A New Approach To Employment Administration

Developing a relationship with a professional employer organization can help law firms more evenly compete for quality employees and reallocate limited resources to focus on client service.

By James J. Gettel & Bruce A. McIlnay

hile people are the greatest assets of any law firm, managing human resources is one of the most expensive and time-consuming administrative tasks in a law firm. Wages, payroll taxes, and employee benefits are among a firm's biggest expenses. The time spent effectively managing these costs adds more expense. The largest law firms employ professional, full-time staff to manage their human resources. This staff can shop for, set up, and administer payroll, insurance, and benefit plans. Staff also is responsible for compliance with tax and employment regulations. In most firms, however, these time-consuming but vital functions fall to experienced lawyers, whose time could be more effectively spent serving clients.

Law firms can benefit from services designed to help businesses focus on their core competencies.¹ Professional Employer Organizations (PEOs) have evolved to provide a practical, economical, and ethical alternative for out-sourcing law firm employment administration. This article explains how a PEO can make a law firm more competitive in the market for quality employees and more effective in firm administration, and offers tips on selecting a PEO. It also describes the recent development of "coemployment" law to support PEO arrangements, and addresses relevant ethical considerations arising from the coemployment relationship.

The Advantages of PEOs

Increasingly, businesses are using PEOs to manage complex employee-related matters.² By contract, PEOs assume a variety of responsibilities for their clients, including payroll management, employee benefit plan design and administration, and tax and human resources compliance.

The PEO delivers services by becoming a "coemployer" of the customer's employees. As coemployers, the PEO and the customer become partners in the employment of their workers. The PEO provides specific employment administration services but the customer retains responsibilities for employee supervision, training, evaluation, discipline, compensation, and other essential terms of employment.³

By using PEO services, a business redirects many noncore business responsibilities to an outside supplier.⁴ PEOs help their customers focus on their primary business rather than on the business of employment. PEOs can reduce the costs and improve the quality of employment administration services and employee benefits.

Competing in the Labor Market. PEOs help smaller businesses attract, retain, and support valuable employees by providing a competitive benefit package and quality employment administration that otherwise might be unaffordable. With unemployment rates in Wisconsin well below 5 percent, Wisconsin businesses face difficult challenges in attracting and retaining qualified employees.⁵ To compete for employees, businesses must offer competitive pay and benefits in addition to a challenging career. Firms also must be responsive to changing employee needs and concerns.

The largest businesses have economies of scale in payroll, benefits, and human resource administration that permit these services to be economically provided by professional, in-house staff. Large businesses also enjoy a competitive advantage in the market for benefit products like insurance.⁶ These economies can be great advantages in competing for quality employees.

PEOs can level the playing field. PEOs allow small and medium-sized businesses to offer competitive and affordable benefits such as health, disability, dental, and life insurance, a 401(k) retirement plan, and a flexible spending account plan. By aggregating the employees of multiple customers to increase buying power, PEOs secure and administer superior benefits for their customers at substantially better prices than smaller firms could obtain for similar benefits.⁷

Reducing Administrative Burdens. PEOs also offer professional administrative services. Businesses that cannot afford to hire a professional human resource manager must rely on busy professionals to take responsibility in areas for which they have little or no expertise. Every issue can require study, and employees must wait for answers. In contrast, PEOs are employment professionals. PEOs regularly handle paperwork, such as payroll tax filings, for multiple companies; provide efficient and responsive claims processing and management for benefit plans, unemployment insurance, and worker's compensation; and assist with human resources compliance, including employee handbooks, forms, policies, procedures, communications, and fiduciary responsibilities.

The professional skills of the PEO benefit primary employers and employees alike. The primary employer is relieved of the time-consuming and expensive tasks of shopping for and comparing insurance and benefit plans, administering the plans they choose, and staying informed about and complying with a myriad of tax- and employment-related regulations. The employee can receive better benefits and timely advice concerning benefits and other employment issues.

Ease in Tracking Costs. In a typical PEO arrangement, employees submit the information necessary to calculate periodic payroll to the PEO. The PEO, in turn, prepares the payroll checks, makes the required withholdings for taxes and benefits, and makes necessary deposits with taxing authorities or benefit plan sponsors. The PEO sends the customer one invoice per pay period, which saves the customer the time and expense of calculating the amounts of various withholdings; and relieves the customer from the burden of making separate deposits with the several taxing authorities. The PEO's invoice represents a concise tally of a firm's total labor costs.

Most PEOs charge a percentage markup on gross payroll to cover mandatory payroll taxes, benefit costs, and a margin for the PEO. Some PEOs will estimate benefit costs, while others provide a direct pass through of actual costs. Typically, the PEO is seeking a fixed, gross dollar margin per employee per year. As a result, the percentage of payroll attributable to this component may be reduced for more highly compensated employees. This fact makes it attractive to a professional firm to include all employees in its PEO contract. This means that attorneys can track not just the cost of their support staff but what it costs to pay the attorneys themselves.

The Development of "Coemployment" Laws for PEOs

PEOs Improve on Earlier Models. The PEO coemployment arrangement should not be confused with historical "staff leasing" arrangements. Early staff leasing arrangements involved firing employees and then "leasing" them back from a third party. The PEO arrangement does not involve the "leasing" practice of "fire, hire, and lease back." Instead, the PEO becomes a coemployer, not a substitute employer.

Neither is a PEO a temporary employment agency. In a traditional "leasing" arrangement, people are assigned to a customer on a supplemental or temporary basis for a specific project or for a fixed, usually short, time. The PEO arrangement is created for exactly the opposite result ­ assisting customers in making a long-term investment in their employees.

Unlike present PEOs, early staff leasing arrangements were limited in scope and produced only isolated cost savings. Staff leasing became disfavored by regulators who considered it abusive. During the 1970s, small business owners could receive pension benefits without providing the same benefits to their other employees whom they leased from a staff leasing company. Congress closed this loophole in 1982 with the enactment of section 414(n) of the Internal Revenue Code.⁸

Some early employee leasing firms got into trouble as they shifted from pension-driven programs to offering low-cost health insurance, unemployment insurance, or worker's compensation insurance coverage. Often the cost savings were illusory, based on underpricing self-funded health insurance, or artificially low worker's compensation experience modifiers, or state unemployment insurance rates. Leasing companies began to fail and regulators took the position that the leasing companies were not true employers. Regulators sought to hold the leasing companies' clients liable for unpaid employment taxes and employee benefits. Today's PEOs, based on the concept of coemployment, have improved dramatically over staff leasing companies of the past.

Coemployment Moves Beyond Common Law Concepts. The coemployment relationship in a PEO arrangement is different from other multiparty employment relationships recognized at common law. This difference permits the PEO and its customer to allocate responsibilities and risks in the employment relationship.

Traditionally, whether an employment relationship exists is determined by reference to the common law of agency.⁹ The Restatement (Second) of Agency¹⁰ is a helpful summary of the common law approach.

The Restatement describes three types of multiparty employment relationships recognized at common law. First, "joint employment" occurs when a single employee, under contract with two employers, and under the control of both, simultaneously performs services for both employers that are the same as, or closely related to, the services performed for the other.¹¹ Second, "dual employment" occurs when an employee is hired by two separate employers at the same time (with or without knowledge of the other) to perform separate tasks for each.¹²Third, and best recognized at common law, is the "loaned servant" employment relationship that occurs when a servant is directed or permitted by his or her master to perform services for another and, thus, becomes the servant of the party to which the servant was "loaned." The "loaned servant" may become another's servant as to some acts and not as to others.¹³

All three traditional types of multiparty employment arrangements contemplate an employment relationship by the employee with both employers. In joint employment and dual employment, both employers simultaneously employ the employee. Similarly, the loaned servant cases concern the question of whether the borrowing person becomes a "special employer." This analysis implicitly assumes that the first employer must retain at least some indicia of an employer and does not completely surrender its rights and obligations as an employer.

While the common law recognizes multiparty employment arrangements, it generally seeks to allocate responsibility between employers according to who controls the employee in a given instance. Depending upon the circumstances, either employer can be held responsible for all liabilities arising from the employment relationship. This result could leave one of the employers responsible for aspects of the employment relationship that it sought to allocate to the other.

The PEO arrangement is different from traditional employment relationships because coemployment makes each employer responsible for different aspects of the employment relationship. In this type of relationship, it is possible that neither employer has all the characteristics of a common law employer. This should not mean that the employment relationship fails, leaving the employee an independent contractor or an employee of only one company or the other.

The proper analysis should be whether the PEO has enough of the characteristics of an employer to be considered a coemployer together with the primary employer. In the PEO arrangement, it takes two employers to create the full employment relationship, with each employer assuming different responsibilities of a single employment relationship. The law is beginning to recognize that both employers in a PEO arrangement do not each have to meet all of the common law criteria for establishing employment relationships. Instead, as long as the PEO and the customer jointly satisfy the criteria, a common law employment relationship will still exist.

Legislative and Regulatory Recognition of Coemployment. The Internal Revenue Service acknowledges that a PEO is the employer responsible for federal employment and unemployment taxes and also may provide qualified plan benefits.¹⁴Many states, including Wisconsin, statutorily recognize PEOs as the employer or coemployer of worksite employees for purposes of worker's compensation and unemployment insurance laws.¹⁵PEOs are legally recognized as employers in the EEOC Contingent Worker Guidance, regulations implementing the Family and Medical Leave Act, new COBRA regulations, recent cases interpreting the Fair Labor Standards Act in coemployment situations, and the OSHA draft "multi-employer worksite policy."

The IRS 1997 Business Plan specifically targeted additional "employee leasing" issues for resolution, but guidance was not released in anticipation of Congressional enactment of the Staffing Firm Worker Benefits Act of 1997 (HR 1891). The bill would have amended the Internal Revenue Code to make it clear that a "qualified staffing firm" is the employer of the employees covered by staffing arrangements, both for purposes of employment tax liability and employee benefit plan sponsorship.¹⁶ The bill also would have amended the leased employee provisions of IRC section 414 to encourage retirement and fringe benefit coverage of employees of qualified staffing firms.¹⁷

Notwithstanding the failure to pass the Staffing Firm Worker Benefits Act, state and federal legislators and regulatory agencies continue to show interest in, and support for, PEO arrangements. A new bill limited to clarifying PEO arrangements will be introduced soon in Congress with apparently strong bipartisan support.¹⁸

Selecting a PEO

A good place to start a search for a PEO is with the National Association of Professional Employer Organizations (NAPEO), which has a Web site.

As with selecting any major vendor, firms should perform a credit check on PEOs under consideration. Firms also should search public records for incidents involving noncompliance with tax requirements and ask for customer referrals. When speaking to the customer, talk to staff employees who have experience in asking the PEO for benefit information or assistance with claim processing. How responsive was the PEO to requests for information?

Given the relative infancy of the industry, many participants are adding to existing, more limited, services to create PEOs. For example, more traditional payroll service or staffing firms are creating PEOs. The firm's history can offer some clues as to its strengths and weaknesses in offering a full-service PEO.

The quality, cost, and variety of benefits offered are important factors to consider. A strong PEO should have sufficient knowledge of, and bargaining power in, the benefits market to offer attractive benefits at costs less than a firm's smaller group could obtain on its own.

In the final analysis, the PEO should in all respects be an outstanding business partner to the law firm.

Conclusion

PEO arrangements can be an effective strategy to combat the spiraling costs of having a professional and clerical support staff perform employment administration. PEOs can offer financial and administrative benefits to legal practices, and employees can receive better benefits, which in turn can increase staff loyalty and reduce turnover.

As lawyers decide whether to enter a PEO arrangement, they should especially review their health insurance and retirement plan costs, and the time and costs associated with employee administration and government compliance. Many lawyers will discover that they spend a lot of time on employment administration (usually in relatively small, disruptive increments) and that PEO services will give them more time to address the quality of services they provide clients.

Chosen wisely, and properly structured, a relationship with a PEO can be an ethical, economic, and efficient means of unburdening attorneys from the "business of law," and free more time to devote to the "practice of law."

Endnotes

¹"An important reengineering principle is that companies should focus on their core competencies and outsource everything else. ... Our core competencies at Microsoft are creating high-volume software products, working with other software companies, and providing customer service and support. We outsource a number of functions that don't fall into those categories, from help-desk technical support for our employees to the physical production of our software packages." Gates, W. H., Business @ The Speed of Thought, pp. 133-34, Warner Books (1999).

²The PEO industry is among the fastest growing industries in the United States. The National Association of Professional Employer Organizations conservatively estimates that more than 3 million employees are in PEO arrangements and that the industry growth rate is 20-30 percent per year. In 1983 only about 4,000 employees were covered by PEO arrangements. The average client customer of a PEO is a small business with 16 employees, though businesses of up to 300 employees find value in PEO arrangements. PEO customers include all types of businesses and professions, including accountants, doctors, and lawyers.

³In some cases, the PEO relationship places greater responsibilities on the law firm as an employer. Generally, the determination of whether an employer is subject to a particular statute is based on the number of workers employed during the year. Workers employed by a PEO are protected by more laws because they are included in the larger workforce of the PEO. Examples of statutes that apply because of the PEO arrangement are COBRA, the Family and Medical Leave Act, Title VII of the 1964 Civil Rights Act, the Age Discrimination in Employment Act, and the Americans with Disabilities Act.

⁴The PEO business is a comprehensive form of outsourcing. A recent American Management Association survey revealed that 94 percent of the responding companies had outsourced at least one activity. The primary reason for outsourcing was to reduce costs, followed by saving time and improving quality. Good PEO services offer all of these benefits.

⁵Retaining employees is especially critical. A recent U.S. Department of Labor study put the direct cost of hiring a new employee at 33 percent of the employee's first year salary. Direct costs include the time involved in recruiting, selecting, and training new personnel. Indirect costs include the decreased productivity of coworkers and the negative impact on customer relationships that turnover creates. For professional positions, turnover costs are even higher because it can take up to three years for a new employee to reach his or her productive capacity.

⁶Smaller law firms' cost disadvantages are most evident in purchasing power for benefits such as health, life, and disability insurance, and retirement plans. In addition, a study by Thomas Hopkins of Diversified Research found that smaller businesses pay about $5,400 per employee to manage regulatory compliance compared to $3,000 for larger firms ­ a cost difference of 80 percent. Staffing Industry Reports, January 1999.

⁷According to a 1996 Bankers Trust Co. study, small business owners generally save 3 to 5 percent of their payroll expenses by outsourcing to PEOs.

⁸Use of leasing as a means to avoid pensions created some animosity in Congress toward the employee leasing industry, and this use of leasing as a "tax shelter" was short lived. See Professional & Exec. Leasing Inc. v. Comm'r, 862 F. 2d 751 (9th Cir. 1988). Under current regulations, businesses that lease their employees either must include the leased employees in their retirement plan or show that the leasing company provides the employees with a plan that is comparable or better.

⁹Courts consider many factors in determining the existence of the employer-employee relationship. Among those factors are: 1) the right to control the details of the work; 2) the furnishing of tools and the work place; 3) withholding of taxes, worker's compensation and unemployment insurance funds; 4) right to discharge; and 5) permanency of the relationship. See United States v. Silk, 331 U.S. 704, 714-16 (1947), and the IRS 20-factor test in Revenue Ruling 87-41, 1987-1 C.B. 296. See also, Siev, Jordan W. and Kirsten M. Eriksson, Are Your Independent Contractors Truly Independent?, 72 Wis. Law. 10 (July 1999); Beightol, Scott C., In Wisconsin, Most Workers Are "Employees," 72 Wis. Law. 13 (July 1999).

¹⁰American Law Institute, 1958-1992.

¹¹The Restatement defines "joint employment" as: "Two persons may agree to employ a servant together or to share the services of a servant. If there is one agreement with both of them, the actor is the servant of both at such times as the servant is subject to joint control. Restatement (Second) of Agency, § 226, comment b. See also, Larson, The Law of Workman's Compensation, § 48.41 (Matthew Bender 1991).

¹²Restatement (Second) of Agency, § 226, "Servant Acting for Two Masters."

¹³Restatement (Second) of Agency, § 227, "Servant Lent to Another Master."

¹⁴PEOs are contractually (and in some states, statutorily) obligated to pay worksite employees without regard to the receipt or sufficiency of payment by customers. Internal Revenue Code section 3402(a) requires every employer making payment of wages to deduct and withhold from such wages federal income taxes in accordance with the tables or procedures prescribed by the Secretary of the Treasury. For the purposes of both sections 3401 and 3402 the term "employer" means the person having control of the payment of wages to an individual (employee) who performs or performed services. Statutes, case law, revenue rulings, and private letter rulings substantiate the responsibility of the PEO for payroll taxes and other withholding liabilities. See, e.g., Revenue Ruling 75-41, 1975-1 C.B. 323; Packard v. Comm'r, 63 T.C. 621 (1975); Private Letter Ruling 7748037, Aug. 31, 1977; Private Letter Ruling 8250042, Sept. 13, 1982 (citing Otte v. U.S., 419 U.S. 43, 51 (1974); In re Armadillo Corp., 561 F. 2d 1382 (10th Cir., 1977); In re Southwest Restaurant Sys. Inc., 607 F. 2d 1237, 1240 (9th Cir. 1979). Internal Revenue Code section 414(n) permits a PEO or the recipient of the PEO's services, or both, to provide qualified plan benefits to employees. The legislative history of section 414 makes clear that the provision does not override traditional common law employee rules and that an employee does not cease to be a common law employee of the recipient by virtue of section 414. See General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (DEFRA Blue Book), 827-28. Section 414(n) also applies to cafeteria plans, group term life insurance plans, dependent care assistance programs, group legal service plans, qualified tuition reduction programs, and employer sponsored health plans. See I.R.C. § 414(n)(3)(C).

¹⁵For unemployment insurance, Wis. Stat. section 108.02(12m) defines an "employee service company" to include a "leasing company" that performs specified services for its customer, including paying, hiring, and terminating employees. For worker's compensation, Wis. Stat. section 102.01(f) defines a "temporary help agency" to include "an employer who places its employee with or leases its employees to another employer who controls the employee's work activities and compensates the first employer for the employee's services, regardless of the duration of the services," and section 102.04(2m) makes "a temporary help agency the employer of an employee whom the temporary help agency has placed with or leased to another employer that compensates the temporary help agency for the employee's services." Seventeen other states provide some form of licensing, registration, or regulation of PEOs.

¹⁶In mid-1997, Congress nearly passed a tax law with the same effect as The Staffing Firm Worker Benefits Act. Early provisions in the Taxpayer Relief Act of 1997 (HR 2014) recognizing coemployer status (and eliminating the 20-factor common law test applied by the IRS to determine employer status in Revenue Ruling 87-41) passed the House and survived the House-Senate Budget conference committee in July 1997, but were dropped at the last minute to avoid vulnerability to a parliamentary point of order.

¹⁷The Staffing Firm Worker Benefits Act did not pass in 1998 for two reasons. First, the Act was attached to HR 3788, legislation focused on comprehensive pension reform which will require further study. Second, the Act defined temporary staffing firms and PEOs as employers, making the bill controversial because it would remove clients of temporary employment agencies from worker classification disputes such as Vizcaino v. Microsoft Corp. (CA-9, 96-2 USTC ¶50,533; 96 FTG ¶3933A and ¶8356). In Microsoft, the federal court found that Microsoft had an obligation under the terms of certain employee benefit plans to cover temporary workers as well as direct employees.

¹⁸Information regarding the status of these legislative initiatives can be obtained from the National Association of Professional Employer Organizations (NAPEO), 901 N. Pitt St., Alexandria, VA 22314.