Self-employed individuals and professional employer organizations
Partners and sole proprietors cannot be PEO employees
TAX ALERT |
On April 19, 2019, the IRS released a Chief Counsel Advice memorandum (which provides guidance on the tax treatment of compensation for partners, sole proprietors and other non-employees performing services for customers of Certified Professional Employer Organizations (CPEOs).
CPEOs often contract with smaller employers to provide certain human resources services that otherwise would need to be handled by the employer, such as issuing paychecks, withholding and depositing payroll taxes, and Form W-2 reporting. As customers of CPEOs, these small employers typically have access to a wider variety of employee benefit plans such as health insurance and 401(k) plans.
The employees of a customer contracting with a CPEO are referred to as “work site employees”. Under section 3511 and the current proposed regulations, the CPEO is the employer or “co-employer” of these work site employees. However, the customer of the CPEO remains the common law employer even when the work site employees’ paychecks and Forms W-2 list the CPEO as the employer per the payroll agreement between the customer and the CPEO. The identification of an employee as a “work site employee” versus a “common law employee” is an important distinction in the employee benefit area and other tax areas (such as section 199A or section 4960).
Special rules apply to CPEO customers that operate as partnerships or sole proprietorships. Under section 3511(f), a self-employed individual, such as a partner in a partnership or the owner of a sole proprietorship, is not a work site employee with respect to compensation paid by a CPEO. Therefore, an agreement between a CPEO and a customer under which the CPEO will be the employer or co-employer of the customer’s employees cannot include these owners as work site employees of the CPEO. In addition, other non-employees performing services for a CPEO customer (such as independent contractors) are not work site employees.
In the recent Chief Counsel Advice memorandum, the IRS addresses what it sees as a misreading of the preamble to the CPEO proposed regulations under section 301.7705-1. Based on an unclear provision in the preamble, some CPEOs have been treating partners, sole proprietors and other non-employees as worksite employees and issuing them Forms W-2. For partners, some CPEOs only report a portion of partner compensation as Form W-2 income; other CPEOs report most of a given partner’s compensation as Form W-2 income.
In the memorandum the IRS clarifies that a self-employed individual is not a work site employee. Accordingly, the CPEO cannot report the compensation paid to a partner, sole proprietor, or other non-employee as wages on Form W-2. The IRS indicates that payments to self-employed individuals are reported on other information returns such as Form 1099-MISC. In the case of a partner providing services to a partnership, the compensation is reported on Schedule K-1 of Form 1065.
The memorandum points out that the unclear preamble language was meant to address very uncommon situations, such as when an individual is receiving payments from the CPEO in two separate capacities. The memorandum gives an example of an individual employed by a CPEO customer who receives a Form W-2 from the CPEO. If this individual also has a sole proprietorship which performs cleaning services for the same CPEO customer, the IRS indicates that the CPEO would report these payments for the cleaning services on Form 1099-MISC. Consequently, one individual would receive both a Form W-2 (as an employee) and a Form 1099-MISC (as a sole proprietor) from the CPEO due to the separate entities.
Businesses with partners, sole proprietors or other non-employees who receive Forms W-2 from a CPEO should discuss the IRS guidance with their CPEO. Since these individuals are not employees, alternate arrangments should be considered. For partners, an entity could shift partner compensation to the Form K-1 during the year. It may be possible, depending on facts and circumstances, to revise the partnership structure to include multiple entities and allow service partners to perform services for a related entity. That entity could be a customer of a CPEO.