Under a typical employee leasing arrangement, a client company fires its employees, who are subsequently hired by an employee leasing company and leased back to the original employer by the employee leasing company.
There is a concern that employers may use PEOs, and employee leasing arrangements generally, to circumvent the tax rules requiring that employee benefits be provided in a nondiscriminatory manner (i.e., not preferring highly compensated employees).
PEOs assert that the employment relationship between the client-company and the work-site employees never terminates with the client company retaining the day-to-day control over the workers in carrying on the client-company’s trade or business, and, PEO becomes a “co-employer”, performing some functions typically associated with a common law employment relationship
- hiring and firing workers
- handling payroll
- providing employee benefits
- IRC § 414(n) creates a special class of employee termed a “leased employee,” considered an employee of a client company for purposes of nondiscrimination testing even though the employee is a not a common law employee
The common law employer must be identified to determine whether a:
- welfare benefit may be provided to a work-site employee under an employer’s plan and thus whether is excludable from gross income
- work-site employee must be considered for nondiscrimination testing
- tax-exempt entity may be used as a vehicle to provide welfare benefits
Authorities have mixed opinions on whether the PEO or the client company is the common law employer.
The service has not taken a formal position on who is the employer in employee leasing cases and has announced that it will not rule. However, in a 1998 Technical Advice Memorandum (TAM) the Service’s position was that leased employees are not per se employees of either the client company or the PEO; and, the facts must be analyzed in each case.
Thus, assuming a worker is a common law employee, the realistic possibilities in a three-party employment arrangement involving a PEO and a client company with respect to who is the employer are the following:
- the PEO is the common law employer, and the client company is the special employer (borrowed servant relationship);
- the PEO and the client company are both concurrent general employers of the work-site employee (dual employment);
- the PEO is the common law employer and the client company does not have an employment relationship with the worker; or
- the client company is the common law employer and the worker does not have an employment relationship with the PEO.
IRS news release advises how employers that outsource payroll functions can protect themselves from unscrupulous service providers (IRC §3402)
While most third-party payroll servicers provide quality service, there are some that leave businesses vulnerable to unpaid bills, the IRS announced, urging employers that outsource payroll functions to take certain steps to protect themselves and explaining the various classifications of providers. A third-party arrangement with a certified professional employer organizations (CPEO), payroll service provider (PSP), or reporting agent (RA) may be right for many employers, the IRS said, explaining that a CPEO, unlike other third parties, in most circumstances is solely liable for paying the customer’s employment taxes, filing returns and making deposits and payments for the taxes reported with regard to wages and other compensation it pays to its employees. The IRS recommended that employers (1) enroll in its Electronic Federal Tax Payment System and make sure a PSP or RA is using it to make tax deposits, and (2) use their own address (not the third party’s) as the address on record for tax correspondence purposes. Each year, a few service providers fail to remit the payroll taxes entrusted to them and close their doors abruptly, and in most instances the employer is still legally responsible for the taxes due just as are those who handle their own payroll duties, the IRS said. [IR-2020-186 (Aug. 19, 2020); FS-2020-12 (August 2020)]