News & Information

CCH® UNEMPLOYMENT INSURANCE — 11/01/13

Payroll service providers may not treat workers as employees and use statutory caps to reduce FICA, FUTA liability

In consolidated tax refund cases, a payroll service provider could not reduce the scope of FICA and FUTA employment taxes it paid by taking advantage of statutory caps for all employees for which it provided payroll services; rather, FICA and FUTA taxes must be calculated based on the employees’ relationship with their common law employers—the entities that hired, fired, and supervised them, the Federal Circuit ruled in Cencast Services, LP v. U.S., September 10, 2013. Further, the payroll service provider was barred, due to undue delay and prejudice, from raising its theory that it overpaid the FUTA and FICA taxes because some of the individuals classified as employees were independent contractors.

Payroll services in motion picture industry

In the motion picture industry, many production workers are employed by different production companies during the course of a year, rather than by a single large production studio. This complexity has made administration of payroll, benefits, CBAs, and taxes difficult. Enter entities like the plaintiffs here: Cencast is a payroll service company that computes and pays compensation to production workers, as well as reports and pays compensation to multi-employer pension and benefit funds, provides post-production financial reporting, and, at issue here, pays employment taxes to the IRS.

Individual production companies continue to both hire and supervise the individual production workers and are their common law employer; Cencast’s role as “statutory” employer is, like other payroll service providers, to pay the production workers and administer the production companies’ payroll and employment tax obligations. According to the court, between 1991 and 1996, Cencast paid over $7 billion in wages to workers on numerous different productions on behalf of production companies.

Procedural background

Cencast also filed tax returns and remitted FUTA and FICA taxes with respect to these employees—approximately $465 million. When it did so, it treated each employee as being in an “employment” relationship with Cencast rather than with the production companies. What did this mean? It had the effect of reducing the overall tax payments because of statutory caps on both FUTA and FICA taxes.

To use the court’s example, when the relevant FICA wage base was $62,700 in 1996, for an employee who earned $100,000 from two employers, Cencast could effectively cut off its FICA liability at $62,700 in wages (when it treated the employee as its own) rather than having to pay the entire FICA liability on $100,000 for the $50,000 in wages paid by each of the two employers. “The amount of tax that was avoided,” said the court, “is exactly equal to the additional amounts of FUTA and FICA tax that individual production companies would have been liable for had those companies conducted their own payroll services and filed their own tax returns.”

Naturally, the IRS would not tolerate this result. In a 1997 Technical Advice Memorandum, the IRS explained that FUTA and FICA taxes should be calculated as though each employee were in an employment relationship with each individual production company, rather than with Cencast. Cencast thus had to apply a separate wage cap with respect to each production company that had an employment relationship. In 2001, the IRS assessed Cencast FUTA and FICA tax deficiencies for the 1991-1996 tax years totaling approximately $43.7 million for FUTA taxes and $15.6 million for FICA taxes.

Litigation ensued, and eventually in 2004 summary judgment was granted to the government on the issue that the production companies were the employers for purposes of calculating FICA and FUTA. The parties even discussed settlement, but in a 2008 status conference, Cencast argued for the first time that it was entitled to reduce its tax obligations because it said some individuals for whom it paid tax were not employees but independent contractors, which would have reduced its tax liability. By 2010, Cencast moved to amend its complaint to include allegations regarding its purported independent contractor overpayments.

Common law employer

For purposes of calculating the FUTA and FICA wage base caps, the appeals court agreed with the government that the employees should be treated as being in employment relationships with the common law employers—the production companies. First, the court found it contrary to the statutory scheme to allow common law employers to reduce their tax liability simply by transferring the functions of wage administration to entities like Cencast. Second, it was not the definition of “employer” that controlled, but the definition of “employment.” Analyzing the statutory requirements of both FICA and FUTA, it found that “employment” must refer to the common law employment relationship. Those statutory references consistently refer to employment in the common law sense, said the court, meaning that the wage cap provision must be calculated with respect to the employee’s various common law employments during the calendar year. “Common law employers provide the ‘employment’ (the remuneration for which is the measure of the statutory cap) even though the statutory employer is ‘an employer’ that ‘paid’ the remuneration,” concluded the court.

Besides, under Cencast’s theory, the statutory employer’s tax liability would be less than the aggregate liability of the production companies if they had paid the employees directly. Clearly, Congress did not intend that common law employers could choose a different wage cap (and effectively reduce the amount of their tax liability) depending on whether they chose to administer payroll themselves or to delegate that responsibility. Instead, Congress intended the wage cap calculation amount to be the same no matter who paid the employees. These wage cap provisions under FUTA and FICA would make no sense, said the court, if the wage caps were applied to the statutorily defined employment relationships and not the common law employment relationships because that would allow common law employers to reduce their tax liabilities by retaining entities like Cencast.

Independent contractor theory

Cencast also argued that, under Court of Federal Claims Rule 15(a), it should have been allowed to amend its answer to the government’s counterclaim to assert the independent contractor theory as an affirmative defense. However, when Cencast filed answers to the counterclaim in both 2003 and 2007, it failed to include the independent contractor theory. Further, when the government and Cencast stipulated to define and narrow the relevant issues in the case in 2008, that stipulation did not mention the independent contractor theory. The court agreed with the lower court that allowing the amended pleadings would result in both undue delay and prejudice to the government, which had devoted significant resources to litigating the issues previously identified. Cencast was aware of its independent contractor theory as early as 1994, and waiting 15 years to bring it up was simply too long, concluded the court.

And although Cencast raised additional arguments surrounding its administrative refund claims in order to justify supplementation of its pleadings to include the independent contractor claims, the appeals court remained unpersuaded. Finding no error in the lower court’s decision, the Federal Circuit affirmed the rejection of Cencast’s claims for tax refunds.