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Third-Party Payers liable for Underpayment of Employment Taxes Resulting from Improperly Claimed ERC Credits.

On Feb. 16, the IRS released a memorandum concluding that third-party payers, such as professional employer organizations (PEOs), certified professional employer organizations (CPEOs), and Section 3504 Agents (collectively, “TPPs”) are liable for underpayments of payroll taxes resulting from improper claims of the employee retention credit (ERC) that the TPPs filed on behalf of clients.

The ERC was enacted under the CARES Act to provide a refundable tax credit to encourage employers to retain employees during the pandemic. It was extended and expanded for 2021 by the Consolidated Appropriations Act. The theoretical maximum credit, assuming eligibility for all six quarters (Q2, Q3, Q4 2020 and Q1, Q2, Q3 2021) was $26,000 per employee. Many businesses filed ERC claims without being eligible to do so and frequently upon the advice of ERC consulting firms. Because the ERC is a credit against payroll taxes, a claim was made on the payroll tax return (i.e. Forms 941) if the ERC claim was filed as wages were paid, or amended return (i.e. Form 941-X) if the ERC claim was filed for prior quarters after the company became aware of the credit. However, if the company used a TPP who filed the payroll returns, then the TPP was required to claim the ERC on behalf of its clients.

A legal memorandum dated Feb. 5, 2024, discussed the legal obligations of these TPPs, concluding that all three types of TPPs are liable for any underpayments of payroll taxes as a result of improper claims, together with clients on whose behalf the TPPs file the claims for the ERC.

Although the agreements between most TPPs and their clients provide clauses where clients agree to reimburse TPPs for payroll tax deficiencies, whether a TPP could be reimbursed for all of its potential liabilities for back taxes clawed back due to improper claims is questionable. To make matters worse for TPPs, congressional bills passed by the House and considered by the Senate, could extend the statute of limitations for the IRS to assess underpayments of ERC claims by two years, giving the IRS plenty of time to audit ERC claims. This bill would also impose preparer penalties on certain firms who helped prepare ERC claims including PEOs and Section 3504 agents.

Since October 2022 the IRS has been publishing guidance to warn companies against taking advice from aggressive ERC consulting firms, but this legal memorandum is the first time to give notice to TPPs of their potential liability for improper ERC claims. In December 2023 the IRS announced a voluntary disclosure program that allow companies to pay back 80% of the improperly claimed credit. Although uncertain, the IRS may consider a similar voluntary disclosure program for TPPs. It is estimated that 17% of businesses with 10 to 99 employees use a PEO. The importance of the PEO industry to small businesses could warrant some type of remedial relief for potential ERC liabilities.

In 2021 IRS noted that both the Third Party Payer and its client will each be liable for employment tax due as a result of any improper claim for the ERC; however, this guidance also states that third party-payers may rely on the client employer’s information regarding the client employer’s eligibility to claim the employee retention credit. Therefore, giving a very mixed message that may have caused confusion regarding a Third Party Payer’s liability when it relies on information provided by its client. Further IRS Notices and other releases after 2021 did not clarify this issue until this latest memorandum.