The Federal Circuit recently issued its opinion in the Cencast Services case. Cencast Services is a payroll service company that handled the payroll function for various motion picture and television production companies. The employees often work for multiple companies over the course of the year. It is well-established law that payroll service companies are “statutory employers” and obligated to withhold and remit payroll taxes, even though they are not the “common law employers” of the employees. The primary issue in Cencast Services was the application of the wage caps for federal unemployment tax (FUTA) and the employer portion of FICA taxes.
Each employer pays FUTA on wages up to $7,000 per year and the employer share of FICA up to a higher amount, $113,700 for 2013. Cencast computed the taxes as though it, rather than the production companies, was the employer. Thus, if a particular employee earned $45,000 each from three different production companies during one year, the payroll service company would pay FUTA on $7,000 of wages and FICA on $113,700 of wages. The amounts would be $21,000 and $135,000, respectively, if the production companies had paid the employee directly. The Federal Circuit ruled in the government’s favor. Both wage caps refer to an amount “with respect to employment has been paid to an individual by an employer during any calendar year.” The court concluded that the obligation to withhold and remit payroll taxes attaches to the statutory employer (Cencast), but the wage caps apply to each common law employer (the individual production companies). Using a service company to process payroll affects who has the obligation to pay but does not affect how much payroll taxes must be paid.
Cencast also argued in the alternative that some of the persons paid were really independent contractors rather than employees and that no payroll taxes were due on the amounts paid to them. However, the court refused to consider this argument. Cencast filed suit in 2002 and the parties agreed to a deadline of February 2007 for adding new legal theories and affirmative defenses. Although Cencast was aware of its independent contractor theory as early as 1994, it did not seek to amend its answer to add that affirmative defense until 2010. The court concluded this delay was unreasonable and would prejudice the government.
Cencast contended that the independent contractor theory was preserved by the original 2002 refund claim. But this theory substantially varied from the theories raised in the claim, and the government did not waive the substantial variance rule. The substantial variance rule may be waived if the IRS considers the theory before the limitations period expires. The court concluded that Cencast had mentioned the theory to the IRS during the audit only as a possible future theory. Cencast did not request the IRS to evaluate, and the IRS did not evaluate, the independent contractor argument as part of the audit. Because that argument substantially varied from the grounds raised in the refund claim, Cencast could not pursue that agument in its refund suit.
Cencast Services illustrates the importance of the substantial variance rule and the waiver doctrine. Taxpayers should include all potential theories in refund claims or otherwise ensure the IRS considers them, to preserve those arguments for a possible refund suit.
If you have any questions about these issues, please contact one of the undersigned or any of the other Tax lawyers at Thompson & Knight.