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Who's the Employer?

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

PEOs in Controlled Groups

(Posted January 16, 2003)

Question 246: Company A leases approximately 90% of its employees to Company B. Companies A and B are in a controlled group. Company A maintains a 401(k) plan for its employees, including the employees leased to Company B. Does Rev. Proc. 2002-21 apply to this arrangement?

Answer: No, I don't think it does, but I surely do wish the IRS had taken the time to define PEO so we had a definitive answer.

Rev. Proc. 2002-21 offers relief from exclusive benefit rule violations to Professional Employer Organization (PEO) plans that follow procedures detailed in that revenue procedure. Implicit in the Rev. Proc. is the notion that most PEOs are not the common law employer of their workers (see Who's the Employer Q&A 175). I discuss this at length in my book. (Q 4:13. References to "Q" are to numbered questions addressed in the third edition of Who's the Employer; subscribers can click to view those questions.) Even if the PEO is the employer, the issue is frequently subject to doubt and disagreement.

Because of this implicit assumption, and the difficulties of making a determination of employee status, the relief is crucial. I believe that the risks of ignoring the Rev. Proc. are so great that I have compared them to bungee jumping using only a string. (Q 4:51.)

Unfortunately, the Rev. Proc. fails to define its most important term, "PEO." So we have to glean that definition from everyday usage and from the purposes of the revenue procedure. (See, e.g., Who's the Employer Q&A 220.)

When I do that, I think one must come to the conclusion that Company A is not a PEO. If A and B were unrelated, it would surely be a PEO, in my view. But with the two businesses in a controlled group, I do not see Company A as subject to the revenue procedure. This issue is crucial here because if Company A is subject to Rev. Proc. 2002-21, and it does not comply with the Rev. Proc., then it will not be able to rely on IRS determination letters after the end of 2003. (Q 4:51.)

Company A is at absolutely no risk whatsoever of being found in violation of the exclusive benefit rule. Because it is in a controlled group with B, all employees of A and B are deemed to have a single employer for most retirement plan purposes, including the exclusive benefit rule. (Q 10:2.) As a result, the core issue in the Rev. Proc. is completely inapplicable. I cannot envision the IRS viewing Company A as a PEO under these circumstances.

In my book, I give two possible alternative definitions of PEO:

A PEO is any organization that provides workers to other companies. In the parlance of IRC §414(n), a PEO would be a “leasing organization.”
Alternatively, a PEO is an organization that, as a significant or principal part of its business, provides workers to other companies. (See Q 4:2 for further discussion.)

The key to either definition is that the PEO is providing workers to other companies. But because A and B are in a controlled group, they are treated as being the same company for purposes of the exclusive benefit rule.

Incidentally, I will be addressing the Rev. Proc. at two upcoming conferences. The first is ASPA's Los Angeles Benefits Conference, where I should be joined on the podium by Richard Wickersham of the IRS. The second is Corbel's Advanced Pension Conference in Orlando, Feb. 12-14, 2003. At that conference I will also be discussing how to analyze controlled group and affiliated service group situations, as well as new developments in the 401(k) world.

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.