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Who's the Employer?

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

PEOs and Retirement Deductions

(Posted June 5, 2002)

Question 195: If a PEO elects to convert to a Multiple Employer Plan because its employees are determined to be common law employees of the Client Organization (CO), how can the PEO get a tax deduction for employer contributions made by the PEO to the common law employees of the CO?

Answer: Excellent question. I'm going to get hypertechnical in my response. Follow me down the path, though, and I think and hope it will make sense by the end.

Suppose back in 1999 a PEO set up a "safe harbor" money purchase pension plan, providing a fully vested 10% contribution for all worksite employees on their payroll. Compare that to the doctor next door, who also set up a 10% money purchase plan, fully vested, covering his employees. What's the difference? The doctor is using his own money to provide the pensions. But the PEO isn't. Rather, it is charging its clients for the pension money as a part of the PEO's fees, plus some overhead and profit. The PEO might pay the worker $10/hour, but it charges its client $16/hour (for example) out of which the PEO covers not only the worker's paycheck, but also his health and retirement benefits, unemployment and worker's compensation insurance, payroll taxes, pay for the various paperwork processing services that the PEO performs, and provides a profit for the PEO's owners. In other words, regardless of who puts the money in the plan, the Client Organization is the real source of the funds. If the client stops paying them, those workers aren't going to see very many more retirement contributions.

Now let's move to the situation you describe. The PEO is not the employer; the CO is. The PEO has gone to a multiple employer plan format because it is a violation of the exclusive benefit rule for the PEO to cover the workers directly. As a part of that format:

Coverage and nondiscrimination tests are run at the client's level.
Assuming the plan was set up after 1988, Code section 404 deduction limits are also applied at the client's level.

Click here for a fuller discussion of the multiple employer plan rules.

Technically speaking, who's contributing money under the plan for the worksite employees? The CO. But the PEO is the entity writing the check to the pension trust. Why is the PEO doing this for people who aren't the PEO's workers? Because the PEO is getting paid for doing it. The PEO is acting as the CO's agent in doing it. The PEO has contracted to act as the CO's agent and is being paid for doing so. So the expenses are deductible under Code section 162 as ordinary business expenses. In a very real sense, it is the CO that has the pension deduction, not the PEO.

Because we've established that the PEO is entitled to the deduction as an ordinary and necessary business expense of acting as the agent of the CO, it does not particularly matter which line of the tax return that expense shows on. I suppose a PEO could list on the "employee benefit plan" line of the return only the expenses for its own back office employees. It then would attach a separate schedule showing the retirement plan contributions it made as agent for its clients. But the tax result will be exactly the same if the PEO combines both portions of its contributions and puts them on the "employee benefit plan" expense line. Certainly nothing in Rev. Proc. 2002-21 requires the separate allocation. Either way, it is deductible.

On June 25 I will be giving a webcast regarding Rev. Proc. 2002-21. Click here for more information. Also, you can review detailed coverage of the Rev. Proc. at my web site.

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.