Businesses utilizing co-employment agreement with a Professional Employer Organizations (PEOs) for payroll, benefits, HR, and other services need to take steps to mitigate risks from potential PEO noncompliance or financial issues. As outlined in a 2023 IRS private letter ruling, client companies can have tax refunds claimed by the PEO redirected by the IRS to satisfy outstanding PEO tax balances, leaving the client company without its entitled refund. By vetting PEO qualifications, protections, and history up front, securing contractual liability transfers, and requiring ongoing account transparency, businesses can better safeguard their interests when co-employing workers through a PEO.
IRS Authority to Redirect Refunds
In May 2023, the IRS Office of Chief Counsel confirmed in a private letter ruling that the IRS has the authority under Internal Revenue Code Section 6402(a) to take a taxpayer’s overpayment and credit it towards “any liability” tied to Internal Revenue taxes owed by that taxpayer.
In the case of COVID-19 employer tax credits and payroll tax refunds, the IRS allows aggregation by third-party payers (TPPs) like PEOs, meaning the PEO claims credits and refunds in an aggregated amount under its own EIN across all its payroll client companies. The IRS therefore deemed the “taxpayer” and refund recipient in these cases to be the PEO entity itself, not the individual businesses on whose behalf payroll is processed.
So in cases where a PEO claims a refund on behalf of client companies but itself has an outstanding payroll tax liability, the IRS is within its rights to take that refund and apply it towards the PEO’s balance due instead of issuing the refund to the PEO to potentially pass down to its clients. Any refund claimed by a PEO directly reduces the PEO’s total employment tax obligations. The IRS does not consider underlying client allocation when processing PEO refunds or audits. Rather, credits and liability are assessed in aggregate at the PEO level.
This ability for the IRS to redirect refunds intended for client companies to pay a PEO’s obligations is strictly a civil legal matter between the PEO and client. But it poses financial risk for businesses using PEOs with outstanding tax balances or compliance issues.
Vetting a PEO for Protection
To better evaluate PEO risk exposure when co-employing, businesses should investigate key indicators in advance and secure contractual guarantees:
IRS Certification
IRS certification of a PEO verifies compliance with payroll processing standards, tax payment timeliness, assumed tax liabilities, and more. This reduces client company compliance worries and tax risks.
Bonding and Insurance
Reputable PEOs carry surety bonds, fiduciary insurance, and other coverages to assume tax and benefit plan risks contractually. This reduces client company liability.
Longevity and Transparency
Established PEOs in business for 10+ years with ongoing client reporting provide stability and visibility. This minimizes viability concerns while enhancing accountability.
State Licensing
A PEO should maintain active licenses and bonding through agencies in all operational states to adhere to localized regulations.
Adherence to Best Practices
Industry certifications like those required by CI, ESAC, and other bodies confirm ongoing compliance to ethical, fiduciary, and risk management standards.
Protective Contract Terms
Co-employment contracts should transfer statutory, benefits, workplace, and compliance obligations from client to PEO. Account access and transparency provisions are also advised.
By thoroughly evaluating the PEO, requiring evidence of protections, verifying adhesion to best practices, reviewing the PEO’s financials, and ensuring comprehensive contractual liability transfer, businesses can better insulate interests when co-employing through a PEO.
Ongoing PEO Vetting
Initial due diligence of a PEO provides client businesses valuable risk coverage, but ongoing vetting is equally important to confirm that certifications, insurance, bonding, and protections remain active over time while the co-employment engagement continues:
- Request and validate renewals of all IRS, state licensing, and industry credentials
- Require evidence of continuous surety bond and insurance policy coverage at prior or higher levels
- Review periodic third-party financial statement audits of the PEO to substantiate stability
- Verify ongoing compliance through random state agency citation records requests
- Have legal counsel review any PEO-issued policy changes for gaps in coverage or liability transfers
- Secure periodic contractual review terms to preserve protections
By incorporating continuous vetting provisions in the initial PEO agreement and conducting recurring due diligence checks, businesses can monitor adherence and intervene promptly should any compliance, financial viability, or bonding risks emerge for the PEO over time. This helps prevent IRS refund redirect surprises down the road.
Evaluating Alternate PEO Structures
Businesses seeking to mitigate PEO risks do have alternate co-employment structures to consider as well:
MES Providers
A Management and Employment Staffing (MES) company serves as the internal human resources department on an outsourced basis rather than serving as a formal co-employer. This avoids coverage risks.
Hybrid PEOs
Specialized PEOs offer combined co-employment and MES arrangements, serving as co-employer only for health plans to maximize coverage scale and mitigate risks for other HR areas a client retains.
Bundled Service Models
Some payroll-HRIS platforms bundle additional voluntary HR services, benefits sourcing assistance, and HR administration à la carte without the formal co-employment entanglements of a PEO. This prevents coverage gaps while accessing efficiencies.
Though not well suited for all situations, these emerging models warrant consideration to secure service support without necessarily introducing co-employment compliance and liability risks should IRS refund redirect or other issues arise.
The landscape of service companies supporting payroll, benefits, and human resources continues evolving to meet small business needs. But vigilance is important when identity and financial interests intertwine, as underscored by the IRS private letter ruling on PEO refund redirects. Staying informed on regulations, protections, and alternative approaches while vetting providers, requiring security provisions, and monitoring selected partners can help business owners access vital back-office support without undue risks.
