Running a multi-location restaurant, retail store, or service business means juggling payroll, workers' compensation, employee benefits, and endless compliance paperwork. It's no wonder that many business owners are tempted by Professional Employer Organizations (PEOs) promising to handle "everything HR" so they can focus on running their business.
But be careful: when you work with a PEO, you're entering a "co-employment" relationship that doesn't fully eliminate your responsibilities, it just makes determining who's responsible for what more complicated. And when things go wrong, business owners discover an uncomfortable truth: you can pay a PEO to handle your payroll taxes, watch them pocket your money, and still end up owing the IRS the full amount plus penalties.
In practical terms, a PEO typically handles:
- Payroll processing and employee database management
- Payroll tax withholding, filing, and payment
- Workers' compensation insurance
- Employee benefits administration (health insurance, retirement plans)
- HR consulting and compliance guidance
- Unemployment insurance administration
- Performance management tools
The National Association of Professional Employer Organizations reports there are over 900 PEOs in the United States serving approximately 175,000 small and midsize businesses.
The Co-Employment Relationship: Shared Responsibility or Shared Liability?
When you contract with a PEO, the PEO becomes the "employer of record" for tax purposes and files payroll under its own Employer Identification Number (EIN). Your employees technically become employees of both your company and the PEO simultaneously.
Here's the critical part most business owners miss: the IRS does not recognize "co-employment" under federal tax law. According to IRS guidance, "The Code does not define the term 'co-employer' and the concept is not recognized under federal tax law."
This creates a gray area. The PEO contract says they're responsible for taxes. Your employees' W-2 forms come from the PEO. But if the PEO doesn't actually pay those taxes to the government, who's liable?
The Common Law Employer Problem
The IRS determines liability based on who is the "common law employer"—the entity that controls the day-to-day work of employees, directs their activities, and makes business decisions. For restaurants, retail stores, and service businesses, that's still you, not the PEO.
A Chief Counsel Advice memo explained the problem clearly: even when a business paid all required amounts to its PEO, and the PEO's contract stated the PEO would remit taxes, when the PEO failed to pay the IRS, the IRS held the business liable for the full amount.
The business owner's defense that they had already paid the PEO was irrelevant. As the common law employer who directed and controlled the employees' work, they remained ultimately responsible.
The $50,000 You Already Paid (That You'll Pay Again)
Consider this scenario, which has played out at businesses across the country:
Your restaurant pays the PEO $50,000 for quarterly payroll, including all employment taxes. The PEO processes payroll and issues paychecks. Everything seems fine. Six months later, you receive an IRS notice: the PEO never remitted your $50,000 in taxes. The IRS wants payment plus interest and penalties.
You've already paid the PEO. But that doesn't matter. As the common law employer, you're still liable. You now face a choice: pay the IRS a second time (while potentially suing the PEO to recover your money), or face IRS collection actions, liens, and escalating penalties.
This isn't theoretical. Research from Yale Law School found that "PEOs may... expose [employers] to the risk of unpaid employment taxes and health insurance claims," noting that class-action litigation and DOL investigations have served as "notable checks on PEOs' conduct."
Certified Professional Employer Organizations: The Solution?
In 2014, Congress created the Certified Professional Employer Organization (CPEO) program to address the tax liability problem. A CPEO is a PEO that has been formally certified by the IRS after meeting rigorous financial, compliance, and operational requirements.
The key advantage: under Section 3511 of the Internal Revenue Code, a CPEO "shall be treated as the employer" and is "solely liable" for federal employment taxes on wages it pays. If a CPEO fails to pay taxes, the client business is protected from liability.
To become certified, a PEO must:
- Have at least one physical business location in the United States
- Provide annual audited financial statements prepared by a CPA
- Post a surety bond of up to $1 million guaranteeing tax payments
- Demonstrate financial responsibility and tax compliance history
- Be managed by individuals with employment tax compliance expertise
- Pass ongoing IRS reviews and audits
The IRS maintains a public list of all certified CPEOs, as well as organizations whose certification has been suspended or revoked.
The Catch: Very Few PEOs Are Certified
Here's the problem: fewer than 10% of PEOs operating in the United States have obtained CPEO certification. The requirements are stringent, the certification process is expensive and time-consuming, and it’s voluntary, so many PEOs simply choose not to pursue it.
State Unemployment Tax (SUTA): The Hidden Complication
Beyond federal tax liability, PEO relationships create complexities with state unemployment insurance that can significantly increase costs.
The Wage Base Restart Problem
When you join or leave a PEO mid-year, the change in employer of record can trigger a restart of the State Unemployment Tax Act (SUTA) wage base for each employee.
Example: Your state has a $10,000 SUTA wage base. An employee has already earned $30,000 by June, so you've finished paying SUTA on them for the year. You join a PEO in July. Now the PEO must start paying SUTA on that employee's wages from zero again, up to another $10,000. You've essentially doubled your unemployment tax costs for that employee.
The Experience Rating Shuffle
States assign each employer an "experience rating" for unemployment insurance based on claims history. Fewer claims mean lower tax rates. When you join a PEO, you're moved under the PEO's pooled SUTA account and experience rating.
If your business has a great claims history and low rate, but the PEO's pooled rate is higher (because they have clients with a high turnover rate), your costs increase. Conversely, if you have high turnover and the PEO's rate is better, you benefit. But you have no control over the PEO's overall pool.
Worse, Indiana's Department of Workforce Development warns that when you join a PEO, you may become liable for unpaid unemployment tax debts of other client companies in that PEO's pool. If the PEO takes on a new client that owes back taxes, you could be on the hook for someone else's tax debts.
Joint Employment Status: OSHA, Wages, and Discrimination
The tax issues are just the beginning. PEO relationships also create joint employer status under various employment laws, which means shared liability for:
Safety and compliance: While OSHA recognizes joint employment with PEOs differs from temporary staffing agency arrangements, safety violations at your worksite could still implicate both you and the PEO. You remain responsible for maintaining a safe workplace for employees who work at your location, regardless of who's listed as employer of record.
Wage and hour violations: Both you and the PEO can be held liable under the Fair Labor Standards Act (FLSA) for minimum wage, overtime, and recordkeeping violations. The employee can pursue claims against both entities.
Discrimination and harassment: Employees can file claims against both the PEO and your company under federal civil rights laws. Your company cannot hide behind the PEO relationship to avoid liability for discrimination that occurs at your worksite.
When PEOs Make Sense (And When They Don't)
Despite the risks, PEOs can provide real value for certain businesses:
Good Fit Scenarios
- Access to better benefits: Small businesses (under 50 employees) that can't afford competitive health insurance or 401(k) plans may access better benefits through a PEO's larger pool
- Limited HR expertise: Businesses without dedicated HR staff in industries with complex regulations (healthcare, hospitality with tipped employees) may benefit from PEO guidance
- Multi-state expansion: Companies expanding into new states may use a PEO to handle varying state payroll tax and unemployment requirements
- Rapid growth: Businesses scaling quickly may need temporary HR support before building internal capabilities
Red Flag Situations
- Cost-cutting as primary goal: If you're choosing a PEO mainly to reduce labor costs, the fee structure (typically 2-10% of gross payroll) rarely saves money
- Non-certified PEOs: Without CPEO certification, you retain tax liability while paying someone else to handle taxes—the worst of both worlds
- Poor industry fit: Businesses with seasonal employees, high employee turnover, or extensive temporary worker usage may find PEO pooled rates increase costs
- Existing HR infrastructure: If you already have payroll systems and HR staff, a PEO duplicates capabilities you're already paying for
Critical Due Diligence Questions
Before signing with any PEO, demand clear answers:
- Are you IRS-certified as a CPEO? If not, walk away or accept that you retain full tax liability.
- What is your SUTA experience rating in our state? Compare it to your current rate. Will joining increase your unemployment insurance costs?
- How do you handle tax payments? Will they pay from their account (giving them control) or will you fund payments in advance from your account (meaning they're just a conduit)?
- What happens if you fail to pay our taxes? Get in writing that the PEO carries errors and omissions insurance and will indemnify you for any unpaid taxes.
- What is your claims history? Request evidence of continuous operations, no IRS penalties, and no suspended/revoked certifications.
- How do mid-year transitions work? Understand exactly what happens to wage bases and experience ratings if you join or leave.
- Can I see the actual contract? Review the Professional Employer Agreement (PEA) with an employment attorney before signing. Pay special attention to liability provisions and termination clauses.
- What verification will you provide? Insist on monthly proof of tax deposits and quarterly confirmation that returns were filed.
The Bottom Line for Shift-Based Businesses
Professional Employer Organizations can provide valuable services, but they're not a magic solution that eliminates HR complexity. The co-employment relationship creates as many complications as it solves, particularly around tax liability, unemployment insurance, and joint employment responsibilities.
For restaurants, retail stores, and service businesses managing hourly employees, part-time workers, and seasonal staff, the risks of non-certified PEOs often outweigh the benefits. You pay someone to handle taxes while remaining ultimately liable if they fail to pay. You inherit their unemployment tax experience rating, which may be better or worse than yours. You may become exposed to other clients' tax debts.
Remember: outsourcing a function doesn't eliminate your legal responsibility for it. You're still the common law employer who directs the work, manages the business, and ultimately answers to all government agencies.
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