EMPLOYEE LEASING: IS IT "A SAFE HARBOR"?

By Larry DiMatteo, Rene Sacasas, and Paul Munter

The determination of employee-independent contractor and employer-employee status has long been debated by judges and legal scholars. This determination is crucial for any would-be employer who expects to avoid paying employer payroll taxes, such as Social Security and unemployment taxes, as well as providing worker's compensation and health-insurance benefits. Employee leasing, or staff outsourcing, has become a popular device for employers to shift the responsibility to withhold payroll taxes and provide employee benefits to a third partyÑthe employee leasing company.

Employee leasing arrangements bring other potential benefits. They eliminate the related record-keeping responsibilities that accompany payroll accounting, and can serve to insulate employers from liability that may result from employee-generated claims. Claims can run the full gamut of employee-generated lawsuits, from sexual harassment and discrimination claims under the Civil Rights Acts, Equal Pay Act, and Age Discrimination in Employment Act to obligations under the National Labor Relations Act or pension payment obligations under TEFRA. Clearly, employee leasing arrangements can offer the employer many advantages.

An "employee leasing firm" is defined in a Minnesota statute as "an employing unit that provides its employees to other firms without severing its employer-employee relationship with the worker for the services performed for the lessee." The lessee is sometimes referred to as the "client company" which is defined in a Florida statute as an "entity that contracts with an employee leasing company and is provided employees pursuant to that contract."

A critical legal issue created by these arrangements is whether an employee leasing contract prevents a judicial finding that the client company is also an employer for the purpose of ascribing liability. To resolve this issue, we can review current case and statutory law to clarify the definition of the employer-employee relationship. Additionally, there is an emerging body of case law that deals particularly with employee leasing, as well as interpreting the purposes of the first generation of state employee leasing statutes.

Employee leasing agreements make representations that traditional employer obligations are shifted from the client company to the leasing company. For example, one employee leasing company brochure states that it "assumes the responsibility for the provision of benefits, payroll, unemployment, and the provision of worker's compensation coverage." It further states that it "assumes many employment responsibilities and risks, while the client retains essential management control over the supervision and direction of the work." It proceeds to assert that the employee leasing company "indemnifies and holds client harmless for failure to comply with the payment of wages [as required by] the Fair Labor Standards Act, withholding [as required] by the IRC, and payments required under the Federal Insurance Contributions Act (FICA), Federal (and state) Unemployment Tax (FUTA), and worker's compensation laws."

The concern, of course, is whether such contractual representations contained in a private agreement, in fact, legally shift these employer obligations from the client company to the employee leasing company. In other words, can a leasing company and its client company contractually abrogate common law relationships and the accompanying rights and duties? If not, will the client company be exposed to liability as an employer or joint employer?

What happens if the employee leasing company fails to honor its contractual obligations as enumerated in the leasing agreement? For example, if the employee leasing company fails to provide health-care benefits according to the company policies, will the employees of the leasing company be able to sue and recover from the client company?

A Tenuous Shield at BestÑThe Legal Implications

The IRS in Rev. Rul. 87-41 proffered a list of 20 factors that might be taken into account in deciding whether a worker is to be considered an employee. The ruling summarizes the determining factors as whether "the persons for whom the services are performed have the right to control or direct" the worker. The Tax Court held that the labeling of an employment relationship as an employer-employee relationship is a question of fact for the trier of fact to determine rather than a contractual assertion. It further stated that "the test generally considered fundamental for resolving this question is the degree of control exercised by the person for whom the work is performed over the individual who renders the services."

In 1993, the Tax Court intimated that this analysis would not be precluded by an agreement designating a worker as an employee of a leasing company and not of the client company. "Our focus is on the actual relationship existing between the parties and that a contract purporting to create an employer-employee relationship is not controlling where applying the common law."

In 1992, the Supreme Court held that, for purposes of ERISA, an "employee incorporates traditional agency criteria for identifying master-servant relationships. Thus, we adopt a common-law test for determining who qualifies as an employee." In another case, the Court listed a number of factors found under the traditional and well-accepted common-law test as the "right to control the manner and means by which a product is accomplished including source of instrumentalities and tools, location of work, duration of relationship, the right to assign additional work, hired party's discretion over when and how to work, and method of payment."

In the particular area of employee leasing, the IRC provides some guidance. Leased employees are to be considered employees of the client company for tax purposes if the leased employee has performed services on a full-time basis for at least one year and the services are of a type historically performed by employees in that particular business field. This does not mean that the leased employee cannot also be an employee of the leasing company for other purposes. Indeed, the Court found that an employee of a jewelry store that leased space from a department store was a "common-law employee of the department store for purposes of determining whether the worker was entitled to benefits under the store's ERISA-governed pension plan."

The flexibility of the control test was recognized by the Tax Court in 1993, where it was argued that the employer-employee designation was to be assigned based upon the totality of the relationship. For example, it has been held that the extent of the control necessary for a professional to qualify as an employee is "less than that necessary for a nonprofessional." This notwithstanding, a leasing company specializing in the leasing of consultants, accountants, and attorneys was held not to exercise sufficient control to qualify its retirement plan under IRC Sec. 401.

The importance of control was evident in a 1993 Florida case involving a leased employee, employed by a leasing company, licensed under Florida's employee leasing company statute, to a client company. The employee was injured at work and filed for unemployment insurance benefits. Although, the worker's compensation representative regularly reported to the leasing company, the employee was discharged for failure to report to the client company. This was held to be misconduct and resulted in a disqualification of the employee's right to unemployment benefits.

The Sufficient Control Test

It seems clear that a client company may be designated as an employer if it exercises sufficient control over the leased employee. The courts, however, have interpreted this in a number of different ways. First, the right to control without exercising actual control may be sufficient to justify an employer designation. If so, a leasing agreement that reserves to the client company "management control over the supervision and direction of the work" would be susceptible to attack on these grounds. Second, a leasing agreement that reposits the right to control and supervise the employee with the leasing company may still not be sufficient to prevent the designation of the client company as an employer. This would be the case when the client company exercises sufficient control to render it a common-law employer or as a statutory employer under a particular statute. In that regard, "the focus is on the actual relationship existing between the parties and that [the leasing] contract is not controlling where application of the common-law factors to the circumstances establishes...[the existence of an employer-employee] relationship."

The issue of joint employer liability also has been raised regarding an unfair labor practices claim under the National Labor Relations Act. "Where two employers exert significant control over the same employees...that they share or co-determine those matters governing essential terms and conditions of employment...they constitute joint employers." This notion of joint employer was reaffirmed in a case where one company employed a number of employees on its payroll and directed them to work under another company's supervision. The Court held that the two companies were joint employers.

Additionally, the language of individual statutes has been constructed to allow for a finding of more than one company as a statutory employer. For example, an automobile dealership was held to be a statutory employer for purposes of a worker's compensation claim of an employee of a trucking company hired to transport new cars for the dealership. A Georgia Court in another worker's compensation case attacked the use of an employee leasing agreement as "a subterfuge, if not an outright fraud" to falsely cover employees of one company on the worker's compensation policy of another company.

Beyond these instances, there have been a number of recent cases that have shown a pattern by the courts to disregard the terms and mandates of employee leasing agreements when assessing liability under a specific statute. For example, a physician who had leased a scrub nurse from an employee leasing company was held to be a statutory employer subject to liability under the Arizona Civil Rights Act. The nurse was discharged by the employee leasing company soon after taking a maternity leave. The terms of the lease agreement provided that the leasing company was responsible for payroll and all employment-related benefits. The determination of employee quality and duty assignments were to be a joint function. The Court held that "the employee leasing arrangement did not alter the essential nature of the doctor's office or his working relationship with the nurse." *

Larry DiMatteo, JD, is assistant professor of business law, Rene Sacasas, JD, is associate professor of business law, and Paul Munter, PhD, CPA, is KMPG Professor of Accounting, all at the University of Miami.

Editor:
Michael Goldstein, CPA

SEPTEMBER 1995 / THE CPA JOURNAL