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Who's the Employer?

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

PEOs and Welfare Plans After Rev. Proc. 2002-21

(Posted May 9, 2002)

Question 178: Given that Rev. Proc. 2002-21 seems to treat PEOs as though they weren't the employer of their worksite employees, what affect does it have on cafeteria plans and other welfare or fringe benefit plans maintained by a PEO?

Answer: The ultimate answer is "It doesn't have any effect at all." However, some additional background will help explain that answer and, in the process, help practitioners better understand what Rev. Proc. 2002-21 does say about qualified plans.

In an effort to help PEOs and their clients understand the issues involved, relying on the various court cases that have looked at the PEO situation and what I know of their arrangements, I have given my opinion that PEOs are generally not the common law employer of the workers on their payroll. That is a broad generalization. There will be specific cases in which a PEO is clearly the common law employer of its worksite employees. But I'm not a government agency and so I can afford to make broad, sweeping generalizations.

The IRS doesn't have that particular luxury. In point of fact, Rev. Proc. 2002-21 never says "PEOs are not the common law employers of workers on their payroll." Rather, it says that the determination of whether the PEO is the common law employer is complex. It also reviews some of the cases I discuss in more depth in Chapter 4 of Who's the Employer in which courts have ruled that the CO is the common law employer. It also points out that if the PEO is not the common law employer, then the exclusive benefit rule is violated if it is the sole sponsor of its retirement plan.

In simple terms (with links to a more complete summary of the various points) the message of Rev. Proc. 2002-21 to PEOs is threefold:

You may have a serious problem.
If you follow our instructions, we'll make most of the potential problem go away.
If you don't follow our instructions, then whether or not you are the common law employer, you will have additional problems with your qualified plans, because you won't be able to rely on a determination letter after 2003.

The consequence of not being able to rely on a favorable determination letter is so serious that few, if any, rational PEOs will forego the opportunity to take advantage of Rev. Proc. 2002-21. Thus, they will either terminate their existing single employer plans or go with a multiple employer plan, whether or not they believe they are the common law employer of their worksite employees.

In this way, the IRS achieves the result of eliminating most or all single employer PEO plans without having to determine, on a case by case basis, whether a given PEO is the employer of its workers. The nice thing is that PEOs avoid the consequences of their prior exclusive benefit violations, and thus maintain the qualified status of their plans. It is a smart decision for the IRS because it enforces the law without undue strain on their resources. It is a good decision for PEOs because it gives them a roadmap to move to qualified status. It is a good decision for participants in PEO plans because they are freed from the cloud of potentially having their retirement plans disqualified, with potentially disasterous consequences.

So, with that in mind, let's look at the welfare issue. Remember that Rev. Proc. 2002-21 does not deal with welfare plans at all. It doesn't say that PEOs automatically are not the common law employers of their workers. So anything we derive from it in dealing with welfare plans is purely extrapolation. So what happens to a cafeteria plan, a health insurance program, or some other welfare benefit package that a PEO offers, if the PEO is not the common law employer of its workers?

The issue is complex because there are many types of plans, each with its own set of nondiscrimination requirements. But here are some of the issues that are raised:

Are the benefits excludable from the income of the workers? Arguably no, looking at the literal language of the Code. However, if the PEO is viewed as the agent of the Client Organizations, the benefits ought to be excludable, and it would be sound public policy for them to be excludable. The IRS has not raised this issue to my knowledge.
Are the benefits tested at the PEO's level or the Client Organization's level? If the CO is the employer, then for most benefits it would seem that the testing should be done at the CO's level.
Are the plans Multiple Employer Welfare Arrangements (MEWAs)? The DOL has opined in several cases that a PEO's welfare plans constitute MEWAs because at least one CO whose workers were included in the plan was the common law employer of the workers. If the plan (or the PEO itself) is a MEWA, then those arrangements are subject to state insurance regulation, which is a very serious concern in several states.
Are the deductions subject to the deduction limits of IRC sections 419 and 419A? If the arrangement is a MEWA, then the 419 deduction rules come into play very clearly.

These are obviously serious issues, and Rev. Proc. 2002-21 gives neither guidance nor relief for these issues. PEOs concerned about these issues would do well to have their legal advisors review their welfare plans carefully.

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.