Rev. Rul. 58-26

Advice has been requested whether (a) a surety corporation or (b) a state board of education is the employer, for Federal employment tax purposes of individuals working on a school construction project under the circumstances described below.

A construction company entered into a contract with a State board of education to construct a public school building for an agreed amount. In connection with such contract, a surety corporation executed a performance bond on which the construction company was named the principal obligor and the board of education the obligee. The bond provided, among other things, that the board was to be saved harmless from loss, cost, or expense by reason of the contract; and, in event of default by the contractor, the surety would not be liable for any obligations incurred by the contractor prior to such default. Shortly before the contract was completed, the construction company defaulted in its performance and failed to complete the construction of the school. As the result of such default, the surety corporation entered into an agreement with the board of education whereby the surety would complete the project, using the same labor crews theretofore engaged by the defaulting contractor, but under the supervision of the surety's own agent, in order that the building would be ready for use at the beginning of the school term. As a matter of convenience, the board agreed to supply the cash for the weekly payrolls, and the Federal employment taxes applicable thereto, out of contract monies remaining in its hands. Such cash was deducted from the payments due from the board on the construction contract. The weekly payrolls were subject to approval by the surety's agent.

It is evident from the facts presented that the surety corporation assumed control of the unfinished construction project in accordance with the provisions of the executed bond in order to save the board from any loss, etc., which might occur by reason of the contract described above. It appears that with respect to the payment of wages and the withholding of the applicable taxes, the board did so on behalf of the surety.

It is the position of the Internal Revenue Service that in a case such as this, where, upon default by a construction contractor, the contractor's surety assumes control of the project and the employees working thereon, the surety becomes the employer of such employees for purposes of the Federal employment tax statutes.

In view of the foregoing, it is concluded that from the time the surety corporation took over the construction project until it was completed, it was the employer, for purposes of the Federal Insurance Contributions Act (chapter 21, subtitle C, Internal Revenue Code of 1954), of the laborers working on such project. The wages paid by the board to such workers on behalf of the surety corporation and the Federal employment taxes applicable thereto should be included on the surety corporation's Federal employment tax returns.

This conclusion is also applicable with respect to the tax imposed by the Federal Unemployment Tax Act and for purposes of the Collection of Income Tax at Source on Wages (chapters 23 and 24, respectively, subtitle C, Internal Revenue Code of 1954).

In taking the position that the above conclusion is applicable for purposes of the Collection of Income Tax at Source on Wages, consideration was given to Revenue Ruling 54-471, C.B. 1954-2, 348. In that case an advertising agency was engaged by a State citrus commission to assist it in demonstrating citrus products. The demonstrators employed to perform the services were paid by the advertising agency (from its own funds), which in turn billed the commission for the amounts disbursed, plus a commission on each demonstrator, and received payment from the commission. That ruling held that, although a common law relationship of employer and employee existed between the State citrus commission and the demonstrators, the advertising agency had control of the payment of `wages' to the extent contemplated by section 3401(d) of the Internal Revenue Code of 1954 and was the employer of the demonstrators within the meaning of that section for the purpose of withholding of Federal income tax on `wages.' The facts in the instant case are distinguishable from those in Revenue Ruling 54-471, supra , in that the surety, who became the common law employer of the labor crews upon the contractor's default, also paid, or controlled the payment of, their wages by arranging with the school board to pay such wages as shown on payrolls approved by the surety's agent out of monies due the surety for completing the contract, or in effect out of the surety's own funds.

It may be pointed out that the conclusion reached in this case does not necessarily apply to all cases in which a surety, under the provisions of a bond, guarantees the covenants and agreements undertaken by a contractor. Each ruling must be based upon the facts in the particular case, especially in view of possible variations in the bond agreements. Compare United States v. Phoenix Indemnity Co. et al. , 231 Fed.(2d) 573, and General Casualty Co. of America v. United States , 205 Fed.(2d) 753.

In both of the above cases, the issue related to the liability of sureties for defaulting contractors. In the Phoenix case it was determined that, based on the provisions of the bond under which the sureties guaranteed the performance of all covenants and agreements undertaken by the contractor, which included an agreement to pay all taxes collectible because of the work , the sureties were liable for all taxes payable prior, as well as subsequent, to the default. Thus, the liability of the surety, as determined by the court in this instance, was based upon its contractural liability and not upon the existence of an employer-employee relationship. Under the circumstances present in the General Casualty case (in which all withheld taxes subsequent to default had been fully paid), the court held that, prior to the contractor's default, the surety had no control over the payment of wages and could not be classed as the employer for that period; also, that it was not liable under any provision of the bond to the United States for taxes withheld by the principal prior to default which the latter failed to pay to the Government.