What is a PEO or Professional Employer Organization?

By William F. Schaake, CIC, CRM, CLCS, ACA Certified
A professional employer organization or PEO is a type of staffing company operating as a co-employer with a contracted organization such as a business or other type of entity. This partnership allows the operating organization to lease back their employees allowing the PEO to handle most of the HR, compliance, and payroll functions. These services can include payroll processing, tax payments & filing, employee benefits administration, pensions & 401k’s, and placement & billing of unemployment & workers’ compensation as well as other statutory insurance. Other services provided can include HR consulting, forms & reporting, compliance, onboarding & terminating employees, training, safety & loss control, risk management, and other human resource and administrative functions.
The PEO files the payroll taxes under its own tax identification number. The employees become part of the PEO’s work force allowing the members to participate in the employee benefits plans and other services that may benefit from a much larger employee base such as group health insurance, employer practices liability and workers’ compensation. See more below from the IRS website:
Employers are responsible for withholding and paying over employment taxes and filing required returns. Whether an entity is an employer is generally determined under the common law rules. An employer determined under the common law rules is referred to as the Common Law Employer (CLE). Many CLEs outsource some or all of their payroll and related tax duties to a third party payer.
A Professional Employer Organization (PEO) is a type of third party payer. If the CLE is outsourcing payroll, the CLE generally remains responsible for paying taxes and filing returns. However, there are provisions in the IRC that provide for limited situations where the CLE’s employment tax obligations may be shared by or shifted to the PEO.

IRC section 3401(d)(1) defines the term “employer” as the person for whom an individual performs or performed any service as the employee of such person (the CLE), except that if the person for whom the individual performs or performed the services does not have control of the payment of the wages for such services, the term “employer” means the person having control of the payment of such wages. A person who is not the CLE but is considered the employer because it has exclusive control of the payment of wages is sometimes referred to as the “statutory employer.”

If a third party, such as a PEO, is a statutory employer, it will be the person responsible for the employment taxes on the wage payments that it had exclusive control of. Significantly, if the third party is merely a conduit for the funds used to pay wages, it is not a Section 3401(d)(1) employer. It is important to remember that the Section 3401(d)(1) employer is only liable for employment taxes on wage payments over which it had control.

A PEO is sometimes referred to as an employee leasing organization. The contract between the PEO and the employer will provide that the PEO will perform some or all of the employment tax withholding, reporting and payment activities related to workers performing services for the employer. In some cases, the employer who contracts with a PEO purports to fire its employees, who are allegedly then hired by the PEO and leased back to the CLE (the PEO’s client). The PEO pays the employees as well as the employment tax liabilities with funds received from the client and files employment tax returns using its (the PEO’s) EIN. Typically, the client remains the CLE and the PEO is not the Section 3401(d)(1) employer because it does not control the payment of wages.

In many cases, the PEO claims to share control over the employees as a “co-employer”.

The Code does not define the term “co-employer” and the concept is not recognized under federal tax law. However, Treas. Reg. 31.3504-2 states that a person that pays wages or compensation to the individuals performing services for any client pursuant to a service agreement is designated to perform the acts required of an employer with respect to the wages or compensation paid. To be designated as a payer under this section, the PEO must assert it is the employer (or “co-employer”) of the individuals performing services for the client. The PEO may implicitly assert it is the employer or co-employer of the individuals performing services for the client by agreeing to:
  • Recruit and hire employees for the client or assign employees as permanent or temporary members of the client’s work force, or participate with the client in these actions;
  • Hire the client’s employees as its own and then lease them back to the client to perform services for the client; or
  • File employment tax returns using its own EIN that include wages or compensation paid to the individuals performing services for the client.
The Regulation further states that if a payer is designated to perform the acts required of an employer then the payer must perform the acts required under each applicable chapter of the Code and the relevant regulations with respect to wages or compensation paid by such payer. All provisions of law (including penalties) applicable to the employer are applicable to the payer and each employer for whom the payer is designated remains subject to all provisions of law (including penalties) and of the regulations applicable to an employer.
The Tax Increase Prevention Act of 2014 required the IRS to establish a voluntary certification program for PEOs in two new Code sections. Section 3511 provides that a Certified Professional Employer Organization (CPEO) shall be treated as the employer (and no other entity shall be treated as the employer) of any work site employee performing services for any client of such organization, but only with respect to remuneration remitted by such organization to such work site employee. Section 7705 created a certification process and defines the term “Certified Professional Employer Organization” as an entity which applies to be treated as a CPEO for purposes of Section 3511 and has been certified by the Secretary as meeting the requirements of certification. The IRS began accepting applications for PEO certification in July 2016. The IRS is required to publish a list of CPEOs as well as de-certified CPEOs. As of February 2017, the IRS has yet to publish such list. See CPEO Public Listings on IRS.gov.

Even after the creation of the certification process, there may be many organizations which function as PEOs but do not become certified. (Source: Third Party Payer Arrangements – Professional Employer Organizations | Internal Revenue Service (irs.gov))