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Who's the Employer?

Answers are provided by S. Derrin Watson, JD, APM

Bootstrapping Employer Status

(Posted May 7, 2002)

Question 174: What if the staffing company (a PEO, as the industry defines it) employs not only the rank and file employees of the client company, but also employs the owner and manager of the client company? Because the employees then would be subject to the direction and control of a PEO employee, wouldn't the worksite employees be considered common law employees of the PEO? Should the single employer plan of such a PEO follow Rev. Proc. 2002-21?

Answer: This argument is one I discuss at length in Chapter 4 of my book, Who's the Employer, but here is a quick summary.

The primary fallacy of this argument is that the owner/manager can be the common law employee of the staffing firm, subject to its direction and control. Unless you establish that, the rest of the argument falls apart.

The classic discussion of this point came in the Tax Court decision in the Professional & Executive Leasing case. There, a staffing firm had a great idea. They said "Mr. Executive, we know you want great benefits for yourself, and don't want to give any benefits to your staff. So, why don't you come work for us and we'll lease you back to your own company. We'll provide you with a fine benefit package. Because your employees aren't on our payroll, they won't participate."

The IRS was not amused, and refused to give the company's plan a favorable determination letter on the grounds that the plan violated the exclusive benefit rule. These people were employees or self-employed individuals of their own companies, and were not subject to the direction and control of the "leasing company." The Tax Court agreed with the IRS and so did the Ninth Circuit Court of Appeals.

Since that case, it has been painfully obviously that if a staffing firm is covering the owners of its clients, it is -- without question, doubt, or argument -- violating the exclusive benefit rule.

Should such a firm use Rev. Proc. 2002-21? Absolutely, yes. It isn't even a close question. If such a firm doesn't use the Rev. Proc., it should look forward to the IRS knocking on the door in 2004 to audit and disqualify the plan. And the IRS will win that fight.

But let's suppose for a moment that the staffing firm gets lucky, and finds a judge who will go along with the argument. The staffing firm still should take advantage of the Rev Proc. Why? Because if it does not comply with the Rev. Proc., it will never again be able to rely on a determination letter from the IRS. For more discussion of this point, see my page on the consequences of noncompliance.

Choosing not to comply is not merely risky. It is foolhardy to the point of being suicidal, from a qualified plan standpoint. It's like bungee jumping using only a long piece of string. Don't try it.

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.