Transitioning from a PEO: Impact on Employee Benefits


Professional Employer Organizations (PEOs) were developed in order to provide a service that would allow small companies to focus on the more important task of running and growing their business. PEOs contract with small to mid-size companies to assume and manage the responsibility of the employer. The PEO will provide an array of services to a small company, such as risk management, personnel management, human resources and payroll functions, claim management for workers compensation and unemployment insurance, and tax compliance. One of the PEO’s most important functions is to provide comprehensive employee benefit packages, including group health, life, disability, and 401(k) plans. Many smaller organizations find it beneficial to join a PEO as a way to lower the cost of plan administration fees, since they are able to pool resources with other companies. A PEO also handles payroll and other benefit administration services, which can help save time and staff for companies with very limited resources.

While PEOs can provide a good employee benefits solution for a small company in the early stages of development, they will not necessarily be a cost effective way to provide benefits once the company has grown. After crossing the 25-employee threshold, it becomes critical to consider other options for providing competitive employee benefit programs.

Cost Issues:

PEOs bring a level of insurance buying power to a small employer that is otherwise unavailable to them, and can provide enhanced plan design options and cost savings for a small group. However, as a company grows beyond various underwriting thresholds to have 25, 50, or 100 employees, the odds increase that a stand –alone benefits program will be more cost effective and flexible than what a PEO can provide.

Another potential cost issue is the PEO’s actual claim history. If the PEO’s overall group has poor claim experience, the small employer may end up paying significantly higher premiums than it would pay on a stand-alone basis.

It is also very important to consider the financial position of the various PEOs. Most are privately held companies, and therefore it is often difficult to evaluate their financial strength. Since many PEOs self-insure certain medical and workers compensation risks, this is a serious concern. If a PEO is bankrupt, which is not uncommon in that industry, an employer could be at risk for unfunded liabilities, even if premiums were paid to the PEO in advance.

Transition Issues:

When a company decides to terminate their arrangement with a PEO, particularly off the calendar year cycle, the employer should carefully consider the following:

  • The company will assume the role of sole employer, with all attending responsibilities. For example, the company must monitor compliance with employment laws, develop policies and procedures for the workplace, assume liability for the payment of wages, and comply with all rules and regulations governing the reporting and payment of federal and state taxes.
  • The company assumes the responsibility for all human resources issues, including the implementation of new benefit and retirement programs and vendors, supervising and disciplining employees, and the hiring and firing of employees.
  • The Federal Insurance Contributions Act (FICA) can pose significant problems for companies considering a PEO transition during the calendar year rather than on January 1st, due to the fact that all employees become “new employees” of the company when the relationship with the PEO terminates. FICA becomes a problem during a PEO transition because when an employee changes employers during the year, neither the employee nor the new employer receives credit for the previous withholding and payment of taxes.
  • Employees who have FICA withholdings on income may be able to obtain a refund when filing their income tax returns. While this is a considerable inconvenience, at least the refund is available.
  • For employers leaving a PEO, the impact of the FICA taxes is far more problematic. The company becomes the new employer, and therefore receives no credit for any FICA taxes that were previously paid through the PEO. In other words, the company can end up paying FICA taxes twice. What makes this even more difficult is that, unlike the employee, the company does not get a refund of these additional payments. For this reason, leaving a PEO in the middle of the calendar year can be a very costly move for a company.

Investment Control

Along with transition issues, companies involved in a PEO lose control over investment options and 401(k) plan administration. Since the PEO assumes responsibility for the overall monitoring and recordkeeping of these plans, companies do not have the same leverage and decision-making power. Proper 401(k) administration involves much more than Annual 5500 Form filing and anti-discrimination testing – planning services for executives and employees, advisor compensation, and compliance regulations must also all be considered. Regardless of their participation in a PEO, employers must remain vigilant about their fiduciary liabilities and the responsibilities they hold over their organizations.

In conclusion, companies considering leaving a PEO should obtain professional legal and financial advice before moving forward. Depending on the circumstances, for some companies it is advisable to wait until January 1st to terminate the PEO contract, thus avoiding the FICA issue altogether.

(Click here to watch WGA’s Louisa Bolick and Ed Flanagan outline some of the pros and cons of using a Professional Employment Organization.)