Barrett Business Services Denied Work Opportunity and Empowerment Zone Tax Credits

PEO Loses $5M+ Tax Credit Battle: Court Rules Only Common Law Employers Eligible

The U.S. Tax Court on Monday dealt a $5 million-plus blow to Professional Employer Organizations (PEOs) nationwide, ruling that only common law employers—not statutory employers or §3504 agents—qualify for lucrative federal tax credits like the Work Opportunity Tax Credit (WOTC) and Empowerment Zone Employment Credit (EZEC). In a decisive opinion that asserts the court’s authority to define “employer” for tax credit purposes, Judge Lauber held that Barrett Business Services, Inc. (BBSI), a PEO, was ineligible for $5.3 million in claimed credits because it was neither the common law employer of the workers nor an agent under §3504. The ruling marks a pivotal moment in the Tax Court’s exercise of judicial power over the IRS’s interpretation of eligibility for employment-based tax incentives, rejecting the notion that statutory employer status or contractual arrangements can substitute for common law employer control.

The PEO Model: How Barrett Business Services Operates

Barrett Business Services, Inc. (Barrett) operates as a professional employer organization (PEO), a business model that emerged in the 1980s to help small and mid-sized businesses manage the administrative burdens of employment. Unlike traditional staffing agencies that merely supply workers, Barrett enters into co-employment agreements with its clients, assuming responsibility for payroll processing, tax withholding, and compliance while the client retains control over day-to-day operations.

The relationship begins when a client company—typically a small business with fewer than 100 employees—partners with Barrett to outsource employment-related functions. Barrett’s clients, known as worksite employers, hire workers who perform services at the client’s physical location. These workers, referred to as worksite employees, remain under the client’s direct supervision for their daily tasks, including scheduling, task assignment, and performance management. Barrett does not direct the worksite employees’ work; instead, it handles the back-office functions that clients often struggle to manage efficiently.

Once onboarded, Barrett integrates the worksite employees into its proprietary payroll system. This system automates wage calculations, tax withholdings, and benefit deductions. Barrett then processes and disburses paychecks to the worksite employees on behalf of the client, ensuring compliance with federal, state, and local tax laws. Under § 3401(d)(1), Barrett acts as a statutory employer by withholding and remitting employment taxes (such as FICA and federal income tax) even though it is not the common law employer—a distinction the Tax Court later emphasized in this case.

Beyond payroll, Barrett provides additional services that clients often lack the infrastructure to handle. These include administering employee benefits like health insurance and retirement plans, managing workers’ compensation insurance, and offering human resources consulting. Barrett also assists with recruiting and training worksite employees, further streamlining the client’s operations. The client remains responsible for the worksite employees’ job performance and workplace conduct, while Barrett focuses on the employment-related administrative tasks that keep the client compliant with tax and labor laws.

This division of responsibilities is central to the PEO model. The client retains operational control over the worksite employees, while Barrett assumes employment administration control, including tax reporting and benefits management. The arrangement allows small businesses to access resources typically reserved for larger corporations, such as competitive benefits packages and compliance expertise, without the overhead of a full HR department. For Barrett, the model generates recurring revenue through service fees, often structured as a percentage of payroll or a flat per-employee charge.

The Tax Credits at Issue: WOTC and EZEC Explained

The Work Opportunity Tax Credit (WOTC) and the Empowerment Zone Employment Credit (EZEC) are two of Congress’s most targeted incentives for hiring and economic revitalization. While both credits reward employers for hiring specific groups of workers or operating in distressed areas, their legislative histories and eligibility rules reveal sharply different goals. The WOTC, created to break down employment barriers for disadvantaged workers, and the EZEC, designed to spur investment in blighted urban and rural zones, operate under distinct statutory frameworks that have evolved significantly since their inception. These credits are not mere footnotes in the tax code; they represent deliberate policy choices with real-world consequences for businesses and communities alike.

The WOTC, codified in § 51, allows employers to claim a credit for hiring individuals from designated "targeted groups" facing employment barriers. The credit equals 40% of the first $6,000 in qualified wages paid to eligible employees during their first year of employment, capping at $2,400 per worker. Targeted groups include veterans, ex-felons, individuals receiving Supplemental Security Income (SSI) or food stamps, and long-term unemployed workers, among others. The credit traces its origins to the 1977 New Jobs Credit, which was later refined in 1978 as the Targeted Jobs Tax Credit to focus on high-unemployment demographics. In 1996, Congress rebranded it as the WOTC, streamlining administrative burdens and emphasizing long-term employment stability. The PATH Act of 2015 permanently extended the WOTC, and the Consolidated Appropriations Act of 2020 extended it through December 31, 2025, reflecting its bipartisan appeal as a tool for workforce development.

The EZEC, found in § 1396, offers a 20% credit on up to $15,000 in qualified wages paid to employees who both live and work in an Empowerment Zone (EZ), a federally designated area suffering from high poverty and unemployment. Unlike the WOTC, which rewards hiring practices, the EZEC aims to revitalize economically distressed communities by incentivizing employers to hire local residents. Enacted in 1993 as part of the Omnibus Budget Reconciliation Act, the EZEC was initially paired with broader empowerment zone programs to provide tax incentives for businesses operating in these areas. However, the Tax Cuts and Jobs Act of 2017 repealed the EZEC for wages paid after 2017, leaving only grandfathered zones eligible for the credit through December 31, 2025. Despite its limited lifespan, the EZEC remains a critical tool for businesses operating in the few remaining designated zones, offering a lifeline to areas still struggling with economic stagnation.

The distinction between these credits is not merely academic. The WOTC is employer-centric, rewarding businesses for hiring specific individuals regardless of location, while the EZEC is place-based, tying eligibility to geographic boundaries. This difference becomes crucial in cases involving professional employer organizations (PEOs) like Barrett Business Services, which must navigate whether they qualify as "employers" under § 51 or § 1396. The IRS has long maintained that only common law employers—those with the right to control and direct the work of employees—are eligible for these credits, a position that has drawn sharp challenges from PEOs arguing they should qualify under broader statutory definitions. The legislative history of both credits, however, reinforces the IRS’s stance. The WOTC’s statutory language and its evolution from the Targeted Jobs Tax Credit reflect Congress’s intent to reward direct employers who hire disadvantaged workers. Similarly, the EZEC’s focus on local hiring in distressed areas aligns with its goal of community revitalization, a purpose that would be undermined if PEOs or other intermediaries could claim the credit without being the common law employer.

For businesses operating in or near empowerment zones, the EZEC’s grandfathered status presents a narrow but valuable opportunity. Employers must ensure that employees both live and work in the designated zone, and wages are capped at $15,000 per employee per year (adjusted for inflation to $16,000 in 2024). The WOTC, by contrast, offers broader applicability but requires strict adherence to pre-screening and certification requirements, including submitting IRS Form 8850 to state workforce agencies within 28 days of hire. Failure to comply with these procedural rules can result in denied claims, even for eligible employees.

The stakes for taxpayers are substantial. The WOTC alone has generated billions in annual tax savings for businesses across industries, while the EZEC, though diminished, still provides critical support to struggling communities. For PEOs and their clients, the question of who qualifies as an "employer" under these credits is not just a technicality—it is a multi-million-dollar liability issue that could reshape the PEO industry’s future. The Tax Court’s upcoming decision in Barrett Business Services’ case will hinge on whether the court interprets these credits through the lens of statutory text or legislative intent, a choice that could have sweeping implications for how PEOs and other intermediaries engage with federal tax incentives.

Barrett vs. IRS: The Battle Over Tax Credit Eligibility

The stakes in this case could not be higher: Barrett Business Services stands to lose over $5 million in claimed tax credits for 2018, while the IRS asserts that the company’s entire claim is invalid because it fails to meet the definition of an "employer" under the Work Opportunity Tax Credit (WOTC) and Empowerment Zone Employment Credit (EZEC). At the heart of the dispute is whether a Professional Employer Organization (PEO) like Barrett—acting as a statutory employer under § 3401(d)(1) or an agent under § 3504—can claim these credits when the underlying employees are supervised and controlled by Barrett’s client companies.

Barrett’s argument hinges on a narrow interpretation of statutory text and legislative history. The company claims eligibility under § 51(k)(2), which defines an "employer" for WOTC purposes as any person for whom an individual performs services, and under § 1396 and § 1397, which similarly define employers for EZEC eligibility. Barrett points to the legislative history of the WOTC, enacted in 1996 as part of the Small Business Job Protection Act, arguing that Congress intended to broaden eligibility beyond common law employers to include entities that pay wages and withhold taxes—such as PEOs. Barrett further asserts that its role as a statutory employer under § 3401(d)(1) and as an agent under § 3504 shifts the employer designation for tax credit purposes, allowing it to claim the credits on behalf of its clients.

The IRS, however, rejects this interpretation. The agency argues that the plain text of §§ 51, 1396, and 1397—which authorize the WOTC and EZEC—explicitly ties eligibility to the common law definition of an employer. The IRS contends that neither § 3401(d)(1) nor § 3504 alters the employer definition for purposes of these credits. In its view, Barrett’s clients are the common law employers because they control the day-to-day work of the worksite employees, while Barrett merely handles payroll and administrative functions. The IRS further emphasizes that § 3511(d) explicitly excludes certified PEOs from claiming the WOTC or EZEC, suggesting that Congress was aware of PEOs’ role in the employment relationship and chose to limit their eligibility. The agency argues that Barrett’s interpretation would "thwart Congressional intent" by allowing intermediaries to claim credits intended for the entities that directly benefit from the employees’ labor.

The IRS’s position rests on a straightforward reading of the statute: the WOTC and EZEC are designed to incentivize hiring from targeted groups, and the entities that make hiring decisions and supervise employees—the common law employers—are the ones Congress intended to reward. The agency dismisses Barrett’s reliance on § 51(k)(2) as overly expansive, arguing that the provision was intended to clarify that the employer need not be the entity that directly hires the employee, but it does not extend eligibility to entities that are not the common law employer. The IRS also points to the legislative history of the WOTC, which repeatedly refers to "employers" in the context of those who hire and supervise employees, not those who merely process payroll.

Barrett, in contrast, frames its argument around the practical realities of the PEO model. The company argues that its clients often lack the infrastructure to handle payroll, tax withholding, and benefits administration, and that Barrett’s role as a statutory employer under § 3401(d)(1) makes it the functional equivalent of an employer for tax purposes. Barrett further contends that denying PEOs the ability to claim these credits would create an unfair burden on small and mid-sized businesses that rely on PEOs to manage their workforce, effectively penalizing them for outsourcing administrative functions.

The IRS counters that the PEO industry’s reliance on statutory employer status for employment tax purposes does not automatically extend to tax credit eligibility. The agency distinguishes between § 3401(d)(1), which shifts liability for employment taxes, and the WOTC and EZEC, which are tied to the economic benefits of hiring targeted employees. The IRS argues that Barrett’s clients are the ones who directly benefit from the employees’ labor and thus should be the ones eligible for the credits. The agency also notes that Barrett is not a certified PEO under § 7705, which would have provided a clear path to eligibility under § 3511(d)—a provision the IRS argues Congress included to prevent PEOs from claiming these credits.

The battle over tax credit eligibility thus comes down to a fundamental question: Does the PEO model, as Barrett describes it, align with Congress’s intent in creating the WOTC and EZEC? The IRS says no, arguing that the credits are designed for the entities that make hiring decisions and supervise employees. Barrett says yes, contending that its role as a statutory employer and agent makes it the de facto employer for tax purposes. The Tax Court’s resolution of this dispute will hinge on whether it interprets the credits through the lens of statutory text or legislative intent—a choice that could reshape how PEOs and other intermediaries engage with federal tax incentives.

Common Law vs. Statutory Employer: The Court's Defining Moment

The Tax Court’s ruling in Barrett Business Services, Inc. v. Commissioner hinges on a fundamental distinction between common law employers and statutory employers—a divide that has reshaped how professional employer organizations (PEOs) and other intermediaries engage with federal tax incentives. The court’s analysis rests on the common law right-to-control test, legislative intent, and the structural differences between employment tax regimes (subtitle C) and income tax credits (subtitle A).

The Common Law Employer: A Multifactor Test

Under federal tax law, an entity qualifies as a common law employer when it exercises control over the manner and means by which work is performed. This determination is not based on a single factor but rather a holistic evaluation of the employer-employee relationship. The Tax Court relied on the seven-factor test established in Weber v. Commissioner, 103 T.C. 378 (1994), which includes:

1. The degree of control exercised over the details of the work;
2. Which party invests in the facilities used in the work;
3. The opportunity for profit or loss;
4. Whether the principal has the right to discharge the individual;
5. Whether the work is part of the principal’s regular business;
6. The permanency of the relationship; and
7. The relationship the parties believe they are creating.

No single factor is dispositive, but the overarching principle is whether the putative employer retains the right to control the work itself—not merely the payment of wages. In Barrett’s case, the court found that Barrett’s clients—not Barrett—exercised this control. The clients supervised the day-to-day activities of the worksite employees, determined their schedules, and directed their tasks. Barrett’s role was limited to payroll processing, tax withholding, and benefits administration—functions that do not equate to control over the work performed.

Barrett’s Statutory Employer Argument: A Bridge Too Far

Barrett contended that it qualified as a statutory employer under § 3401(d)(1), which defines an employer for purposes of federal employment taxes as:

"The person for whom an individual performs or performed any service, except that if the person for whom the services are performed does not have control of the payment of the wages, the term ‘employer’ means the person having control of the payment of such wages."

Barrett argued that because it paid and withheld taxes on behalf of its clients’ employees, it should be treated as the employer for purposes of the Work Opportunity Tax Credit (WOTC, § 51) and the Empowerment Zone Employment Credit (EZEC, § 1396). The court rejected this argument, emphasizing that § 3401(d)(1) is a creature of subtitle C—the section of the Code governing employment taxes (FICA, FUTA, and income tax withholding)—not subtitle A, which governs income tax credits.

The court’s reasoning turned on statutory structure and legislative history. Subtitle C’s primary purpose is to ensure the collection of employment taxes, while subtitle A’s credits are incentive programs designed to achieve specific policy goals—in this case, hiring disadvantaged workers (WOTC) and revitalizing distressed communities (EZEC). The court held that Congress intended these credits to flow to the entities that make hiring decisions and supervise employees—the common law employers—not the intermediaries that merely facilitate payroll.

The § 51(k)(2) Red Herring

Barrett also invoked § 51(k)(2), which provides that no credit shall be determined under § 51 for remuneration paid by an employer to an employee performing services for another person unless the amount reasonably expected to be received by the employer exceeds the remuneration paid. Barrett argued that this provision implicitly recognizes a three-party employment arrangement, where an entity other than the common law employer could qualify as the "employer" for credit purposes.

The court dismissed this argument as unpersuasive, noting that § 51(k)(2) addresses wage reimbursement arrangements—such as third-party payers in the construction industry—where the employer (e.g., a general contractor) pays wages to employees of a subcontractor but expects reimbursement. The provision does not, the court held, expand the definition of "employer" for credit eligibility. Instead, it prevents double-dipping where an employer claims a credit for wages paid by another entity. The court concluded that Barrett’s reliance on § 51(k)(2) was a misreading of its purpose, as it does not alter the common law employer standard for WOTC or EZEC eligibility.

The Court’s Power Play: Subtitle A vs. Subtitle C

The Tax Court’s ruling is notable for its assertion of authority over the IRS’s interpretation of tax credits. By rejecting Barrett’s argument that § 3401(d)(1) defines "employer" for subtitle A credits, the court rejected the IRS’s invitation to conflate employment tax regimes with income tax incentives. The IRS had argued that because both subtitle C and subtitle A deal with wages, the definition of "employer" should be consistent across both. The court disagreed, emphasizing that each subtitle serves distinct purposes:

• Subtitle C (employment taxes): Ensures revenue collection by designating the entity responsible for withholding and remitting taxes.
• Subtitle A (income tax credits): Provides policy-driven incentives to encourage specific behaviors (e.g., hiring disadvantaged workers).

The court’s holding reinforces the Tax Court’s role as the final arbiter of statutory interpretation, particularly when the IRS seeks to expand its enforcement authority beyond the clear text of the Code. The ruling also limits the IRS’s ability to expand the scope of tax credits through administrative interpretation, requiring Congress to explicitly define eligibility if it wishes to include intermediaries like PEOs.

The Rubber Meets the Road: Why Barrett Lost

The court’s analysis boiled down to three decisive factors:

1. Legislative Intent: The WOTC and EZEC were designed to incentivize hiring decisions by the entities that benefit from the labor—the common law employers. The court found no evidence that Congress intended to extend these credits to PEOs or other payroll intermediaries.
2. Statutory Structure: The credits are located in subtitle A, which governs income tax, not subtitle C, which governs employment taxes. The court refused to import a subtitle C definition into subtitle A without clear congressional direction.
3. Factual Reality: Barrett’s clients, not Barrett, controlled the work, hired the employees, and supervised their daily activities. Barrett’s role was administrative, not operational.

The court’s conclusion was unequivocal: Only common law employers are eligible for WOTC and EZEC. Statutory employers under § 3401(d)(1) and agents under § 3504 do not qualify, regardless of their role in payroll processing or tax withholding. This holding reshapes the PEO industry’s engagement with federal tax incentives, forcing intermediaries to reconsider their eligibility for credits they have long claimed.

The § 3504 Agent Argument: Why Barrett Still Lost

Barrett’s final gambit hinged on a narrow but aggressive reading of Section 3504, arguing that its role as a designated payroll agent under that provision automatically entitled it to claim the WOTC and EZEC credits. The court, however, dismantled this claim with surgical precision, reinforcing a fundamental principle: § 3504 agents are not employers for purposes of income tax credits.

Section 3504 allows the IRS to designate a fiduciary, agent, or other person to perform acts required of employers—such as withholding and remitting payroll taxes—but it does so without altering the underlying employer-employee relationship. The statute explicitly states that while agents designated under § 3504 are subject to "all provisions of law (including penalties) applicable in respect of an employer," this liability is limited to obligations tied to the employer’s role as a tax-withholding entity. The court emphasized that the phrase "in respect of an employer" refers specifically to employment tax liabilities, not to income tax credits like WOTC or EZEC.

The IRS countered that Barrett’s argument conflated administrative compliance with substantive eligibility. The court agreed, noting that WOTC (§ 51) and EZEC (§ 1396) are income tax credits tied to the employer’s status as a common law employer, not to its role in processing payroll. The court held that Barrett, as a § 3504 agent, was performing ministerial acts—withholding and remitting taxes—on behalf of its clients, but it was not the employer for whom the employees worked. The employees were hired, supervised, and paid by Barrett’s clients, and it was those clients who bore the economic burden of the wages and the tax consequences of the credits.

The court’s rejection of Barrett’s § 3504 argument was not merely textual—it was structural. The judges stressed that allowing agents under § 3504 to claim credits would undermine the statutory framework of WOTC and EZEC, which are designed to incentivize direct hiring decisions by employers, not intermediaries. The IRS’s position, which the court adopted, was that only the common law employer—the entity that controls the work and bears the financial risk of employment—can claim these credits. Barrett’s attempt to bypass this requirement by invoking § 3504 was, in the court’s view, an end-run around the statute’s plain meaning.

This ruling shuts the door on a long-running industry strategy where PEOs and payroll agents sought to claim tax credits by positioning themselves as "agents" under § 3504. The court’s interpretation makes clear that tax credits are not administrative tools—they are employment incentives reserved for those who make the hiring decisions. For Barrett, the loss was total: even if it had been designated as a § 3504 agent (a fact the court did not conclusively establish), it would still fail the eligibility test for WOTC and EZEC. The message to the PEO industry is unambiguous: if you are not the common law employer, you cannot claim the credits.

What This Ruling Means for PEOs and Taxpayers

The Tax Court’s ruling in Barrett Business Services delivers a clear, industry-shaking message: tax credits are not administrative tools for PEOs to wield—they are employment incentives reserved for those who make the hiring decisions. The court’s interpretation of § 51 (WOTC) and § 1396 (EZEC) leaves no ambiguity: only the common law employer may claim these credits, regardless of statutory employer status under § 3401(d)(1) or agent authority under § 3504. For PEOs—especially those operating under the co-employment model—the implications are stark.

For non-certified PEOs, the ruling eliminates any remaining doubt about their eligibility for WOTC and EZEC. Even if a PEO is designated as a § 3504 agent or qualifies as a statutory employer under § 3401(d)(1), it cannot claim the credits unless it is also the common law employer. The court’s reasoning hinges on the purpose of the credits themselves: Congress intended WOTC and EZEC to incentivize direct hiring decisions, not to serve as a backdoor for payroll intermediaries to monetize tax benefits. This aligns with the IRS’s long-standing position that employment tax credits are tied to the employer-employee relationship, not the payroll function.

For certified PEOs (CPEOs), the ruling does not directly address their eligibility, but it reinforces the importance of CPEO certification under § 3511. While CPEOs are not automatically entitled to WOTC or EZEC, their clients—who remain the common law employers—can still claim the credits if they meet the statutory requirements. The court’s focus on the common law employer test means that CPEOs must ensure their clients are the ones making the hiring decisions and retaining control over the employees’ work. This could lead to more stringent co-employment agreements that explicitly define the client’s role in hiring and supervision.

For taxpayers operating in empowerment zones or hiring from targeted groups, the ruling underscores the need for direct engagement with the hiring process. Employers cannot rely on PEOs to claim WOTC or EZEC on their behalf unless the PEO is also the common law employer. This may force some businesses to re-evaluate their PEO relationships, particularly if they were hoping to outsource the administrative burden of tax credit claims. The court’s emphasis on the 28-day pre-screening requirement for WOTC (IRS Form 8850) also means that employers must act quickly to certify eligible hires, as delays could jeopardize credit eligibility.

The ruling leaves several open questions that could shape future litigation or legislative action. First, the court did not conclusively determine whether Barrett qualified as a § 3504 agent, leaving unresolved whether such agents could ever claim WOTC or EZEC. Second, the decision does not address whether leased employees under a PEO arrangement could ever qualify for the credits if the PEO itself is not the common law employer. Third, the fate of EZEC—already on life support after the TCJA—remains uncertain, as the court’s ruling does not revive the credit but may influence future legislative efforts to expand or restore it.

For now, the Tax Court has spoken: if you are not the common law employer, you cannot claim the credits. PEOs must adapt by either restructuring their co-employment models to ensure their clients retain common law employer status or limiting their claims to employment tax withholding and remittance responsibilities. Taxpayers, meanwhile, must take ownership of the hiring process to maximize WOTC and EZEC benefits. The ruling also serves as a warning to the IRS: the Tax Court is willing to police the boundaries of tax credit eligibility with precision, and PEOs should expect increased scrutiny in audits. Whether Congress will step in to clarify or expand these rules remains to be seen—but for now, the message is clear: tax credits are not a PEO perk.