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.