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Workers Compensation Issues

The Employee Leasing Decision

Christine Fuge | August 1, 2000

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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.

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.


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.

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