Can Government Contractors Qualify for Employment Tax Refunds?

At a glance

• The main takeaway: For government contractors, the key to obtaining employment tax refund eligibility is meeting the definition of successorship, but there are varying definitions of eligibility for Social Security/FUTA and State Unemployment Insurance tax.
• Assess the impact: Since government contractors often acquire contracts and not assets, the road to capturing employment tax refunds may be more complex than it is for other companies.
• Take the next step: Aprio’s Employment Tax team can help you determine whether your organization should be eligible for refunds, document the technical basis for eligibility, and capture applicable refunds through the amended return process.

Schedule a free consultation today to learn more!

The full story:

Has your organization experienced internal restructurings, acquired/merged with another business, or acquired and staffed new projects in the middle of a tax year?

If you answered yes, you may have left money on the table with respect to payroll taxes. It’s not uncommon for employers, such as yourself, to question applicability for both federal and state employment tax refunds since the road to securing these valuable refunds can be complex. Third-party payroll providers generally do not advise on this opportunity or actively pursue on behalf of their clients, and internal payroll departments may not be well-versed in the eligibility and recovery requirements of these tax refunds.

However, the key to unlocking most federal and state employment tax refund eligibility is meeting the definition of successorship for employment tax purposes. It is important to note that this definition will vary in terms of eligibility for Social Security, Federal Unemployment Tax Act (FUTA), or State Unemployment Insurance (SUI) successorship. In all instances, qualifying for successorship and being eligible to capture these refunds can become multiple lanes merging into a single road.

Understanding Federal Successorship (Social Security/FUTA) eligibility

Successorship for federal employment tax purposes may generally be met when:

“[An] employer (successor) acquires substantially all the property (1) used in a trade or business of another employer (predecessor), or (2) used in a separate unit of a trade or business of a predecessor, and, in connection with or immediately after the acquisition (but during the same calendar year), the successor employs individuals who immediately prior to the acquisition were employed in the trade or business of the predecessor.” IRC Section 3121(a)(1).”

While in most cases successorship may seem fairly straightforward, complexities with respect to eligibility for refunds may arise in several instances:

1. When no actual assets are acquired as a result of a new contract acquisition, and the prior provider’s employees are transferred to another organization to satisfy the staffing requirements along with the use of the ultimate client’s assets, successorship may apply but should be closely analyzed for applicability.
2. Only a portion of a business is acquired, say one manufacturing facility out of three, or if one division of employees is transferred to a new entity, the thought is often that successorship is not met because ALL the assets/employees did not move in the transaction. Note the second successorship qualifier above, i.e. the transfer of a separate unit of a trade or business to another employer. Consider prior transactions where only portions of another business, or a division in an internal reorganization was transferred.
3. Moving business and employees between payroll systems due to a transaction often makes real-time continuation of year-to-date (YTD) taxable wage bases impossible or too time consuming to implement. This does not mean that successorship is not met, and refunds are often left on the table because of system constraints that may be mitigated because of the post- transaction refund process.

Application of successorship to certain government contractor transactions

IRS Revenue Ruling 68-105 provides an additional definition of successorship that has specific relevance in the government contracting space. Specifically, Revenue Ruling 68-105 details the transfer of the USE of U.S. government property when a contract is transferred from one vendor to a second vendor, and the relevance towards successor status. The transfer of the property used by the first employer to the second employer in the Revenue Ruling case was memorialized by an inventory accounting arrangement transferring the USE of the property from the prior vendor to the successor vendor. In that case, the IRS determined via the Revenue Ruling that:

“[b]ecause the second employer obtained the possession and use of all of the Government owned property used by the first employer it satisfies the requirement of acquiring substantially all of the property used in the separate unit of the trade or business.” 

Additionally, the Revenue Ruling goes on to state that “it is immaterial that the second employer did not acquire an interest in the property used..”

The statute of limitations on capturing prior period federal employment tax refunds is three years from the due date of filing the original Forms 941 for the applicable tax year. The earliest open year for filing refunds via Form 941-X is 2021, since the 2021 Forms 941 were due by April 15, 2022, expiring April 15, 2025. Form 940 is due January 31 of the tax year, so the statute of limitations for FUTA (Forms 940) refunds runs back to 2022, with a deadline of January 31, 2026.

Complexities of State Unemployment Insurance Successorship (SUI) eligibility

SUI tax successorship is often more complicated than federal employment tax because the definition of successorship varies from state-to-state, as do statutes of limitations and deadlines for requesting successorship. There are also potential negative consequences in being considered, or accepting, successorship for SUI purposes since the carry-over of YTD wages could also entail accepting the prior employer’s unemployment experience. Sometimes a short-term gain in YTD taxable wage base continuation can be negated by a longer-term increase in unemployment tax rates. As a result, prospective and prior period successorship positions should be considered on a state-by-state basis, and include:

• An in-depth review of unemployment tax rates,
• Recent history (e.g. has the prior company experienced layoffs that will impact the SUI rates in the future but are not included in the rate structure yet), and
• Impact via state law.

In the event of a transfer of employees between related legal entities, successorship almost always applies and is generally mandatory, with some notable exceptions, and should be considered for both taxable wage base and experience rate transfer purposes.

Next steps to exploring employment tax refund eligibility

While exploring refund applicability in both the federal and state context, it is important to note an employer may need help from the predecessor to quantify and capture the refunds or at least have the ability to gain access to payroll records in the event of an unrelated party transaction. That is to say, in order to take the taxable wage base carryover afforded by successorship, a successor employer will generally need to have access to details of the YTD taxable wages paid to the employees’ pre-transaction to file for the refunds.

Despite a myriad of issues to be concerned within the payroll tax space, not to mention day-to-day payroll processing, it may be worthwhile to take a step back and look at transactions dating back to 2021 and see if hidden opportunities are on the table. In addition, prospective planning for upcoming transactions may help in properly documenting successorship in real time, and avoid a retroactive refund requirement.

Feasibility with respect to potential refunds is a fairly easy process, although recovery can be a bit complex, but capturing cash from historical transactions can certainly be gratifying.

The bottom line

Aprio’s Employment Tax team has vast experience in the world of employment tax. We can help you determine your eligibility in claiming a refund by meeting the definition of successorship for employment tax purposes. 

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