I spent some time researching staffing agencies and PEOs (Professional Employer Organization) for “leased employees” for a client this past week. I was pretty sure of the answer, but the leasing agency was also pretty sure of a different answer as well.
Leasing employees has become a popular way to pay employees of your business. Instead of having to deal with HR issues and payroll, you can simply have your employees work for a leasing company. You write one check to the leasing company and they pay the employees and payroll taxes. It is easier for the employer. But the question frequently comes up as to whose employees they actually are. Do they work for the leasing company or do they work for the business?
In this case, the question had to do with retirement plans. The client had an operating business inside an S Corporation. There was also another S Corporation that was used to just include the “leased” employees. They were more the rank and file of the company. Senior Management was all direct employees and also received retirement benefits through the first operating company.
I’m not sure exactly who had told my client that leased employees, especially if they were in another company, didn’t have to receive benefits like pension plans. There was a lot of finger pointing. Maybe it was their new CFO who was anxious to save some money. Maybe it was the leasing company who, using carefully couched promises, seemed to indicate that was how it works but never quite gave a definitive answer. Or maybe it was the previous CPA who had turned a blind eye to the process.
Here’s how it works.
The IRS states that leased employees are required to be included in nondiscriminatory coverage tests (Code Sec 410 (b)). This is true even if you have a written plan that excludes leased employees. Note that this is in regards to the coverage tests. The end result may be that owners and highly compensated employees don’t get as much as you would think for the retirement plan. The second issue is that you may also likely need to include them as if they were regular employees on payroll, providing the same pension benefits.
IRS Code Section 414(n) defines who is a leased employee. Most employees from a PEO or leasing company will fall under the IRS definition of a leased employee if these three tests are met:
- The individual must be hired pursuant to an agreement between the recipient employer (who sponsors the retirement plan) and the PEO, staffing agency, or leasing organization.
- The individual must work on a substantially full-time basis for at least one year. (Note that there are differing definitions of full time; it may be as few as 1,000 hours per year. The IRS defines “full time” based on varying circumstances. Talk to your pension plan expert advisor to make sure you’re on the same page. )
- The individual must perform services under the primary direction and control of the recipient employer.
If the employee meets all three of the above tests, then that worker is considered a leased employee that must be included in the retirement plan. The IRS counts leased employees as eligible for retirement plans.
If you exclude leased employees from the business’s retirement plan solely because they are not on the recipient’s payroll you may be looking at serious penalties and fines. And, in the worst cases, even plan disqualification which means a whole lot of unexpected tax for everyone.
There are some strategies that may help you preclude covering the employees. I don’t know of any way to avoid covering them in the tests, however. It’s something you must think through ahead with an expert in pension tax law. Don’t just assume all is well and ignore it. The penalties can be huge if you get it wrong.