Professional Employer Organizations (PEOs) are among the fastest growing employment trends, particularly within the health care industry. The National Association of Professional Employer Organizations (NAPEO), the national trade association for PEOs, estimates on its website that the average PEO has grown more than 20% each year for the last six years, and PEOs now employ between 2 and 3 million workers in the United States. An offshoot of employee leasing arrangements, PEOs differentiate themselves from leasing arrangements by the intended permanency of the PEO employment relationship, as opposed to the temporary, projectoriented nature of most leasing arrangements. In the typical PEO scenario, the PEO hires all or a significant portion of the existing employees (the Worksite Employees) of an established entity or business unit, with the Worksite Employees continuing to supply the same services to the original employer (the Client Organization).

An analogy to a famous childhood nursery rhyme best describes the workings of a PEO: When it is good, it is very, very good and when it is bad, it is horrid. The problem is that PEOs, as institutions, have grown more quickly than the employment, tax and employee benefit laws that govern them, which remain woefully far behind.

The workings of each PEO arrangement are negotiated between the PEO and the Client Organization. In general, the PEO becomes the employer of record for the Worksite Employees and assumes all payroll and human resources functions. The PEO provides the payroll, employment and tax withholdings, employee benefit plans, workers’ compensation, state unemployment insurance, as well as COBRA and HIPAA administration and compliance. Usually the PEO has the authority to hire, discipline and fire employees, but normally the day to day supervision resides with the Client Organization. The negotiated terms may vary, but typically, the PEO and the Client Organization share responsibility for employment law compliance. As a result, in most instances, a “joint-employer” relationship is established. The PEO is the employer for payroll, employment and tax withholding purposes and for some employment law responsibilities, and the Client Organization is the employer for employment responsibilities, depending on how the responsibilities are broken down between the two parties.

The treatment of employee benefit plans in a PEO context is tricky. In most instances, the IRS views the Client Organization as the common law employer, primarily due to the Client Organization’s exercise of the right to direct and control the Worksite Employees on a daily basis. This can be a problem, as one of the motivating factors for a Client Organization to contract with a PEO is to pass employee benefit plan responsibility to the PEO. As a result, the defined contribution retirement plans offered by most PEOs (usually 401(k) plans) are set up as multiple employer plans, in accordance with IRS Revenue Procedure 2002-21. (Multiple employer plans are not to be confused with “multiemployer plans” which provide benefits only to employees whose benefits are negotiated pursuant to collective bargaining.)

A multiple employer plan is defined under Section 413(c) of the Internal Revenue Code of 1986, as amended (the Code), as a plan that provides benefits to employees who are employed by two or more employers that are not within the same controlled group under Code Section 414. By providing a multiple employer plan with each Client Organization adopting the plan as a participating employer, the PEO does not violate the “exclusive benefit rule” that requires tax-qualified retirement plans of single employers to provide benefits for the exclusive benefit of their own employees. However, multiple employer plans that provide defined contribution retirement benefits are complicated and somewhat risky. (The status of defined benefit pension plans sponsored by PEOs is unclear, as the plans are not covered by Revenue Procedure 2002-21, although many commentators believe that the same principles should apply.) Under a multiple employer retirement plan, each Client Organization that has adopted the plan must individually satisfy the coverage, nondiscrimination and top-heavy tests. Therefore, a Client Organization that incorrectly runs one test can threaten the tax-qualification of the plan for all other participating Client Organizations. Further, a Worksite Employee who is employed or has been employed by more than one Client Organization participating in the plan is entitled to eligibility and vesting credit based on the Worksite Employee’s aggregate service with those Client Organizations. This can be expensive for the Client Organizations, as well as a significant administrative burden.

Welfare plans (medical, dental, prescription drug, life insurance, etc.) are not covered by Revenue Procedure 2002-21 and their status in the PEO context is unclear. However, the Department of Labor has taken the position that a welfare plan covering employees of two or more unrelated employers is a multiple employer welfare arrangement (MEWA) that could subject the plan to onerous state insurance laws, a particular problem when the Worksite Employees are in multiple states.

For purposes of Equal Employment Opportunity (EEO) claims brought by Worksite Employees, the Sixth Circuit (covering Michigan) has determined co-employment by evaluating “authority to hire, fire and disciple employees, promulgation of work rules and conditions of employment, issuance of work assignments and instructions, and supervision of employees’ dayto- day activities.” EEOC v. Regency Windsor Mgmt. Co., 862 F. Supp. 189, 191 (W.D. Mich. 1994). However, for purposes of the Fair Labor Standards Act, the courts have determined coemployment status by applying an economic realities test, which considers (1) the nature and degree of the putative employer’s control of the workers; (2) the degree of direct or indirect supervision of the work; (3) the direct or indirect right to hire, fire or modify work conditions; (4) the power to determine pay rates or methods of wage payments; (5) the payroll preparation and payment of workers’ wages; (6) the ownership of facility where work occurred; (7) whether the worker performed a line job integral to the end product; and (8) the relative investment in equipment and facilities. See Aimable v. Long & Scott Farms, 20 F. 3d 434 (11th Cir. 2004).

PEOs provide a valuable service to small and midsize companies that want to shed payroll and human resource functions and gain access to employee benefit plans that otherwise would be unavailable on a cost-effective basis. However, until the employment and benefit plan laws catch up with the current marketplace, employers entering into PEO arrangements must make themselves comfortable with the legal uncertainties associated with many facets of common law and joint employer designations.