Section of Taxation Publications
  VOL. 55
NO. 1
FALL 2001
Contents | TTL Home

 Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
 Welfare Benefits Provided by PEOs
John B. Richards

Attorney-Advisor, Internal Revenue Service, Office of Chief Counsel. DePaul University College of Law, J.D., 1997; Georgetown University Law Center, LL.M. Candidate, February 2002. The views expressed in this article those of the author and do not necessarily represent the position of the Internal Revenue Service. Thanks to Patricia M. McDermott, Michael A. Thrasher, and Mary Oppenheimer for their helpful comments. Special thanks to my wife JoAnn for her help and support.


A. The PEO Industry

A professional employer organization (PEO) provides a client with workers who traditionally would have been on the client's payroll and treated as its employees. A PEO enters into an agreement with a client company to manage the human resources aspect of the client's business. The agreement usually makes the PEO responsible for hiring and firing workers, managing payroll (including withholding and paying state and federal payroll taxes), and providing employee benefits. In addition, a PEO takes on an employer's responsibilities extending beyond payroll and benefits to compliance with employment laws, such as the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA), the Health Insurance Portability and Accountability Act (HIPAA), the Family and Medical Leave Act (FMLA), the Americans with Disabilities Act (ADA), and state and federal discrimination laws, such as Title VII of the 1964 Civil Rights Act.

PEOs typically offer health insurance, retirement savings plans, and other employee benefits associated with a traditional long-term employment relationship. PEOs enjoy economies of scale that allow them to provide employee benefits at a lower cost than if the client provided the benefits. Indeed, in many cases, employees who receive benefits, such as health insurance, would not receive these benefits but for the client's relationship with a PEO. The National Association of PEOs (NAPEO) estimates that two to three million Americans are currently employed under a PEO relationship and that there are approximately two thousand PEO companies paying wages and providing employee benefits of more than $18 billion annually. According to NAPEO, the industry is growing by 20%-30% per year.

PEOs distinguish themselves from employee leasing companies. Under a typical employee leasing arrangement, a client company fires its employees, who are subsequently hired by an employee leasing company and then leased back to the original employer by the employee leasing company. PEOs assert that the employment relationship between the client company and the work-site employees never terminates. Instead, the PEO becomes a "co-employer," performing some of the functions typically associated with a common law employment relationship, such as hiring and firing workers, handling payroll, and providing employee benefits with the client company retaining the day-to-day control over the workers in carrying on the client company's trade or business.

B. Why PEOs Cause Concern

Although PEOs clearly do provide some employees with benefits they otherwise would not receive, there is 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. For example, a company could circumvent the rules by labeling the PEO or leasing company as the employer so as not to provide, or to reduce substantially, the benefits provided to work-site employees. Section 414(n) of the Code creates a special class of employee termed a "leased employee," who is considered an employee of a client company for purposes of nondiscrimination testing even though the employee is a not a common law employee of the client company. This provision reveals Congress' intent that leasing arrangements not be used to discriminate in providing benefits. In addition, an employee leasing company may in substance be providing insurance to employees of multiple employers. Thus, the concern also exists that PEOs may be used to circumvent state insurance laws.

C. Overview

This paper discusses the federal tax issues arising under the Code and issues arising under the Employee Retirement Income Security Act (ERISA) when a PEO provides welfare benefits to work-site employees. Part II discusses the definition of welfare benefits under the Code and ERISA. Part III discusses Service guidance and other authorities on determining who is the common law employer in a three-party employment relationship, including the significance for federal tax purposes of being a "general employer," "special employer," or "dual employer" under the common law.

Part IV discusses the federal tax issues that arise if a PEO is not the common law employer of a work-site employee. Specifically, this Part discusses the excludability of welfare benefits and the application of the nondiscrimination provisions. In addition, this Part discusses the leased employee rules under which a work-site employee may be treated as an employee of a client company even if he or she is not a common law employee of the client. Next, this Part discusses issues arising with respect to the deductibility of contributions to a welfare benefit fund under section 419 of the Code. This Part then discusses the vehicles through which a PEO could provide welfare benefits, such as a multiple employer trust (MET), which could be tax-exempt if it qualifies as a Voluntary Employees' Beneficiary Association (VEBA). Finally, this Part discusses recent proposed legislation that deals with many of the tax issues arising due to the uncertainty of determining who is the employer.

Part V discusses significant issues arising for PEOs under ERISA. First, this Part discusses recent case law on whether a worker is entitled to participate in an employer's welfare benefit plan and the guidance that these cases provide on drafting welfare plans to ensure that work-site employees are excluded from a client company's welfare benefit plan. This Part next discusses issues arising when employees are transferred to a PEO, including the recent Supreme Court decision on whether workers who are transferred to an employee leasing company have standing to sue for nonvested welfare benefits under ERISA. This Part then discusses whether a welfare plan sponsored by a PEO is an ERISA-covered plan and the implications for the PEO and the client company if the PEO's plan is not considered to be an employee welfare benefit plan. Finally, this Part discusses the effect of a plan's status as an ERISA-covered plan or a Multiple Employer Welfare Arrangement (MEWA) on ERISA preemption of state insurance laws and existing state laws regulating MEWAs.

Part VI discusses COBRA and HIPAA issues that arise from the uncertainty regarding the identity of the employer and how proposed legislation would resolve these uncertainties. Finally, this Part discusses the issues arising under COBRA and HIPAA for MEWAs.


Published by
Section of Taxation, American Bar Association
With the Assistance of
Georgetown University Law Center


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