Worker Classification: The Statutory Employer Exemption and Control of the Payment of Wages

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Jason B. Freeman

Jason B. Freeman

Managing Member


Mr. Freeman is the founding member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney.

Mr. Freeman has been named by Chambers & Partners as among the leading tax and litigation attorneys in the United States and to U.S. News and World Report’s Best Lawyers in America list. He is a former recipient of the American Bar Association’s “On the Rise – Top 40 Young Lawyers” in America award. Mr. Freeman was named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas for 2019 and 2020 by AI.

Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service. He has previously been recognized by Super Lawyers as a Top 100 Up-And-Coming Attorney in Texas.

Mr. Freeman currently serves as the chairman of the Texas Society of CPAs (TXCPA). He is a former chairman of the Dallas Society of CPAs (TXCPA-Dallas). Mr. Freeman also served multiple terms as the President of the North Texas chapter of the American Academy of Attorney-CPAs. He has been previously recognized as the Young CPA of the Year in the State of Texas (an award given to only one CPA in the state of Texas under 40).

Federal law defines an “employer” for tax purposes as “the person for whom an individual performs or performed any service, of whatever nature, as the employee of such person.”[1] There are, however, exceptions to this rule that may deem another entity to be an employer when that entity has control over the payment of wages. Specifically, when the common law employer—that is, the person directing the employee to perform services—does not have control of the payment of the employee’s wages, and another person does, then that other person may be considered the “statutory” employer with regard to those wages.

While this exception appears straightforward on its face, the IRS has adopted a broad interpretation of what constitutes “control of the payment” of wages. In Paychex Business Solutions, LLC, et al., v. United States of America,[2]the district court for the Middle District of Florida held that Paychex, a third-party payroll processor, was a statutory employer under § 3401(d)(1) because it “actually controlled the accounts from which the wage payments were made” to its client companies’ employees.[3] Under the facts of the case, Paychex’s clients had no such control over the accounts that disbursed funds to the employees.[4] With this holding, the district court rejected the argument that Paychex was merely a conduit for the client companies’ funds since (1) Paychex debited the client companies’ accounts prior to disbursing funds to employees, and (2) Paychex’s disbursement of funds was “contingent upon or proximately related to” payment to Paychex by the client companies.[5] In rejecting the conduit argument, the court relied on prior cases interpreting § 3401(d)(1) and the fact that there was uncertainty about whether the client companies actually had sufficient funds to pay Paychex before Paychex disbursed funds to employees.[6]

The IRS recently issued a recommendation of nonacquiescence to the Paychex holding in Action On Demand 2020-1 (“AOD”).[7] In doing so, the IRS first stated the two-part test to determine whether the statutory employer exemption applies: (1) the common law employer must not have control of the payment of wages, and (2) the other person must have control of the payment of wages.[8] The IRS maintained that the Paychex holding erred on the first prong—that is, in the court’s determination that the client companies were not common law employers due to their arrangement with Paychex.[9] The IRS examined the legislative history of § 3401 and found support for a narrow interpretation of “special definitions of the term ‘employer,’” which “are designed solely to meet special or unusual situations.”[10] According to the IRS, “control” under § 3401 means legal control, which cannot be established by a wage-paying entity when that entity’s payment of wages is “contingent upon, or proximately related to, the entity having received funds from the common law employer.”[11] The IRS further clarified in the AOD that having “exclusive control over the bank account from which wages are paid” is not dispositive in determining control under § 3401(d)(1).[12]

As applied to the facts of Paychex, the fact that Paychex “received the funds from their clients before issuing paychecks to the clients’ employees” meant that “the clients and not [Paychex] had control over the payment of the wages as in almost all instances the Plaintiffs received the funds from their clients before issuing paychecks to the clients’ employees and the clients remained liable for the amount of the payments if the funds were insufficient to satisfy” the disbursement of wages.[13] The IRS found this approach to be consistent with “the IRS’s longstanding position” that “absent statutory authority, an employer may not simply delegate or contract away its taxing responsibility.”[14] Further, the IRS distinguished Paychex from the cases relied on by the district court on the grounds that none of the court’s cited cases involved a payment arrangement exactly like the one in Paychex; rather, in the prior cases, third parties paid the employees out of their own funds, or out of a pooled account.[15] Thus, these third parties were not merely functioning as conduits.[16]


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Need assistance in managing the business planning processes? Freeman Law advises clients with corporate and other entity formations and reorganizations. Restructuring entities—through conversions, mergers, and liquidations—can involve particularly complex tax and regulatory considerations. Freeman Law provides experienced tax and business counsel, helping our clients achieve their organizational goals in a tax-efficient manner. Schedule a consultation or call (214) 984-3000 to discuss your corporate structuring or business and tax planning concerns. 


[1] 26 U.S.C. § 3401(d).

[2] 2017 WL 2692843 (M.D. Fla. 2017).

[3] Id. at *7.

[4] Id.

[5] Id.

[6] Id.

[7] A.O.D. 2020-1 (Mar. 16, 2020).

[8] Id. at 3.

[9] Id.

[10] Id. at 4.

[11] Id.

[12] Id. at 5.

[13] Id. at 6.

[14] Id.

[15] Id.

[16] Id.