Leased Employees: IRS Definition and Rules

An employee leasing arrangement allows a business to contract with an outside organization to handle human resources and payroll for a worker. While this structure can offer administrative simplicity, the Internal Revenue Service (IRS) has established specific rules to govern these relationships. These regulations define when a worker is considered a “leased employee” and dictate the consequences for the recipient business.

The IRS Definition of a Leased Employee

The IRS applies a three-part test to determine if a worker is a leased employee for benefit plan purposes. The first condition is a written or oral agreement where the recipient pays the leasing firm for the services performed by the individual.

The second part of the test requires the individual to perform services for the recipient on a “substantially full-time” basis for at least one year. This is met if the individual works at least 1,500 hours for the recipient during a 12-month period or works at least 75% of the hours expected of a regular employee in that same role.

The final element of the test is whether the services are performed under the “primary direction or control” of the recipient organization. This means the recipient, not the leasing agency, has authority over how the work is done. Examples of exercising primary control include the recipient setting the worker’s daily tasks and schedule, providing the necessary tools and equipment, and determining the specific duties of the job.

Consequences for Employee Benefit Plans

A worker who meets the definition of a leased employee is treated as an employee of the recipient company for specific benefit plan requirements. This rule prevents companies from using leasing arrangements to exclude workers from benefit plans, which could unfairly favor highly compensated employees. The impact is most significant for qualified retirement plans, such as 401(k)s and profit-sharing plans.

The recipient business must include its leased employees when performing annual nondiscrimination testing for these plans. These IRS-mandated tests ensure a plan does not disproportionately benefit the company’s owners and highest-paid employees. For example, the coverage test requires a plan to benefit a sufficient percentage of non-highly compensated employees.

If a company has a significant number of leased employees who are not offered participation in the retirement plan, it may struggle to pass these tests. A failed nondiscrimination test can have severe consequences, including financial penalties or the disqualification of the entire retirement plan.

The Safe Harbor Plan Exception

A “safe harbor” exception allows a recipient company to avoid treating leased employees as its own for retirement plan purposes. This provision applies if the leasing organization provides a qualifying retirement plan for the leased workers, recognizing they already receive a substantial retirement benefit from the leasing agency.

To qualify for this safe harbor, the leasing organization’s plan must be a money purchase pension plan providing a nonintegrated employer contribution of at least 10% of compensation. The plan must also offer immediate participation and ensure employees are 100% vested in employer contributions right away.

This safe harbor exception has a significant limitation. A recipient company can only use this exception if leased employees do not make up more than 20% of its non-highly compensated workforce. If this threshold is exceeded, the safe harbor is unavailable, and the recipient must treat the leased employees as its own for benefit plan testing.

Employment Tax and Reporting Obligations

The rules for employment taxes are distinct from those governing employee benefit plans. For federal employment taxes like Social Security (FICA), federal unemployment (FUTA), and income tax withholding, the leasing organization is considered the employer. The leasing firm is responsible for calculating and remitting these taxes and issuing the annual Form W-2.

However, this arrangement does not eliminate all risk for the recipient. If the leasing organization fails to fulfill its tax obligations, the IRS can hold the recipient liable as the “common law employer” for any unpaid employment taxes. To address this, the IRS created a certification program for Professional Employer Organizations (PEOs).

When a business partners with a Certified PEO (CPEO), the CPEO is designated as the employer for federal employment taxes on wages it pays to workers. This arrangement provides the recipient business with statutory protection from liability for unpaid FICA, FUTA, and federal income tax withholding.