What is a PEO? Guide to Professional Employer Organizations

A Professional Employer Organization (PEO) is a third-party service provider that processes payroll and carries out HR and compliance activities on behalf of corporate clients. This often includes withholding and paying employment taxes, and administering employee benefits: By doing so, they usually become the ‘Employer of Record’ for those employees (more on what this means below).

Carrying out these activities is the business of a PEO. They don’t do anything but payroll and HR-related tasks.

There is no single list of services that all PEOs provide. The services provided by a PEO will depend on the contract they sign with their corporate client, their chosen business model, and any laws and regulations that apply to that PEO under state or federal law.

Depending on the jurisdiction, and the agreement between the client and PEO, both may be recognized as ‘co-employers’. This means that the responsibilities of the employer are split between both the PEO and the client company. 

How does a PEO relate to an Employer of Record (EOR)?

A closely related concept to PEO is the concept of an ‘Employer of Record’. An Employer of Record (EOR) is the entity that has the legal responsibility or responsibilities of the employer. Often, the EOR is legally responsible for withholding income taxes and administering payroll taxes and employee benefits.

The EOR usually only takes on those legal responsibilities clearly set out in the contracts that they sign, and as recognized under the law where they are based. For example, under the federal tax code, the Internal Revenue Service (IRS) may recognize an EOR as the ‘statutory employer’. This means that EOR has the responsibility for withholding and submitting federal employment taxes and fulfilling associated compliance tasks. It also means that taxes are filed under the legal name of the PEO and using their own Employer Identification Number (EIN).

But EOR is not just a tax concept. For example, an EOR may be recognized as the legal employer for collective bargaining purposes. The key feature of an EOR is that their employer role is limited to specific legal duties.

In most cases, a PEO acts as an Employer of Record. Not only do they process payroll, and manage taxes and benefits, they do so under their own name authorities recognize them as the employer when they do so.

But the reverse is not always true: Not all Employers of Record are PEOs. For example, in California, the Employer of Record of In-Home Supportive Services (IHSS) carers are “public authorities”. These quasi-governmental bodies, created by county governments, mean carers are covered by the National Labor Relations Act, can join unions and collectively bargain, and have access to all the benefits that other employees would have access to. These public authorities are not private businesses at all, and therefore not PEOs.

The history of PEO and its origin in employee leasing 

 Prior to the 1990s, the terms PEO and EOR were not commonly used. However, a related concept known as ’employee leasing’ was popular. No one is quite sure when this practice first began, as it was not widely-publicized or well-known until the early 1970s, but by 1993, according to the New York State Inter Agency Task Force on Employee Leasing, there were 15,000 leasing companies in the United States.

In its original form, employee leasing proceeded as follows: A regular company officially terminated its existing employees and arranged for an employee leasing company to hire those employees. The original company then ‘leased back’ those employees onto their worksite. 

For the original company (the ‘client company’), this meant saving time and money through transferring the most onerous employment responsibilities to another party, including responsibility for health insurance, 401k contributions, and workers’ compensation. From the perspective of the employee, it would have looked as though little had changed, even though the underlying legal relationships had altered significantly. 

In its unregulated 1970s form, employee leasing was controversial. It meant:

• Due to the lower health and safety risk profile of employee leasing company, artificially low workers’ compensation premiums could be paid. Those premiums did not reflect the actual risk for workers engaged on the worksite. This has been referred to as the ‘Workers Compensation Shuffle‘.
• It was used by client companies to avoid providing their workforce with the pension plans they would otherwise be entitled to: Under the Revenue Act of 1942, in order to use pension plans to offset their tax bills, businesses were prohibited from discriminating between employees with pension plans (I.e., the executives could not be generous to themselves and leave the rank-and-file employees with nothing). As a workaround, some companies used employee leasing to claim that some workers were ‘not their employee’, and therefore could be paid less than they would otherwise get (For an extensive discussion of these matters, see a recent article in the Berkeley Business Law Journal from law academics Katherine Sanford Goodner & Ursula Ramsey).
• If the employee leasing company went insolvent/bankrupt, employees could be deprived of their entitlements. 

In light of these concerns, federal law changes in 1982 and 1986 substantially changed the rules, regulating the industry.

What is a certified Professional Employer Organization?

In 2014, two new sections of the IRS Code were introduced to establish a voluntary certification program for PEOs. A certified Professional Employer Organization (CPEO) is a U.S.-based business entity that has met a set of requirements set out by the IRS.

Once certified by the IRS, the certified CPEO will be treated as the sole employer of a client’s workforce. This has the benefit for client companies that they will no longer be liable for federal employment taxes as a ‘co-employer’ of workers.

In order to become certified, a PEO must:

• have a physical business location within the United States
• a history of financial responsibility and organizational integrity, and
• be managed by individuals who have knowledge or experience regarding federal and state employment tax compliance and related business practices.

Once certified, the CPEO is required to post an annual bond of up to $ million guaranteeing payment of employment taxes.

Currently, less than seven percent of PEOs in the U.S. are certified by the IRS.

How do PEOs operate?

How a PEO works depends on the chosen business model of the PEO, the engagement agreement between the client company and the PEO, as well as the laws and regulations that apply in a given state or country. 

Generally speaking, the PEO and client company will agree that the PEO will provide the following services: 

• Payroll processing
• Benefits administration, including pension contributions, workers’ compensation and other employment-related insurances
• Employment tax compliance. This includes employee income tax withholding, payroll tax administration and managing state unemployment taxes.
• Any other HR functions as agreed. 

Once a business partners with a PEO, the PEO and client company generally become co-employers of the business’s employees. This means that both the client and company share employment responsibilities: The client company is generally responsible for the day-to-day direction of the employee, while the PEO is responsible for the administrative and compliance tasks related to employment. 

Due to their differencing responsibilities, in co-employment, the client company is sometimes known as the ‘operational employer’ or ‘worksite employer’, while the PEO is known as the ‘legal employer’ or ‘administrative employer’.

As legal employer, the PEO usually becomes responsible for:

• Filing necessary tax and employment documentation with the authorities
• Withholding and paying employee income tax, payroll tax, unemployment tax and so forth
• Providing compliant labor contracts
• Hiring and onboarding of employees
• Termination, severance, and offboarding, where appropriate. 

In turn, the client company remains responsible for: 

• Directing staff in their duties
• Health and Safety in the workplace
• Communicating with the PEO to ensure that administrative and compliance duties are fulfilled. 

Note, the IRS observes that in the US, despite what is said in any PEO agreement, client companies can still be legally liable for employee taxes. The IRS does not recognise the concept of ‘co-employment’ in its Tax Code, and may find the client company liable as the “common law employer”. 

The way to mitigate this legal liability is for a client company to engage a CPEO — as discussed earlier in this article.

In exchange for the responsibilities and liabilities that it takes on, the PEO charges the business a fee for its services. The size of that fee depends on factors such as the number of employees and the type of HR services provided, and the chosen fee model of the company. 

The most common charging models are: 

• A flat fee per month, per employee
• A percentage of gross payroll. 

Why choose a PEO?

The alternative to using a PEO is to carry out the standard payroll and HR functions in-house. So why pass this to a third party? There are pros and cons to engaging a PEO that need to be weighed up before you commit to this option. We consider these below. In short companies interested in PEO solutions need to consider:

• How much more what it cost to hire and pay internal employees to pay these tasks?
• What are the risks of performing the task internally versus outsourcing it
• Would other outsourcing solutions, such as payroll outsourcing, temp agencies or staffing agencies be a better option?
• Once the decision has been made to go PEO, which PEO should be chosen?