Answer: Let's take a look at the particular section to which the question refers: "In the case of a person who is an employee of the recipient (whether by reason of this subsection or otherwise), for purposes of the requirements listed in paragraph (3), years of service for the recipient shall be determined by taking into account any period for which such employee would have been a leased employee but for the requirements of paragraph (2)(B)."
IRC 414(n)(2)(B) says that a worker is a leased employee only if he or she has been performing services for the recipient on a substantially full-time basis for at least a year. That requirement is disregarded computing service for someone subject to section IRC 414(n)(4)(B). So, this section takes into account service during the period a person meets the other three requirements of leased employee status: (1) they aren't an actual employee of the recipient; (2) they are performing services pursuant to an arrangement between the leasing organization and the recipient; and (3) they are under the recipient's primary direction and control.
To facilitate discussion, let's refer to all persons who meet those three requirements as "leased workers." All leased employees are leased workers. A leased worker becomes a leased employee (and is treated as an employee) once he or she satisfies the substantially full-time test of IRC 414(n)(2)(B). Leased workers who are not leased employees do not have employee status under IRC 414(n)(1).
Section 414(n)(4)(B) says that if a worker is either a common law employee or a leased employee, then you must count all service performed while he or she was a leased worker.
With that definition, consider the following full-time (2,000 hours/year) workers at Recipient, Inc. In each case (unless otherwise specified) the worker is on the payroll of Sam's Staffing Firm, and works under Recipient's primary direction and control. Recipient has a calendar year plan and is determining hours of service as of 12/31/2001.
Ed Employee is a common law employee of Recipient, Inc., notwithstanding the fact that he is on Sam's payroll. IRC 414(n) does not apply to Ed. Ed is an employee of Recipient and Recipient must credit Ed with all hours of service at Recipient.
Lenny Lease is a common law employee of Sam. Lenny started working at Recipient 2/1/1999. Lenny was a leased worker as of 2/1/1999. Lenny becomes a leased employee on 2/1/2000 and hence is deemed to be Recipient's employee on that date. As of 12/31/2001, Lenny has three years of service. All time as a leased worker must be counted, including time prior to the date Lenny became a leased employee.
Sally Switch was Sam's common law employee when she started working for Recipient on 1/1/1999. Recipient hired her as a full-time employee on 9/1/1999. During the period from 1/1/1999 to 8/31/1999, Sally was a leased worker. Sally was never a leased employee because she did not satisfy the substantially full-time standard. She became Recipient's common law employee on 9/1/1999. She is credited with three years of service. Because of 414(n)(4)(B), we count the period she was a leased worker.
The question points out an inexactitude in the language of 414(n)(4)(B) in that 414(n) never technically defines "recipient." However, it is clear from the context that the recipient is simply the business for whom the worker provides services. Viewed in that light, Recipient, Inc. is the recipient of the services of all three workers described above.
The interpretation suggested by your question would have us restrict the definition of "recipient" to the person for whom a leased worker performs services. That position would say that once Recipient, Inc. hires Sally, Recipient, Inc. is no longer a "recipient" under 414(n) because Sally is no longer a leased worker. However, nothing in 414(n) requires that conclusion. Moreover, such an interpretation would effectively change the language in 414(n)(4)(B), applying it to "a person who is an employee of the recipient (whether by reason of this subsection or otherwise)." It would have the effect of changing that clause to "a person who is a leased employee of the recipient." That is not the choice Congress made, and we must interpret the entire passage so that all of it makes sense if we can.
Leased employee issues are discussed in more detail in Chapter 4 of my book, Who's the Employer?.