Whenever I am working with someone new to employee benefits, one of the first comments I hear is "this is like learning another language." These novices are correct; employee benefits is a language unto itself and one of the most confusing terms is that of "leased employee." In the past several years, an increasing number of companies have begun utilizing staffing firms, also known as employee leasing companies or professional employer organizations (PEOs), to provide workers. The workers obtained through staffing companies are often mistakenly labeled "leased employees" when they should have been identified as common law employees. This article is designed to help you understand (1) how to categorize workers obtained through a staffing company and (2) what "leased employees" are.
To clarify some of the confusing terminology, let's start with the terms the Internal Revenue Service (IRS) uses in identifying the participants in a staffing arrangement. There is the PEO, which is the staffing company that enters into a service contract to provide workers (Worksite Employees) to a client organization (CO). The Worksite Employees are utilized as long-term workers, not merely as "temps" to replace a vacationing receptionist or to perform short-term special projects. It is essential that a CO determine whether or not the Worksite Employees are the CO's common law employees. There is no simple test for making this determination. However, in almost every court decision and Revenue Ruling that has addressed this issue, the CO has been held to be the true common law employer, and not the PEO.
Most of the decisions and rulings have utilized the 20-factor test of common law employee status. This test was originally used to distinguish between an independent contractor and an employee. In looking at the factors that would make the CO the true common law employer, there seems to be an emphasis on whether the Worksite Employee is performing services of a kind normally performed by an employee and is acting under the direction and control of the CO. There is a notable exception for a traditional "temp" agency that sends people to a variety of short-term assignments or a nurses registry. However, the typical scenario where a company leases most of its staff from a PEO almost always leaves the company - not the PEO - as the common law employer.
In some circumstances, a co-employer relationship has been fashioned between the PEO and CO. However, for employee benefits purposes, there is no legal recognition of a co-employer relationship. Therefore, one or the other, but not both, will be the common law employer.
If the Worksite Employees are the common law employees of the CO, then they must be counted for employee benefits purposes. While companies can design their plan documents to exclude Worksite Employees from participation, they should be careful of potential nondiscrimination testing problems. This could be especially problematic for companies that have a large portion of their workforce comprised of non-highly compensated Worksite Employees. For example, qualified retirement plans are subject to minimum coverage testing. If the retirement plan excludes all Worksite Employees and they are all non-highly compensated employees, the plan could fail the test. Self-funded health plans under Section 105(h) of the Internal Revenue Code of 1986, as amended (Code) could also face testing failures for excluding these employees.
In addition to benefits issues for Worksite Employees, the issue of payroll taxes can also be troublesome for companies utilizing PEOs. If the CO is the common law employer, then it is also liable for payroll taxes, even if the PEO is contractually obligated to pay them. Earlier this year the IRS issued Information Release 2004-47 (April 5, 2004) warning COs of their potential liability if a PEO fails to pay the required payroll taxes. In that Release the IRS stated:
"There are two primary categories of third party payers - Payroll Service Providers and Professional Employer Organizations. Payroll Service Providers typically perform services for employers such as filing employment tax returns and making employment tax payments. Professional Employer Organizations offer employee leasing meaning that they handle administrative, personnel, and payroll accounting functions for employees who have been leased to other companies that use their services. Many of these companies provide outstanding services to employers. Unfortunately, in some instances, companies of both types of services have failed to pay over to the IRS the collected employment taxes. When these employment service companies dissolve, millions in employment taxes can be left unpaid. Employers are urged to exercise due diligence in selecting and monitoring a third party payer. For example, when choosing a third party payer, employers should look for one that is reputable and uses the Electronic Federal Tax Payment System (EFTPS). This allows the business owner to verify payments made on their behalf. Also, an employer should never allow their address of record with the IRS be changed to that of the third party payer."
In its warning, the IRS cited both criminal prosecution and civil penalties for failure to remit payroll taxes.
Next, we address "leased employees." Code Section 414(n) - which applies to employee benefits - defines the term "leased employee" as one who is not the common law employee of the entity for whom they are performing services and who has performed services on a substantially full-time basis for the recipient employer/plan sponsor for a least one year. Thus, by definition, a common law employee is not a leased employee. If a Worksite Employee is the common law employee of the CO, then there is no leased employee issue. Leased employee issues only arise where there is a long-term temp worker. For example, Acme Widgets utilizes T-Account, Inc., a staffing company, to handle its bookkeeping. Assume that under the 20-factor test the Worksite Employees are the common law employees of T-Account. These Worksite Employees provide services to Acme for over one year. At the end of the year, the Worksite Employees will be the "leased employees" of the Acme. What does this require of the Acme?
Leased employees are treated as employees of the CO for both retirement and certain welfare plans (not self-funded plans under Code §105(h)). As stated above, a CO's benefits plans can be designed to exclude leased employee from participation so long as the nondiscrimination coverage tests are passed. Another concern with leased employees is crediting service for those who either participate in retirement plans as leased employees or become the common law employees of the CO and then participate. For purposes of both participation and vesting, the entire period for which the leased employee has performed services for the CO must be taken into account in accordance with Code Section 414(n)(4), whether or not the person was working full-time.
Returning to our example, Acme hires Debbie Credit, a Worksite Employee from T-Account, as its head bookkeeper. All of Debbie's service under the staffing/leasing contract with Acme, including the time she was still a common law employee of T-Account, must be credited for purposes of eligibility and vesting under Acme's qualified retirement plans. Acme also decides to hire Bill Pei as assistant bookkeeper. Bill has only worked at Acme for 3 months so he is not a leased employee. Nevertheless, Code Section 414(n)(4)(B) requires Acme to credit Bill's 3 months of service for vesting and eligibility purposes.
In conclusion, companies utilizing staffing firms should pay close attention to the employment status of the workers. The employee benefit plans need to be reviewed to make certain that they properly include and exclude the intended categories of workers. Another important consideration is payroll taxes. COs should make certain that PEOs are depositing the appropriate taxes in a timely manner or else face the possible liability themselves. Finally, if Worksite Employees are not the CO's common law employees, then they may be leased employees and it is important that records of their service be maintained for possible credit under benefit plans.
Andrea L. Bailey is a Partner with the law firm of Constangy, Brooks & Smith, LLC. She is based in the Atlanta, Georgia office, one of 13 offices across the country. The firm has exclusively counseled and represented management in labor and employment law matters since 1946. For any questions about this or other benefits issues, contact Andrea L. Bailey at email@example.com.