The Employee Leasing Decision
August 2000
Employee leasing offers a variety of benefits,
including a possible reduction in net expenses. However, it is not a strategy
without risk. This article reviews some of the issues to assess when considering
this option.
by
Christine Fuge
IRMI
The concept of leasing employees first emerged in the late 1970s. Much of
the initial popularity of employee leasing can be attributed to two advantages
that no longer exist. One of the discontinued benefits, which involved the arrangement
of pension plans, was entirely legal; the other, workers compensation premium
manipulation, often was not.
The
Tax Equity and Fiscal Responsibility Act of 1982 allowed an employer to
exclude leased employees from its pension plan as long as the leasing company
was funding a pension plan with a minimum contribution of 7½ percent of each
employee's total compensation. This was referred to as a "safe harbor arrangement."
By leasing its nonprofessional staff, an employer was thereby free to design
a very generous pension plan for its professionals and executives without losing
its tax-favored status under the
Employee Retirement Income Security Act (ERISA). However, the
1986 Tax Reform Act eliminated this advantage for most employers. The new
requirement stated that if leased employees constitute more than 20 percent
of an employer's total workforce, they must be counted as employees for purposes
of meeting ERISA's qualification requirements.
A second benefit derived from employee leasing arrangements during the 1980s
was actually an abuse of the workers compensation insurance system. Employers
with poor loss experience could escape the consequences of poor risk management
and safety practices by manipulating the experience rating plan rules. "Mod
renting" was a common practice whereby an employer with a high debit experience
modifier would transfer its employees to a leasing company with a modifier of
1.0. When the losses began to work their way into the leasing company's modifier,
either the client would find another leasing company with a favorable modifier
or the leasing company would restructure its ownership, thereby requalifying
for a mod of 1.0. Some firms went so far as to establish a subsidiary leasing
company whose only client was the parent. As soon as the subsidiary's loss experience
(which was actually that of the parent) caught up with it, the subsidiary would
be dissolved and another established.
Even more disturbing was the outright premium fraud that was perpetrated
through leasing arrangements. Because leasing companies pool the payrolls of
a large number of clients, employee misclassification and blatant misrepresentation
of payrolls could be accomplished with little risk of detection during premium
audits.
Despite the elimination of the safe harbor loophole and a tightening of the
experience rating rules, the employee leasing industry has flourished. According
to the National Association
of Professional Employer Organizations (NAPEO), during the period between
1984 and 1998, the number of employee leasing firms operating in the United
States grew from around 100 to more than 2,000. The number of leased employees
rose from roughly 10,000 to an estimated 2-3 million with an average increase
of 20-30 percent per year. These data confirm that employers derive other benefits
from employee leasing arrangement that continue to drive their popularity.
Whether employees approve of the arrangements is unclear since much of the
literature on the subject is promulgated by the leasing industry and cannot
be expected to be impartial on the subject. Depending on the scope of responsibilities
transferred to the leasing company, employees may or may not notice a change
in their day-to-day activities. This is because in many instances, employees
hold the same positions, work the same hours, and report to the same supervisors.
However, unions generally oppose employee leasing, arguing that leasing arrangements
overcomplicate the employer-employee relationship and increase the complexity
of filing an employer grievance. Despite the lack of concrete data on employees'
overall attitudes about the arrangements, most employees would derive some benefits
from a leasing arrangement. Whether the benefits outweigh the costs would be
a matter of personal opinion.
Benefits of Leasing
The two most widely cited benefits ascribed to employee leasing are reduced
administrative costs and access to improved (and/or lower cost) benefits. Listed
below are some potential advantages and disadvantages for employers and employees,
which are discussed further in this article.
Advantages to Employer
- Reduced administrative costs
- Human resources expertise
- Lower cost/higher quality employee benefits
- Safety and loss control services
- Advice on compliance with employment-related laws
- Potentially lower cost workers compensation insurance
Disadvantages to Employer
- Liability for leasing company's failure to file taxes, deliver promised
benefits, etc.
- Loss of control (may be minimal in some cases)
- Possible "shock impact" on employee relations
Advantages to Employee
- Improved benefits
- Protection under federal laws
Disadvantages to Employee
- Must be fired and rehired to implement plan
- Potential for uncollectible benefits
- Red tape
Reduced Administrative Costs
Many employers like the leasing arrangement because it frees up their time
and relieves them of the need to stay current on a multitude of employment-related
laws, file onerous reports and paperwork, and make quarterly tax deposits. (Most
leasing companies make tax deposits on at least a weekly basis, and some do
so on almost a daily basis. Therefore, even Uncle Sam derives a cash-flow benefit
from the leasing arrangement.) Employee leasing companies generally assume most
of the responsibilities associated with payroll, including all employment-related
tax filings, procurement of employee benefits, and ensuring compliance with
a multitude of requirements, such as ERISA and COBRA. The client usually remains
responsible for providing and maintaining a safe workplace and for supervision
of employees.
The specific responsibilities of each party should be spelled out explicitly
in the contract. Responsibility for recruiting, hiring, training, disciplining,
promoting, conducting performance reviews, and firing varies. Some leasing companies
retain the sole responsibility for some or all of these functions primarily
for liability reasons and to preserve their status as an employer or coemployer
of the leased employees. Because few employers would concede full control over
such decisions as hiring/firing, promotions, and pay scales, the practical application
of this provision is that the leasing company carries out these tasks in consideration
of the client's wishes.
Transferring the tedious and time-consuming administrative functions associated
with personnel to the leasing company can be extremely cost-effective for an
employer, particularly for small-to medium-sized employers, i.e., those with
fewer than 150 employees. Small businesses often cannot afford to hire a full-time
accountant or human resources manager, so the owner or managing partner must
spend a considerable amount of time performing administrative functions. The
leasing company can relieve the client of all payroll-related tax filings, including
state and federal unemployment taxes and FICA taxes, state and federal tax withholdings,
401K deductions, any other withholdings. Some leasing companies will require
a deposit to secure payments made by the leasing company on the client's behalf.
Employee Benefits
Because they pool the employees of a large number of clients, leasing companies
have the advantage of group purchasing power for employee benefits. Because
risk is spread over a larger group, and because most insurers offer discounts
on coverages generating a certain amount of premium, small employers can usually
reduce their total cost of employee benefits. Alternatively, employers may be
able to offer a higher quality benefit package for roughly the same amount of
money. An improvement in the quality of benefits will help the firm attract
and retain better employees and improve employee morale.
Most leasing companies have standard benefit "packages" that cover all employees
leased from the company. (Some leasing companies will not accept unionized employees
because they do not want their benefits package to be subject to collective
bargaining.) While this practice makes good underwriting sense (by ensuring
a more uniform spread of risks) and simplifies the job of the leasing company,
the client loses some control over the choice of benefits. Some employers may
not need or be able to afford an extravagant benefits package. Others will incur
employee dissatisfaction, resentment, and turnover if the package is too meager.
To some extent, however, the employer can mitigate the impact by choosing a
leasing firm that offers an acceptable benefits package. Large leasing companies
may offer a limited number of plan options, such as an indemnity plan versus
a health maintenance organization (HMO), and several "tiers" of benefits within
each plan.
Safety and Loss Control Services
Many leasing companies provide extensive safety and personnel loss control
services to their clients. The client usually retains responsibility for on-site
supervision, but leasing companies often retain the right to inspect the workplace
to ensure the client is maintaining a safe work environment. While this may
seem like a relinquishment of control on the part of the client, this type of
risk management expertise may significantly reduce the client's workers compensation
costs.
When the leasing company purchases workers compensation insurance for covered
employees, it has an obvious incentive to provide loss control services to clients-leasing
companies with high debit experience modifiers will be of no value to prospective
clients. Further, large leasing companies are often involved in a workers compensation
retro but sell the coverage on a "guaranteed cost" basis. Indeed, this is a
prime source of profit (or loss) for many leasing companies.
Because higher costs always find their way back to the buyer of goods and
services, clients would be wise to work with the leasing company and, if possible,
its insurer to devise an effective safety program. In fact, leasing companies
frequently turn down prospective clients with poor loss experience and substandard
safety programs. If losses increase to the point where the leasing company is
losing money on the insurance, it would eventually have to raise its rates,
which hurts its competitive position, or absorb the difference as a cost of
doing business.
Advice on Employment-Related Laws
Employees of many small businesses do not have access to the same legal protections
that employees of larger companies are granted, such as the
Americans
With Disabilities Act (ADA). When these employees are transferred to a larger
leasing company, they are afforded all the same protections as employees of
larger companies.
Leasing companies are professional human resources managers and as such should
stay current on all employment related laws, such as those concerning discrimination
and immigration. By retaining the right to make (or at least approve) all hiring,
promotion, and termination decisions, a good leasing company can keep a client
from exposing itself to claims of wrongful termination and discrimination. Similarly,
some leasing companies provide employees with written job descriptions and employee
handbooks that can strengthen an employer's legal position in such actions and
advise the client on eliminating practices that could result in charges of sexual
harassment.
Choosing a Leasing Company
The degree of success an employer realizes from an employee leasing arrangement
will, to a large extent, be determined by the leasing company it chooses. In
particular, employers should exercise care in ensuring that the leasing company
is financially sound and can provide evidence that it makes tax and insurance
payments on time. Criteria to utilize when choosing a leasing company include
the following.
- Financial stability
- Membership in an industry association
- Experience in your industry
- Good track record
- Benefit program that meets your needs
- Commitment to safety
Employers should check into the financial condition of both the leasing company
and the insurance companies it uses to provide benefits to employees. Clients
should check with the leasing firm's accountant to verify that withholdings
have been made on time and with its insurance companies to verify the existence
of coverage. If the leasing company utilizes a third-party administrator (TPA),
a meeting should be held with the adjustors who will be handling the account
to verify that the TPA carries errors and omissions coverage.
The leasing industry's reputation was damaged by highly publicized frauds
against employers and insurers. Industry organizations have attempted to clean
up the industry by enforcing strict standards of conduct. For example, NAPEO
requires its members to adhere to a strict code of ethics and professional operating
standards. Audits certifying that taxes and insurance premium payments have
been made on time must be filed quarterly. Members that self-insure any part
of medical benefits to leased workers must adhere to minimum reserving practices
and stop-loss insurance requirements, and they must purchase a bond.
During the interview, leasing companies should be willing to go over their
contract and point out the client's responsibilities and remaining legal liabilities.
They should also be willing to show a breakdown of their charges and explain
the method by which insurance and other expenses are passed through to the client.
Because leasing companies make tax deposits on a very frequent basis, penalties
for late filings are unusual. Nevertheless, the contract should stipulate that
the leasing company reimburse the client for any penalties or fines it incurs
because of an error or omission of the leasing company in this regard.
When the leasing company is providing workers compensation insurance on leased
employees, it should back that up with a sound safety program. A lack of interest
in safety should be a red light to the client. At the very least it shows a
disregard for the client's net costs (since premiums are generally passed through
to the client); at worst, it may be a sign that the company is engaging in workers
compensation insurance premium fraud. Because safety needs differ by industry,
it is important to choose a leasing company with a proven ability to control
losses in the employer's industry. Ask the leasing company to provide a list
of clients in your industry, and contact those references.
Summary
Employee leasing can offer many employers a variety of benefits, including
a reduction in net expenses. However, it is not a strategy without some risk.
Employers should carefully choose a leasing company with a favorable track record
that offers the services it desires. Further, employers should make a conscientious
effort to allay employee concerns through clear communication about how the
transition will be made and the benefits they will obtain from the leasing arrangement.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
to provide legal, accounting, or other professional advice or opinion. If such advice
is needed, consult with your attorney, accountant, or other qualified adviser.