Why You Should Avoid PEOs—Especially For Workers’ Compensation Insurance

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PEOs claim to offer a smorgasbord of benefits for business owners. But buyer beware. Signing up with a PEO comes with a number of strings attached—especially when it comes to workers’ compensation insurance. And for most businesses, the damage can take years to undo.

What is a Professional Employer Organization (PEO)?

What does PEO stand for?

PEO stands for Professional Employer Organization.

What is a PEO?

According to the Society for Human Resource Management (SHRM), “A professional employer organization (PEO) is an organization that enters into a joint-employment relationship with an employer by leasing employees to the employer, thereby allowing the PEO to share and manage many employee-related responsibilities and liabilities.”

The arrangement works like this: A business owner enters into a contract designating a PEO as the official employer of record over the business’s employees. The PEO then leases the employees back to the business owner. This arrangement gives the PEO legal authority to manage the HR and insurance functions of the business.

Sometimes, this arrangement requires that the business “fire” its employees before they can be “rehired” by the PEO. As the United States Internal Revenue Service (IRS) explains, “In some cases, the employer who contracts with a PEO purports to fire its employees, who are allegedly then hired by the PEO and leased back to the CLE (the PEO’s client).”

Are there other names for a PEO?

A PEO may sometimes be referred to as a labor contractor, employee leasing company, or lessor, according to the National Council on Compensation Insurance (NCCI).

What are the benefits of a PEO?

There are certain benefits that make PEOs seem like an attractive solution—especially for small businesses who may lack the resources, expertise, or desire to manage their company’s human resource functions.

According to SHRM, some of the HR services a PEO can manage include:

  • Employee benefits administration
  • Recruiting and hiring
  • Payroll administration
  • Unemployment administration
  • Workers’ compensation administration
  • Compliance assistance
  • Drug testing programs
  • Family and Medical Leave Act administration

Other benefits commonly cited by PEOs include enhanced risk management services and safety programs, return-to-work programs, and pay-as-you-go workers’ compensation insurance policies.

What’s the catch? The disadvantages of a PEO

While PEO services may alleviate administrative burdens for some, the benefits definitely come with a cost. For business owners considering the leap to a PEO, here are some potential disadvantages to consider.

Workers’ Compensation Disadvantages of a PEO

PEOs typically pool all clients together under a single workers’ compensation insurance policy.

PEOs are responsible for providing workers’ compensation coverage for each and every one of their clients. PEOs typically accomplish this by purchasing one master policy.

As the NCCI explains, a master policy is, “A standard workers’ compensation and employers liability policy written in the name of the PEO covering the leased workers of multiple client companies and direct workers of the PEO required to be covered pursuant to the workers’ compensation laws of the state of coverage.”

In a master policy, the PEO is listed as the primary named insured. In some cases, the underlying businesses may be listed as “additional named insureds,” or they may be listed under the policy endorsements.

Businesses then lose their experience modification rating.

Once a master policy is issued, the workers’ comp data from the underlying businesses—such as payroll, premium, and loss history—is no longer reported to the workers’ compensation rating bureau. (For more on experience modification ratings, check out the article “How the Experience Modification Rate (Ex Mod) Works.”)

Instead, the data from all PEO clients are combined and reported together. As the NCCI explains, when workers’ comp insurance is written through a master policy, “Aggregated payroll, premium, and losses are reported for the PEO and all of its clients.”

The rating bureau then uses this combined data to issue a single experience modification rating for the PEO as a whole.

The result: The individual businesses that make up a PEO lose their individual experience modification ratings.

“A master policy approach dissolves the one-to-one link between the policy and the payroll and loss experience of the individual client companies that statistical plans require and computer systems were designed to support,” the NCCI explains. “As a result, individual risk experience ratings can no longer be calculated for these businesses using existing automated systems.”

Many businesses are shocked to learn that once they leave their PEO they no longer carry an experience modification rating of their own. Additionally, they are not permitted to carry forward the experience modification rating of their former PEO.

Unfortunately, these companies then find it extremely difficult, if not impossible, to secure workers’ comp coverage with private carriers—even if their individual record is squeaky clean.

Most private insurance carriers will not extend workers’ compensation coverage to businesses with no experience modification rating.

Nearly all private insurance companies require that potential insureds carry their own individual experience modification rating to be considered for coverage. Without an Ex Mod rating, a business will be hard-pressed to secure a workers’ comp policy with almost any private insurance company. These businesses often wind up with coverage through carriers of last resort until they can reestablish their Ex Mod rating.

It can take years for a business to reestablish an experience modification rating.

In most cases, rating bureaus like NCCI require individual workers’ comp data from the three most recent, consecutive years in order for a business to qualify for its own experience modification rating.

For businesses exiting a PEO, this can feel like starting from square one. Most businesses leaving a PEO are forced to find coverage in the residual market for at least three years before they have reestablished enough individual risk data to qualify for an Ex Mod rating.

Unfortunately, this often means three years of higher premiums and sub-par coverage.

Tax Disadvantages of a PEO

Taxes can get tricky.

Once a business signs on with a PEO, their tax reporting often changes—sometimes drastically.

Every PEO is different, and the agreement should outline which party is responsible for the issuance of payroll, payroll tax withholdings, and tax reporting.

“The client company reports its wages under the PEO’s federal employer identification number (FEIN),” SHRM explains.

Sometimes these changes can create confusion and lead to inadvertent reporting errors—especially for businesses who manage their tax reporting in-house.

You might trigger an IRS audit.

By entering into an agreement with a PEO, business owners open themselves up to new potential tax issues. Specifically, the IRS lists the following PEO situations as “issue indicators”:

  • Salaries and wages reported but no employment tax returns filed by the [Common Law Employer (CLE)]
  • Contracts that indicate the CLE is outsourcing one or more payroll and related tax duties to a third party
  • Payroll funds being transferred from the CLE to a third party
  • Wages not paid from the CLE’s bank account(s)

The IRS has published warnings regarding PEOs.

When it comes to PEOs, the IRS provided the following guidance for its auditors:

“Agents should inform any CLE using a PEO that, generally, the CLE is not relieved of its employment tax obligation with regard to wages paid to its employees by using a PEO. In addition, the Agent should advise the CLE to use due diligence in the selection and continuing use of the services of a PEO.

In other words, be careful which PEO you contract with.

“Co-employer” is not a legally-recognized business relationship.

Some PEOs use the term “co-employer” to describe their relationship with clients. The term paints a picture of equal partnership and between the PEO and the business owner.

But the term is misleading. Legally, there is no such thing as “co-employers.”

As the IRS explains, “In many cases, the PEO claims to share control over the employees as a ‘co-employer’. The Code does not define the term “co-employer’ and the concept is not recognized under federal tax law.”

HR Disadvantages of a PEO

SHRM lists the following as potential disadvantages to a PEO from an HR perspective:

  • Loss of control of essential processes and people
  • An outside company’s influence on your culture
  • Diminished value of internal HR department
  • Lack of control and security over employee paperwork
  • A loss of institutional knowledge
  • Security issues with the vendor’s system
  • Resistance from employees

There’s a better workers’ compensation solution for hazardous and safety-critical businesses.

Too often, blue-collar businesses resort to joining a PEO because feel they have no other choice for workers’ comp coverage. But there’s a better solution.

Foresight Workers Compensation is designed specifically for businesses in hazardous or safety-critical industries. Foresight covers construction, trades, manufacturing, light industrial, logistics, and short-haul trucking risks, just to name a few.

Plus, Foresight wraps proprietary risk management technology into every policy. A rigorous third-party evaluation by leading insurance actuaries found Foresight’s proprietary risk management software improves safety engagement and reliably reduces workplace incident frequency.

Get started today with Foresight

Looking for a competitive workers’ compensation quote for your blue-collar business? Foresight is here to help!

With fast pricing indications, online submissions, and in-app reporting, Foresight provides unrivaled value for brokers and businesses seeking safety and savings through technology. Learn more at getforesight.com.

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Ask your agent about Foresight, or find a broker near you for a free quote.

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Author: Foresight

We’re a team of compliance, safety, and commercial insurance professionals transforming workers compensation. We write about technology, trends, regulations, and value-adding services.