DOR Excise Tax Advisory on Paymasters

The Washington Department of Revenue’s Draft Excise Tax Advisory on Paymasters … Will This Affect You?

The Washington Department of Revenue (DOR) is revisiting the taxable/non-taxable status of paymasters. There is no expressed statutory exemption or deduction for paymasters; however, for years, DOR has approved properly enacted paymaster structures as non-taxable. DOR’s legal premise appears to be that the paymaster is a “mere conduit”, passing funds between the person who owes the money to the person who is owed the money. It seems simple.

Paymasters come in many shapes and sizes. Many businesses employ the paymaster concept, unaware that DOR might treat the reimbursements as gross income should it determine that the business is more than a mere conduit. Unfortunately, the decision is not based upon what the parties actually do but what they may have documented in writing. Consequently, paymasters can be a trap for the unwary.

So, why are paymasters a tax issue?

To put this into the context of the B&O tax burden, let’s assume the paymaster handles $1,000,000 per year of payroll. If the paymaster cannot exclude or deduct the $1,000,000 from gross income of the business, then it will pay service B&O tax on that amount at the rate of 1.8%, or $18,000 per year. If the aggregate cost for each affiliate to handle its own payroll was more than $18,000 per year, then maybe this additional tax is a bargain price for the efficiency … if the taxpayer knew about it and included the tax cost into the operating budget, or planned around it to avoid the cost entirely. Whichever the case, the taxpayer should take this potential cost into consideration and not assume that there is no cost to the non-qualifying paymaster structure.

An informal paymaster is typically paying for an affiliate’s expenses and then receiving a reimbursement.  Consider these examples:

  1. A corporate parent might maintain the accounting, human resource and general counsel functions at its level but allocate shares of the cost to the affiliates for which it reimburses the parent for the shared costs. Query: Did the parent sell these overhead functions to the affiliates?
  2. A parent might sweep all affiliates’ bank accounts into a consolidation account and credit each affiliate with the proportionate interest that the bank paid on the overnight investment of the funds. Query: Is the parent a financial institutional earning interest from the bank and then paying interest to the affiliates?
  3. A parent might buy goods and services for the group, benefitting from the power of volume purchases, assigning the goods and services and being reimbursed for their proportionate share. Query: Did the parent buy and resell copy paper, software seat licenses, fuel for the equipment and so forth?
  4. A parent or an affiliate might be the single payer of the affiliates’ entire payroll. Query: Is the parent the employer of the affiliate employees, selling the employee services to the affiliates like a temporary staffing company?

This post deals only with the last example … formal paymasters that taxpayers employ to administer efficiently the payroll of the business family.  However, the issues discussed are relevant to all types of paymasters, and DOR is actually reviewing the universe of affiliate transactions.

What’s in the proposed ETA?

Citing to WAC 458-20-111, the proposed Excise Tax Advisory (ETA) explains that a paymaster can exclude receipts if three requirements are met. These are:

  1. Customary advance or reimbursements: The amounts received must be customary advance or reimbursements to a paymaster for paying the employer obligations of a client;
  2. Inability to provide services:  The services provided by the employees to the client must be services that the paymaster does not or cannot provide and for which no liability attaches to the paymaster.
  3. No liability except as agent:  The paymaster must not be liable for paying the employer obligations, except as the agent of the client.

DOR paraphrases these requirements as “the client must be … liable for the employer obligations, and the paymaster must be a bona fide agent with no obligation to furnish employee labor or services to the client and no liability to pay the employer’s obligations.”

Customary Advance or Reimbursement

Let’s take each requirement in order, beginning with customary advance or reimbursement.  An advance is the money that the principal gave you and that you held before the principal’s obligation was ripe for payment. For example, payday is on the first of the month. The affiliate transfers the payroll funds to the paymaster at the end of the preceding month.  On the first, the paymaster uses the advance to make payroll.  A reimbursement is money that the paymaster receives after the fact. For example, the paymaster uses its own funds to make payroll on the first of the month.  On the second of the month, the affiliates transfer the funds to paymaster for the payroll that it paid from its own funds.

According to the ETA, the advance or reimbursements must be customary, and in the context of paying an employer’s employees, the ETA (or anything DOR has published for that matter) sheds no light on what might be considered customary. Perhaps the absence of “customary” in DOR’s paraphrase of the requirements signals its view that the term is not important or critical to the analysis.

It also says that an advance or reimbursement must be received to pay the employer’s obligation to its employees. This requirement cannot be satisfied by the paymaster simply denying employer status or having an agreement with the client that the paymaster is not the employer. Rather, a facts and circumstances analysis determines if the paymaster was satisfying its own obligation, or the principal’s obligation to the employees.

A potential problem with this requirement is that when the paymaster is the “employer of record” (the official reporter and remitter of payroll taxes to federal and state agencies), the paymaster has the legal obligation to pay the employees. Fortunately, the ETA only presumes an “employer of record” is liable to the employee for the wages, and the presumption can be overcome if two requirements are satisfied:

  1. The principal, and not the paymaster, has all aspects of control over the employee such as:
    1. Determining and supervising employee activities;
    2. Setting compensation;
    3. Hiring and firing authority; and
    4. Other similar employer obligations.
  2. The principal agrees in writing … that is enforceable by the employees … that it is the client that is liable for all employer obligations.

Thus, clearly when a paymaster is an “employer of record”, there must be written documentation under this ETA if there can be any hope that the paymaster’s advance or reimbursement receipts will be excludable or deductible.

Inability to Provide the Services Performed by the Employees

The second requirement is that the paymaster must not be able to provide the services performed by the employees. This requirement prevents a taxpayer from characterizing the transaction as a paymaster for services that it could have performed.  Let’s take a simple example. Assume that you own a landscape design business.  Your kids also mow lawns in the neighborhood. However, you don’t want your kids to have the money until you can teach them how to manage it. Your neighbors agree to help you teach your kids these financial lessons.  They agree to pay you the money that your kids earn, allowing you to teach your kids how to manage their earnings: spend some on the gasoline and yard bags, spend some on movies, candy and pop, and save the rest. When DOR shows up, you explain that the money that you collected for your kids was for lawn services that they sold to the neighbors and not part of your landscape design services that you sold. DOR could disagree, because you had the ability to provide lawn-mowing services as part of installing lawns, planting shrubs and designing sprinkler systems.  It would argue that you paid your children to perform lawn-mowing services that you sold to your neighbors.

To avoid this potential conflict, tax planners often create an LLC or corporation to be the paymaster. Typically, it will have no employees and will not perform any other activities other than handling wages.  The ETA offers another way around the problem. The paymaster can enter into a written agreement with the principal that establishes that the paymaster has no obligation to provide the service and no liability for the quality, property or any aspect of the services.

The ETA goes on to explain that the paymaster cannot have the obligation to provide the service or assure the quality of the service. So, if the employee fails to show up to work, the paymaster cannot be responsible for providing another employee.  In the landscape design example above, as embarrassing as it might be for you, if your kids didn’t show up to mow the lawn or didn’t do a good job, then your neighbors must look to your kids and not to you to remedy the problem.

It is interesting that the ETA expressly dismisses any defense based on the legal authority to perform the service. For example, if the employee is providing legal service, then the paymaster will not be heard that it is not the employer on the theory that the paymaster is not licensed to practice law. (Actually, this seems like pretty good evidence that the paymaster is not providing the service.) Fortunately, this is a two way street, the ETA says that being legally or physically able to perform the service does not prove that the paymaster performed the service either.

A recent and relevant case addressing the lawful authority to perform a professional service is Washington Imaging, wherein a radiology firm argued that it could not be taxed on money for which it factually billed and actually collected on behalf of doctors who provided professional medical services that related to the radiology done by the taxpayer. The radiology firm contended that it did not have the professional credentials to practice medicine performed by the doctors, did not lawfully own the doctors’ funds that it received and, therefore, should not be taxed on the money received and paid over to the doctors. The state Supreme Court accepted the factual and legal truth that it was unlawful for the radiology firm to perform the professional medical service, but concluded that the definition of “gross income of the business” nevertheless included the money in which it had no lawful interest. The court described the distribution of the doctors’ fees as simply paying for a cost of doing business of providing a bundle of radiology and professional medical services.

No Liability Except as an Agent

The third requirement is that the paymaster can have no liability except as agent. According to the ETA, there must be a bona fide agent relationship and there can be no liability to pay employer obligations except as agent.

Regarding the bona fide agent requirement, “standard common law agency principles” determine whether a bona fide agency exists. According to the ETA, a critical requirement of the common law is that there be mutual consent and control.  This means that the paymaster has the burden to prove that the paymaster and the client consented to the agency and that the paymaster acted at the insistence and under the direction and control of the client.  These can certainly be proven by an actual conduct, but it would be prudent to establish the consent, control and direction through a writing.  In the summer lawn mowing example above, the neighbors should enter into an agreement consenting to the agency with instructions to you as to how the money paid to you should be dispersed (e.g., that you cannot tender the money to your kids until the neighbor has approved of the work performed).

Regarding the second requirement, the ETA says that the paymaster can only have agent liability. The liability cannot be primary or secondary if it is independent of its agent status. This means that the paymaster cannot be a surety or a guarantor of the client’s obligation as the employer. According to DOR, an agreement that establishes that the paymaster has no liability is not necessarily binding. There are circumstances when statutes or facts and circumstances determine who the employer is and agreements between the paymaster and the client may not have the power to alter those legal conclusions. One exception was mentioned above — the “employer of record” situation under 26 U.S.C. sec. 3504. According to the ETA, it is an exception because under that code section, federal law requires that notice be given to the employee that the paymaster, as the employer of record, is only an agent.

Agent liability is somewhat confusing, at least from this author’s perspective. Under the common law, an agent can have primary, personal liability as an agent if it is acting as the agent of an undisclosed principal. Contrarily, at least one DOR determination  holds that an agent does not have “liability as agent only” unless the principal has been disclosed. Thus, based on the ETA’s requirement that the employee knew that (1) the client is the employer and (2) the agent has no liability, one can conclude that DOR contradicts itself when it claims that it is using common law principles of agency. In both cases of a disclosed and undisclosed principal, under the common law, the actor is a bona fide agent but the extent of liability varies. DOR’s position on a disclosed principal appears to be a corrupted view of the common law regarding “liability as an agent only”. DOR appears to be using the select principles of the common law regarding disclosed principals and not using the greater body of common law on principal and agents.

The Department of Revenue is taking comments on this draft. A copy of the draft ETA on paymasters can be obtained by contacting Kate at DOR whose address is katea@dor.wa.gov.

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