According to a recent survey, 88% of small businesses think that tax laws are too complicated for them to handle payroll on their own. It’s evident how expensive little payroll mistakes have become when you add in the 13.6% rise in IRS collections from unpaid taxes and penalties. The issue is that most owners don’t really know how to file their PEO taxes until they see anything unusual on their W-2s. Knowing the real PEO tax effects upfront will help you avoid a lot of trouble, time, and money later.
If you miss a deadline or make a mistake in your calculations, you could face fines or audits. In 2026, this risk will only get worse with remote teams and hiring across state lines. When you use a PEO, the key concerns are simple: who pays the taxes, who is responsible, and how do you keep track of earnings without causing accounting problems?
A PEO files taxes for its clients by gathering wage and tax information from all of them and completing Form 941 under its own EIN. The PEO’s larger submittal includes information about your employees’ earnings, withholdings, and tax payments. You still have to pay taxes, but the PEO does all the math, reporting, and sending of money.
This is more important than you might believe. Only 34% of small businesses hire outside companies to handle payroll, and only 21% use third-party software or platforms. That means that most small businesses are trying to deal with this on their own, even if they may not have the skills to do it perfectly.
Only 78% of payroll processes are correct on average around the world, and 18% of employees had payroll problems happen three or more times in a single year. When the IRS looks into them, those are not little problems.
When you work with a PEO, your own team usually stops submitting payroll taxes, and the PEO’s systems and experts take over.
Here is what usually happens:
This arrangement cuts down on mistakes a lot. The IRS says that the amount of fines and interest it collects on payroll taxes has gone up by more than 13% in the past few years. This is mostly because people make mistakes when they file their taxes and miss deadlines. A PEO lowers that risk by making compliance more centralized.
How state tax reporting works is one of the most misunderstood parts of PEO tax ramifications. Different states have different rules about PEO partnerships.
In some states, the PEO is the official employer for some payroll taxes. The PEO’s Employer Identification Number, or EIN, is used to file taxes.
The client company is still the official employer in this case. Even though the PEO takes care of the filing, your company’s EIN is used to pay the taxes.
Some states need a mix of both. A unique PEO reference ID connects the PEO to the client’s state unemployment account.
It’s very important to work with a PEO that keeps an eye on these standards because they change a lot, especially as we get closer to 2026.
The key is transparency. Most modern PEO platforms provide detailed payroll reports that make reconciliation straightforward.
Another area where PEO tax responsibilities often confuse is year-end reporting.
This design makes it easier to run things at the end of the year and lowers the risk of reporting errors.
Tax liability depends on your contract and whether the PEO is certified.
The IRS has authorized Certified Professional Employer Organizations, or CPEOs, and they meet severe financial standards. In a CPEO arrangement, the PEO takes care of federal employment taxes, which gives the customer further protection.
This extra level of protection is one reason why more firms are choosing certified suppliers in 2026. Only approximately 21 percent of small businesses fully trust the integrity of their own payroll.
It’s 2026, and a number of new rules are making it harder for PEOs to file taxes and follow payroll rules. You could have trouble following the rules even if a PEO is in charge of your payroll if you don’t know about these changes.
There is a part of the SECURE Act 2.0 that went into force this month. People who are 50 or older and made at least $150,000 in 2025 must now make catch-up contributions to their 401(k), 403(b), or certain 457(b) plans on a Roth (after-tax) basis. Your payroll system needs to find the affected employees based on their W-2 wages from the previous year and send their catch-up payments to the right place. You need to get in touch with your plan provider right away if your plan doesn’t offer a Roth option.
Several states will start offering new Paid Family and Medical Leave programs in 2026. Minnesota started taking money out of paychecks on January 1, 2026, and benefits started in 2027. For wages up to $185,000, the combined employee and employer rate is 0.88%. Maryland’s program was supposed to start in the middle of 2025, but it was pushed back, and now employers have to join by January 2027.
There are some tax effects that come with these PFML programs. When an employer pays the employee’s part of PFML payments (called “employer pick-up”), that money is considered taxable income for income tax, FICA, and FUTA purposes. This changes how earnings are recorded on W-2s, and it needs to be accurately shown in PEO tax calculations.
On January 1, 2026, minimum wage increases went into effect in many states and towns. Many states currently tie pay increases to inflation, so the rates adjust every year without any new laws. Your PEO should be keeping track of these automatically and changing payroll as needed, but be sure they are using the right state and local minimums based on where your employees actually work.
For more than 25 years, we’ve helped businesses in Connecticut deal with the difficulties of paying payroll taxes. We know everything there is to know about PEO taxes because we deal with them every day for hundreds of client organizations.
When you choose us, you get more than simply payroll processing. You’re getting a partner who makes sure your PEO tax file is correct, on time, and meets all the rules in all the places where you do business. We take care of the hard parts so you can focus on running your business instead of worrying about whether you’re correctly withholding Connecticut income tax.
Let’s speak if you’re currently doing payroll taxes on your own or if you’re dealing with a supplier that doesn’t make it clear how to record earnings while using a PEO, and other tax issues.
We offer a free consultation in which we go over your present position, explain how our PEO tax management works, and show you what it would be like to work with us for your business. Want to know more? Please fill out our contact form or call 860.528.5555.
FAQs
Liability depends on the contract and whether the PEO is certified. CPEOs generally assume federal employment tax responsibility.
Wages are recorded based on the PEO’s payroll invoice, with gross wages, employer taxes, benefits, and fees categorized correctly in your accounting system.
Yes, in most arrangements, the PEO issues W-2s using its EIN for employees covered under the PEO agreement.
Yes, PEOs are designed to manage varying state and local tax rules, which is especially valuable for remote and distributed teams.