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BenefitsLink > Q&A Columns >

Who's the Employer?

Answers are provided by S. Derrin Watson

Watson's Take on PEO Controversy

(Posted April 9, 2002)

Question 153: Recently, the BenefitsLink newsletter has highlighted conflicting articles by the Center for a Changing Workforce and the National Association of Professional Employer Organizations. What's your take on the situation?

Answer: PEOs or staffing firms provide a useful service in our economy. The value that the marketplace puts on these services is shown by the millions of workers who are currently on the payroll of such organizations.

Of course, the choice to use such firms rests primarily with their client, the company for whom the workers perform services. There are many reasons an employer might choose to use such a firm, and different firms indeed have different reasons. Some want the better benefits that the purchasing power of a larger organization, such as a PEO, can provide. Some want the convenience of having someone else do payroll tax forms. (I have seen the IRS virtually insist that a small employer use such an arrangement in order to make sure that payroll taxes would be handled properly in the future.) Some want to move some or all of their employees into a lower benefit structure.

Whatever the company's reason, in a free society the worker always has a choice. The worker can accept the arrangement, or can peddle his services elsewhere. That's the joy of a relatively free market economy. You can vote with your feet. Whether involvement in a particular PEO or staffing firm arrangement will be good for a particular worker will depend heavily on the terms of that arrangement and the other opportunities available to the worker.

NAPEO is quite concerned about distinguishing its members from other types of arrangements, and does not want its members referred to as "staffing firms" or "payrolling arrangements." And certainly there are significant differences between the different firms and the arrangements that they offer. Any company contemplating such an arrangement would be well advised to determine carefully its own goals, shop around, see what is available, and make an informed decision after consulting with its professional advisors.

I am not nearly as concerned with what a relationship is called as I am with the effects of that relationship on tax and retirement plan obligations. Those effects will be determined by the substance of the relationship, not by the label affixed to it. That principle is the centerpiece of decades of litigation over worker tax status.

This is why I have said for years that most such arrangements leave the client, or recipient, company as the common law employer of the workers. To that end, I appreciate NAPEO's repeated assertion that "The employment relationship with the original employer continues and is expected to continue should the PEO arrangement be terminated." Indeed that is so; case after case has found it to be so.

In light of that admission, I am quite puzzled by NAPEO's statement that:

Section 414(n) of the Internal Revenue Code provides that for the purpose of determining whether a client discriminates in providing retirement benefits to its employees, a “leased employee” is treated as an employee of the client and benefits provided by the PEO are treated as being provided by the client for that purpose.

In admitting that workers on their payroll are still employees of the companies for which they are providing services, NAPEO has admitted that those workers are not leased employees. The first requirement of leased employee status is that the worker not be a common law employee of the recipient, a requirement NAPEO correctly admits is violated in their arrangements. The Ninth Circuit's Burrey decision makes this point very clearly.

Without the 414(n) leased employee rules, there is absolutely nothing in the Internal Revenue Code or any IRS pronouncement that would treat the benefits the PEO provides as being provided by its recipient client for testing purposes. The only way the client can take advantage of those benefits is to cosponsor the plan.

And frankly, that may be the only way that the PEO or staffing firm can provide those benefits. Because while there have been many cases asserting that the client recipient is the common law employer of the workers, there has been virtually no case which has held for retirement plan purposes that the PEO is also a common law employer. As for NAPEO's assertion that a "co-employer" relationship exists, the IRS disagrees. GCM 200017041, which I've recently posted on my Resources page, puts the matter very bluntly: "The concept of a 'co-employer' is not recognized in Subtitle C of the Internal Revenue Code."

This is why there is a need for legislation to clarify the situation of staffing firms/PEOs. Over the years there have been several proposals, some of which are mentioned in NAPEO's paper. As far as I'm aware, none has gotten out of committee, largely thanks to the opposition of organized labor.

But such firms cover an increasingly large segment of the American workforce, and their workers should not be left in a legal limbo. What we have now is a confusing and awkward situation, in which many employers do not realize they are walking into a huge trap.

I discuss leasing arrangements and the possibility of dual employer arrangements in a staffing firm or PEO context at length in chapter 4 of my book, Who's the Employer.


Important notice:

Answers are provided as general guidance on the subjects covered in the question and are not provided as legal advice to the questioner or to readers. Any legal issues should be reviewed by your legal counsel to apply the law to the particular facts of this and similar situations.

The law in this area changes frequently. Answers are believed to be correct as of the posting dates shown. The completeness or accuracy of a particular answer may be affected by changes in the law (statutes, regulations, rulings, court decisions, etc.) that occur after the date on which a particular Q&A is posted.


Copyright 1999-2017 S. Derrin Watson
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