteria for determining whether an employer can qualify as a successor employer and receive credit for the employer’s portion of Social Security tax paid by the predecessor employer.
- The successor must have during the calendar year acquired substantially all the property used in a trade or business, or used in a separate unit of a trade or business, of the predecessor
- Such employee was employed in the trade or business of the predecessor immediately prior to the acquisition and is employed by the successor in the successor’s trade or business immediately after the acquisition
- Such wages were paid during the calendar year in which the acquisition occurred and prior to such acquisition
Predecessor-successor rule’s impact on government contractors and subcontractors
Revenue Ruling 68-105 and Revenue Ruling 72-269 apply the predecessor-successor rule to government contractors and subcontractors in the following situations:
Revenue Ruling 68-105 considered the issue of whether an employer who was a successful bidder for a United States Air Force (USAF) maintenance contract may qualify as a successor employer to the prior contractor for purposes of applying the annual wage base limit. The maintenance contract required the contractor to maintain, repair, and overhaul USAF airplanes. For work on the contract, the contractor used government-owned equipment and tooling of substantial value, which the USAF provided to the contractor through an inventory accounting arrangement.
On July 1 of the calendar year, a new contractor assumed responsibility under a similar maintenance contract, obtained through a competitive bid. Upon assuming contractual responsibility, the new contractor employed approximately 300 employees who, immediately prior to the acquisition, were employees [at the base] by the old contractor. The USAF also turned over all government-owned property formerly used by the predecessor to the successor through an inventory accounting arrangement with the government, similar to that previously held by the predecessor.
After considering the facts and the regulations, the IRS ruled that the successor employer could take credit for the wages paid by the predecessor contractor.
Specifically, the Revenue Ruling concluded that:
- The USAF maintenance operation was a separate unit of the predecessor employer’s busines
- The second employer obtained possession and use of substantially all government-owned property used by the first employer in its operations,
- The transferred employees were employed in the trade or business of predecessor immediately prior to the acquisition and became employed by successor immediately after the acquisition; and
- The first employer paid these wages during the calendar year in which the acquisition occurred and prior to the acquisition.
The IRS deemed as immaterial the fact that the successor employer did not acquire an interest in the property used in performing the contract. In addition, the method of acquisition by the successor of the property of another employer was immaterial in the view of the IRS. For the purpose of the predecessor-successor rule, an acquisition may occur by purchase or any other transaction whereby another employer acquires substantially all of the property used by one employer. “Substantially all the property” may consist of substantially all the property used in the performance of an essential operation of the business, or it may consist of substantially all the property used in a relatively self-sustaining entity that forms a part of the business.
Revenue Ruling 72-269 applied a similar fact pattern as the one in Revenue Ruling 68-105 to a government subcontractor. The facts of the ruling present an employer X as the operating contractor for the United States Atomic Energy Commission (AEC) in the operation of one of its facilities. Upon expiration of employer X’s contract on June 30, the contract was awarded to employer Y on July 1 of the same calendar year. Responsibility for, and control of, government-owned property of substantial value previously used at the site by employer X, passed to employer Y. However, employer Y had entered into a subcontract with subcontractor Z for the performance of an essential operation of the commission’s facility. The subcontract with Z was effective on July 1 and effectively Z gained operating control of, and was responsible for, substantial government-owned property and equipment. Z also employed approximately 200 employees who immediately prior to that date were employees of employer X.
The Revenue Ruling concluded that as subcontractor Z, the successor employer, is entitled to take credit for the wages paid by employer X, the predecessor employer, for purposes of the wage base limit.
If you believe you have overpaid Social Security tax, there may be an opportunity to re-file and claim refunds. If you wish to find out more or require further guidance in navigating the complexities surrounding wage base limitation issues, consult your local tax professional or contact us.