The Latest on Rev. Proc. 2002-21
January 30, 2003, I (Derrin Watson) shared the podium with Mr. Richard Wickersham of the IRS at ASPA's Los Angeles Benefits Conference in a presentation focusing on Rev. Proc. 2002-21. In the course of the presentation Mr. Wickersham made several important clarifications and explanations regarding the Rev. Proc. As with any such pronouncements at a conference, his comments are not binding on the IRS. However, his comments are a good indication of the current approach of the IRS on the issues involved. Perhaps even more importantly, they make a great deal of sense.
General Issues
While Mr. Wickersham addressed several specific issues, he made some general comments which are important to understanding the issues that followed:
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Mr. Wickersham shares my impression that most PEOs are not the common law employers of the workers on their payrolls. Rather, the recipient/CO is likely the common law employer.
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An important IRS purpose in promulgating the Rev. Proc. is efficient use of its resources. Auditing and litigating employee status issues is complex and expensive. The Rev. Proc. allows the IRS to eliminate the issue, without harming Worksite Employees, and without involving IRS the IRS in the time, expense, and manpower concerns of case by case determinations. At the same time, the IRS is not interested in harming innocent Worksite Employees or causing problems for Client Organizations or PEOs which have acted in good faith, but perhaps with imperfect understanding of legal requirements.
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That being the case, the IRS is focused on having substantial compliance with the Rev. Proc. It is more interested in having PEOs follow the key outlines of the Rev. Proc., than in insisting on dotting every "i" and crossing every "t."
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The IRS may issue additional guidance, at some future date, on some of the thorny issues involving administration of multiple employer plans after the Rev. Proc.
With that general background, we proceed to some of the specific issues we discussed:
What is a PEO?
The Rev. Proc. never defines what a Professional Employer Organization, or PEO is. Without that definition, it is difficult for some employers to know whether they are subject to the Rev. Proc. I tried to pin Mr. Wickersham down on a definition and he deftly declined to give one. In fact, he commented that had the Service provided a definition, it would simply have inspired further questions.
I've tended to draw my inspiration for a PEO definition from the Marx Brothers: "If it walks like a duck, talks like a duck, and quacks like a duck, it's probably a duck." That is to say, if most observers would look at a business and say "This is a staffing firm; this is a PEO," then it probably is one. Mr. Wickersham drew his inspiration from the Supreme Court, "I can't tell you what pornography is, but I know it when I see it." I still prefer ducks.
The working definition of PEO I've been using since July is that a business is a PEO if its primary business consists of leasing workers to other businesses. This definition would exclude, for example, a hospital which incidentally leases staff members to neighboring clinics, inasmuch as leasing workers is not the hospital's principal business. Mr. Wickersham confirmed that the IRS does not intend to treat businesses which are not primarily in the employee leasing line as PEOs.
Having said that, Mr. Wickersham seems to be working from a more limited definition of PEO than mine. While he refused to define specifically a PEO, he did describe it as a business which primarily takes over all or virtually all the employees of a recipient, to be the recipient's outsourced HR department, in effect.
This definition would exclude businesses which provide specific manpower needs. For example, suppose a staffing firm specializes in providing technical employees, such as programmers. A client would call the firm saying "we have a major program and need three C++ programmers for a couple of years." Such a firm could do nothing but provide Worksite Employees for its clients, but it still would not be a PEO because it would not take over a firm's entire workforce.
How do we handle true temporary employees?
Mr. Wickersham confirmed that a firm which only deals with true temporary employees ("My receptionist is out for a week and I need a replacement") is not a PEO. A more interesting question involves a firm which has two divisions. One division conducts a standard PEO business. The other division handles true temps. Obviously the firm is a PEO unless the first division is miniscule. The question is how to handle the true temps. If they are treated as Worksite Employees, they will never be able to be covered under a qualified plan, because they do not do enough work for any one client to have the client cover the worker under a multiple employer plan, but if the PEO covers them under a 401(k) plan, it will violate ¶5.03(4)(a) of the Rev. Proc. To me, the only rational way to deal with this problem is to treat true temps as though they are back-office employees of the PEO, and not as Worksite Employees. There is no need for these workers to be regarded as Worksite Employees because they generally are truly common law employees of the PEO.
What happens if a PEO generally complies with the Rev. Proc. but missteps some of the technical requirements?
Today's catch phrase is "substantial compliance." Much as EPCRS tells plans to fix minor mistakes and go forward, so the IRS will not come down like a ton of bricks on a PEO which misses a deadline by a few days or doesn't follow every detailed rule of the Rev. Proc., said Mr. Wickersham. That position is consistent with the purposes of the Rev. Proc. as he defined them as well as with current national office policy in general.
Having said that, my advice to PEOs remains that they should comply strictly with the terms of the Rev. Proc., because that will leave no doubt about substantial compliance, and no question of problems from an overzealous auditor. However, a PEO need not lose sleep if there is an accidental mistake or a good business reason for a minor modification from the Rev. Proc., so long as the overall framework of the Rev. Proc. is followed.
Will the 401(k) distribution restrictions interfere with the PEO's duty to distribute Worksite Employee money via the spinoff plan or prevent a Client Organization from setting up a plan in 2004 covering Worksite Employees who received distributions?
No. That would be contrary to both the letter and the spirit of the Rev. Proc. Do not expect the IRS to raise this issue as PEOs are moving into compliance. What will happen in 2009 is another matter, but for the moment that is not an issue. As I've said before, "The whole emphasis of the Rev. Proc. is to make the problems of single employer PEO plans go away. By the end of the 2003 plan year, those plans either should be terminated or be converted into multiple employer plans. The Rev. Proc. is trying to smooth the way for that to happen. That being the case, I don't think we should expect the IRS to be throwing technical roadblocks in the way of those who are trying to follow their lead."
How does a PEO determine who is the common law employer of a Worksite Employee for purposes of administering a multiple employer plan after the Rev. Proc?
The Rev. Proc. gives no guidance on that issue. However, I answered that question in our session by suggesting that the underlying assumption of the Rev. Proc. is that most Worksite Employees are common law employees of the Client Organizations for which they work, not the PEOs which pay them. That assumption conforms to reality. That being the case, I said (a) chances are good the Worksite Employees are common law employees of the Client Organization and (b) even if they are not, the IRS will likely not give any grief to a multiple employer plan which treats the Worksite Employees as common law employees of the client. I asked Mr. Wickersham if he felt that was a fair summary of the situation and he concurred.
How will the IRS apply the "bad apple" rule to PEO multiple employer plans?
The 413(c) regulations are quite clear that "The failure by one employer maintaining the plan (or by the plan itself) to satisfy an applicable qualification requirement will result in the disqualification of the section 413(c) plan for all employers maintaining the plan." Mr. Wickersham pointed out that in handling a multiple employer plan under EPCRS, sanctions are computed on the basis of the offending employer, not the plan as a whole. (See Rev. Proc. 2002-47, §10.17.) While that is certainly good, it still leaves open the issue of who pays for the sanctions and pays for the costs of fixing a defaulting employer's portion of the plan if that employer has gone bankrupt. (Likely answer: the other cosponsors.)
How will the IRS resolve other issues on the operation of PEO multiple employer plans?
Mr. Wickersham listed a number of questions for which there is less than complete guidance at present. How do you handle 401(a)(9) rules or highly compensated employee definitions for owners/Worksite Employees who were (erroneously) not treated as 5% owners under the PEO plan? How do you handle prior year testing for 2004, the first year under the new regime? In each case, Mr. Wickersham stated a couple of different ways to treat the issue and admitted there is uncertainty. The IRS may give us guidance on these issues in the future.
How likely is the IRS to go after COs, who have no protection under the Rev. Proc?
While the Rev. Proc. does not afford any relief to Client Organization which have been improperly administered under the mistaken belief that Worksite Employees are common law employees of the PEO, there are no IRS plans to aggressively audit these situations. The same resource allocation concerns that gave rise to the Rev. Proc. in the first place will keep the IRS from conducting witch hunts for offending COs. However, Mr. Wickersham noted, an abusive CO, perhaps an owner being covered for the 415 limit under a PEO plan and the 415 limit under a separate CO plan, may well find IRS enforcement activity.
While we did not discuss it at the time, I believe this indicates the approach the IRS will take to PEO plans which convert to multiple employer status. Section 4.03 of the Rev. Proc. states, "For the purpose of determining whether a PEO Retirement Plan or Spinoff Retirement Plan satisfies the qualification requirements in § 401(a) upon plan termination (as described in section 5.06), Worksite Employees may be treated as if they were employees of the PEO." This important protection is unavailable to PEO plans which convert to multiple employer status. Nonetheless, I doubt that the IRS will ask converting plans to redo prior year's administration based on the true employees of the PEO. However, the lack of a transition rule does remain to allow the IRS to deal with abusive situations. Plans concerned about this should probably terminate rather than convert. Most PEO retirement plans, on the other hand, should be able to convert to multiple employer status without concern.