As all employers know, during the past 10 to 15 years, payroll systems, employment taxes, benefits withholding and related payroll functions have become progressively more complex and burdensome. During the same period Congress has continued to add to employer payroll and administrative burdens with such acts as "COBRA" (Consolidated Omnibus Budget Reconciliation Act) and "FMLA" (Family Medical Leave Act). In addition, administrative aspects of benefit programs, such as 401(k) "pre-tax" withholding retirement plans, pre-tax and post-tax withholding health insurance and pre-tax flexible spending accounts, have gotten progressively more complex and administratively burdensome. This has proven particularly burdensome for smaller employers who cannot spread the cost over a large workforce.

Many employers in the construction industry have asked about a type of entity known as a professional employer organization ("PEO"). PEOs claim that if employers allow PEOs to put employees of the regular employers on the PEOs' payroll, the PEOs can administer payroll systems, handle the other administrative burdens referred to above, and provide benefits to those employees more cost-effectively than the employers themselves can. Employers must examine such claims closely because there are limitations on the legal capacity of PEOs to make benefits available to employees working for other employers, and the employers themselves may need to adjust benefits to other of their employees based on what a PEO does make available to the PEOs' "employees" working for those other employers.

WHAT IS A PROFESSIONAL EMPLOYER ORGANIZATION?
There is no one universally agreed definition of a PEO. The National Association of Professional Employer Organizations (NAPEO) website defines a PEO as an organization that provides an integrated and cost-effective approach to human resources administration by contractually assuming substantial employer rights, responsibilities, and risk, and by establishing and maintaining an employer relationship with the workers assigned to its clients. According to NAPEO, a PEO's contract with its clients provides that the PEO will:

Another definition was included by the Internal Revenue Service ("IRS") in Revenue Procedure 2002-21. The IRS described a typical PEO as an entity that makes an agreement with another employer (called a client organization or a "CO") whereby Worksite Employees (individuals who perform work at, and under the direction of, a CO) are placed on the payroll of the PEO, claimed as PEO employees, and claimed to be eligible to participate in PEO-sponsored employee benefit plans.

EVOLUTION OF PEOs
The current-day PEO evolved from earlier forms of a contingent workforce. Perhaps the first type of contingent workforce consisted of employees from temporary agencies. Businesses such as Kelly Services, Manpower and the like supplied employees to employers on a temporary basis either for a special project, or for a busy season. Those temporary employees remained employees of the temporary agency for most employment purposes. Their assignments at given employers were brief, and then they were reassigned to other employers who were also seeking their services temporarily.

Another step in the evolution was utilization of contingent workers in what was referred to as a two-tiered structure in which employers employed both regular employees and a second tier of employees. The second tier employees received lower wages, lower benefits and were always understood to be the first to go in case of a business downturn.

Originally, the two-tiered contingent workforces were designed to be temporary. They arose in times of business uncertainty when it was felt that hiring people without expectations of long term employment would make it easier to lay them off when business conditions warranted. However, as employers began to realize the savings associated with two-tiered systems, employers' desires to have a permanent contingent workforce grew.

Having a sizeable and permanent lower-tiered contingent posed some problems for employers in the employee benefits area, however. The problems centered, at least in part, on the non-discrimination rules that have been developed under the Internal Revenue Code ("Code") to prohibit employers from awarding disproportionately higher benefits to highly compensated employees under self-insured health plans and tax-qualified retirement plans.

Under the Code, employers are allowed to provide certain benefits to their employees on a tax-advantaged basis. With respect to self-insured health benefits, the tax advantages include no tax to the employee on the benefits received; with respect to retirement benefits, the advantages include no income tax on money contributed to a plan on an employee's behalf and accumulation of earnings in the retirement plan on a tax-deferred basis, such that employees pay taxes only when withdrawing money in retirement.

Under either type of plan, the tax-advantaged benefits are available only if, among other things, the employer does not discriminate in favor of highly compensated employees by providing disproportionately higher benefits to them. Accordingly, having a sizeable long-term lower-tiered workforce could cause an employee benefit plan to fail the non-discrimination tests if the benefits to the lower-tiered workforce continued to be lower than those paid to the regular employees.

At this point in the evolution, PEOs entered the picture, proclaiming that by placing the Worksite Employees on the PEO's payroll, the PEO could take over the burdensome payroll and administrative functions referred to above, and maintain its own benefit plans, at whatever level of benefits it chose, without having to compare the benefits received by the Worksite Employees to the other employees of the CO, thus eliminating the problem of discrimination in favor of highly compensated employees. This sounded so promising to many employers that PEOs proliferated rapidly once this concept began "making the rounds."

IRS POSITION
In May 2002, the IRS issued Revenue Procedure 2002-21, addressing the question of whether a PEO is permitted, under the Code, to maintain tax-qualified retirement plans providing benefits to individuals who perform services for a number of COs while on the PEO's payroll. The IRS concluded that PEOs may do so, but only if the plan qualifies as a "multiple employer" plan (as discussed below).

The IRS reviewed the basic requirement of the Code that tax-advantages are available to retirement plans only if the plans are maintained for the sole and exclusive benefit of employees of the sponsoring employer (in the case under review, the PEO). The IRS utilizes a common law test to determine who is an employer eligible to maintain such plans. The common law test assesses the "right to control" the work of an individual. If an entity has the right to control the duties and the time of performance by an individual, that entity is the employer; merely placing an individual on a payroll and paying them, without actually directing their day-to-day activities, does not qualify an entity as an employer.

Accordingly, the IRS concluded that a PEO may not maintain a single qualified plan for all CO employees on the PEO payroll whose work activities are not directed or controlled by the PEO, but who are instead directed and controlled by other employers (COs). Effectively, this means that the employees covered by the PEO benefit plans must be treated as employees of the actual employer--the CO.

The IRS ruled PEOs may cover the employees of several COs, but only through a "multiple employer" plan. Under a PEO "multiple employer" plan, the employees of each CO are tested separately under the Code's non-discrimination rules; and, any retirement plan actually maintained by the CO must be tested under the non-discrimination rules taking into account the CO employees on the PEO payroll (even though separately covered by the PEO plan). There are two significant risks for COs with the IRS ruling: (i) the tax advantages of the entire PEO plan are at risk if even just one CO group of employees does not pass the Code's non-discrimination tests; and (ii) the CO's separate plan (for example, covering the owner or key management) generally cannot meet the Code's non-discrimination rules unless it also covers the CO's employees covered by the PEO's plan.

The IRS gave PEOs until the end of the first plan year beginning on or after January 1, 2003 to correct the problem without jeopardizing the tax-favored status of the benefits already accrued by employees in the PEOs' plans. The IRS gave PEOs the option to either terminate the PEO's plan and distribute all plan benefits out to employees, or convert the plan so it meets the Code's requirements for a multiple employer plan. The IRS also ruled that PEOs must notify their COs of the course of action chosen by the PEO in this regard. For PEOs with calendar year plans, the IRS' notice deadline is May 2, 2003.

HEALTH CARE PLANS
In the health care area, a PEO that has Worksite Employees of several different COs on its payroll may be a Multiple Employer Welfare Arrangement ("MEWA"). A MEWA is an entity that generally provides self-insured health care benefits to employees of many separate employers. Generally, they are seen as vehicles through which several smaller employers may join together to provide benefits on a more cost-effective basis because of economies of scale and the pooling of risk among the greater population of employees that the several employer workforces represent. MEWAs are generally subject to state insurance regulation as well as certain federal regulation, and the benefits provided to an employer's employees through a MEWA must be taken into account when the employer runs the nondiscrimination tests to see that the self-insured health benefits provided to its remaining employees (those who do not receive benefits through the MEWA) remain qualified for tax purposes.

As a result, a PEO that is a MEWA is not a panacea for small employers. If a MEWA/PEO is operated in conformity with all applicable regulations, and if it provides complementary benefits that permit the employers' own benefit plans to remain eligible for favorable tax treatment, it may prove useful for an employer that investigates carefully.

ROLE FOR PEOs?
What may PEOs do? Certainly a PEO can take over the administrative functions of a payroll department, or even a human resources department, if the employer chooses to have a PEO do so. This will save the employer from having to employ a payroll department, from the administrative burden and expense of collecting and remitting employment taxes, and from other administrative duties inherent in the employer-employee relationship. A PEO may even be engaged as the third party administrator of an employer's benefit plans. However, under current law, except with regard to multiple employer plans and MEWAs as described above, the PEO may be engaged to perform any of those services only as the agent of the employer; PEOs will not be deemed the actual employer of Worksite Employees who do not perform services for the PEO.

Employers considering the use of PEOs must take care to ensure (with appropriately secured indemnification provisions) that if the PEO is employed as the employer's agent for the above purposes, the PEO will carry out the employer's obligations to collect and remit payroll taxes and operate the benefit plans, the worker compensation systems and similar aspects of the employment relationship appropriately because if the PEO fails to do so, it will be the employer's responsibility to "make it right," which could include additional penalties and taxes.

Another "hot button" issue for employers regarding PEOs is that a PEO, the same as any other business during economic hard times, may become insolvent. Because the PEO often is responsible contractually for employee contributions to employee benefit plans, and for the collection and payment of employment taxes, each CO of the PEO bears a risk that such funds are not properly handled and/or remitted. In such case, employees, health care providers and the IRS will certainly look to the CO for reimbursement of these funds even though the employer already paid such amounts through its contractual fees with the PEO.

It is possible that if the law is not changed, employers will conclude that they have little real reason to use PEOs and that the "old-fashioned" way of dealing with employees (having real personnel, payroll and human resources departments) is the best way to operate in the modern world.