Earlier this year, one of my clients informed me they were changing payroll providers, mid-quarter. As we started a discussion of why it is better to make payroll changes starting in a new quarter, I slowly learned they weren’t just changing payroll providers, they were moving to a PEO.
I had never heard of a PEO, and in case you have not either, a PEO is a Professional Employer Organization. According to Wikipedia, “A professional employer organization (PEO) is a firm that provides a service under which an employer can outsource employee management tasks, such as employee benefits, payroll and workers' compensation, recruiting, risk/safety management, and training and development.
The PEO does this by hiring a client company's employees, thus becoming their employer of record for tax purposes and insurance purposes. This practice is known as co-employment.”
How it Works
My client closed not only their account with their outsourced payroll services provider, they also closed their State and Federal employer accounts, as if the company had closed. The PEO prepares the payroll under its own FEIN.
My client still submits their payroll hours on a bi-weekly basis, as well as all new hires and terminations, they just submit it to the PEO. The PEO prepares the payroll and employees are paid via direct deposit, as before.
There are many good reasons to use a PEO, the most common of which is to save money. My client researched switching to a PEO on their own, and came to the conclusion that using a PEO, while expensive, would in the end save them money due to the PEO’s ability to provide Workers Comp and healthcare insurance at significantly lower rates then the client can get on their own.
Most PEO providers also offer cafeteria plans, which are out of reach for most small businesses. My client is now able to offer their employees benefits such as a Health Savings Account and Flexible Spending plans, and disability and life insurance, which are excellent employee recruiting and retention tools.
Interestingly enough, my client opted to not use the PEO’s 401K service, as the client felt the investment options were limited, so they are using a different third party provider for the 401K. Most PEOs offer additional services (for additional fees), such as background checks. The PEO basically becomes an outsourced Human Resources department; they need just one person as a main point of contact at my client’s firm.
While the switch made excellent business and economic sense for this particular client, there were several unexpected Gotchas which we had difficulty anticipating (read more below).
1. Payroll Tax Withholdings Reset: Since my client elected to start this process mid-quarter/mid-year, and effectively closed their own State and Federal employer accounts, all Social Security, Medicare, and State withholdings started over with the PEO. So employees who had reached withholding caps had their withholdings begin again, meaning by year-end many will have exceeded the threshholds, and can expect refunds. The PEO provided little guidance on this topic, other than generic language to provide to employees suggesting they contact their tax preparers for more information.
2. Two W2s: All employees will receive two W-2s this year, one directly from my client, up until the point of the handoff to the PEO, and one from the PEO.
3. Bank Debit Confusion: The PEO charges a single fee per payroll for their services, which includes the actual payroll costs (gross wages, employer taxes and employer share of insurance costs), the PEO fees, and deductions for other fees and services. It took us some time to figure out the breakdown of each bi-monthly bank debit, as we expected just one large debit following each payroll run. Instead, we see not only the large payroll debit, but also separate debits from other third parties for the employee withheld portion of the 401K (since my client selected an alternate third party provider), and for the employee withheld portion of the flexible spending plan.
My client still has separate bank debits for life insurance and for auto and business owner insurance. It was unclear to me from the start which insurance the PEO service was/was not providing, so in the end I had to make a list in Excel of what debits to expect from whom.
4. Reporting Difficulties: As a bookkeeper, I contacted the PEO service to request reports which correspond to each debit, so I can verify the correct amount is being deducted from my client’s business checking account. This proved easier said than done. The PEO provider’s website offers dozens of reports, but you have to manually select all the parameters each payroll run. I finally learned they offer Saved reports, but
a.) they must be initially configured and saved, and
b.) they are not automatically generated.
I spent hours on the phone with the PEO account manager customizing and saving reports so I can obtain the data I need. Now after each payroll, I must login to the PEO and manually run, download and save the memorized reports. I’m sure this process differs with each PEO provider, but it is an onerous process with the provider my client selected.
5. Talk to the CPA: I connected with my client’s CPA firm, who also had no other clients using a PEO - so this was all new to them too, and we decided to post all PEO debits to “Contract Labor” – meaning we made Inactive all the Payroll and many of the insurance expense accounts.
While PEO services are expensive, ranging from 3-15% of total gross payroll (per Wikipedia), they can expand the range of benefits offered to employees, and can provide significant insurance cost reductions to employers. The initial transition to a PEO service can be rocky, and bookkeeping entries will certainly be impacted. Bottom line: be sure to do your homework to determine if a PEO is the right choice for your clients, and ask a lot of questions. The answers may surprise you!