Small businesses & M&A transactions: Considerations when a company uses a PEO

Professional employer organizations (PEOs) are a common method for small and mid-sized employers, or multi-national businesses with a smaller US presence, to obtain comprehensive payroll, human resources, and employee benefits services. When a company relies on the services of a PEO and that company is part of an M&A transaction, there are a variety of considerations that should be taken into account, including PEO contracts, 401(k) plan spinoffs and terminations, health coverage, payroll transitions, and purchase agreement provisions. Buyers may also want to enter into a PEO arrangement post-closing as an expedient way to provide human resources services and benefit plans to target employees post-closing.

What is a PEO/?

A PEO is a co-employer with another employer that, under a contract, handles certain human resources-related obligations. (For convenience, the entity that contracts with the PEO will be referred to in this article as the “employer” even though the PEO contract may provide for a co-employment relationship.)  PEOs often provide HR functions such as payroll; income and employment tax withholding and reporting; health, welfare, and retirement benefit plans; management of unemployment and workers’ compensation claims; compliance assistance on laws such as the Fair Labor Standards Act and the Affordable Care Act; and employee handbooks and policies.

Although the relationship between an employer and a PEO is contractual, there are many employment-related legal obligations that an employer cannot shed via contract. Those obligations include rules regarding earned wages, reimbursement for business expenses, unemployment benefits, age discrimination, and minimum wage and overtime.  The employer and PEO may allocate responsibility for these matters between themselves, but the government regulators and plaintiffs lawyers will generally look to the employer in the event of claims or non-compliance.

Form of transaction will often impact the decisions with respect to the PEO

Transactions are structured in a variety of ways, which may influence how the PEO relationship should be treated following the closing of the transaction. For example, in a stock deal, the PEO contracts between the parties generally stay in place, but with an asset deal certain contracts may be left behind with the seller, or will need to be specifically assumed by the buyer under the terms of the purchase agreement. Employees will usually terminate their employment with the seller during an asset deal, and will need to be rehired by the buyer or a buyer’s affiliate, even if they are in a co-employment relationship with a PEO.

One key question for the buyer is whether they wish to continue a PEO’s services moving forward. If the buyer plans to integrate the target’s business and employees with a business the buyer already owns, then they may not need the services of the PEO post-closing. On the other hand, if the buyer does not have other US operations, or does not want to integrate the target business at the time of closing, they may want to continue the services of the PEO post-closing. If the buyer does not want to continue the PEO, then they should consider when certain benefits end and whether there will be a gap between the PEO’s benefits ending and when the new benefits take effect.

In a carve-out transaction where the target business relied on the human resources infrastructure and benefit plans of the selling company, buyers that do not have sufficient HR infrastructure in the US may also want to consider whether PEO services are needed post-closing, particularly if they cannot enter into a transition services agreement with the seller.

PEO contracts

If a buyer and seller agree that the PEO services are not needed post-closing and want to terminate the PEO contract, they will need to look at the contract term to determine what notice periods are required. Some PEO contracts have a provision that allows the contract to be terminated with limited notice in the case of a transaction. Others may have an early termination fee. A review of the contract will assist the parties in determining how to approach the termination and how much notice the PEO should receive.

401(k) plan spinoffs and terminations

In a stock acquisition, buyers often wish to terminate the target’s participation in a 401(k) plan that the target sponsored or participated in prior to the transaction. One reason for this approach is that there can be potential compliance issues with the 401(k) plan that the buyer may not want to take on. Another reason for this approach is that the buyer would prefer to avoid the administrative time and costs associated with maintaining or merging the target’s plan.  Due to tax code rules, the 401(k) plan has to be terminated prior to closing, or else the buyer will not be able to terminate the plan post-closing (absent certain limited exceptions) while the buyer maintains a 401(k) plan in their controlled group.  Instead, they would either need to continue to maintain the plan or merge it into a plan sponsored by the buyer or an affiliate of the buyer.

A PEO usually offers a 401(k) plan structured as a multiple employer plan, sponsored by the PEO. This means that while the PEO is a plan sponsor, each employer using the PEO’s services is also an adopting and sponsoring employer of the plan.  Because the PEO 401(k) plan covers multiple, unrelated employers, it is not practical for a buyer to demand termination of the entire multiple employment plan.  Instead this is usually accomplished by spinning off the target’s portion of the PEO plan into a new target-sponsored 401(k) plan, which is then terminated. Because this approach can take some time to accomplish and requires the PEO’s cooperation, it is important for the parties to communicate with the PEO as soon as they can.

Health coverage

The Affordable Care Act (ACA) requires that applicable large employers (those with 50 or more full-time equivalent employees) offer medical coverage to their full-time employees that is affordable, minimum essential coverage that meets minimum value requirements. Being an applicable large employer is determined across a controlled group of related companies. An M&A  transaction that is a stock purchase may cause the target company to shift from being a small employer that is not subject to the ACA’s requirements to offer medical coverage to being an applicable large employer as a result of being a part of a buyer controlled group. If an applicable large employer does not offer ACA compliant coverage, they may owe tax penalties under Section 4980H of the Internal Revenue Code.

If, following the transaction, the target will be required to provide group health coverage to its employees, the buyer will need to make sure that coverage is in place. Where the employees are part of a carve-out transaction, the plan they participated in may be left behind, and if the buyer does not have benefit plans in place a PEO may be a good option to provide coverage.

Buyers should make sure they understand what their post-closing structure looks like, and make sure that they do not unintentionally create an issue where the target employees (and any other full-time employees in their controlled group) are not offered ACA-compliant coverage. The parties will also need to make sure that they understand who is responsible (the employer or the PEO) for providing the ACA information reports (Forms 1094 and 1095). Practically speaking, if a transaction happens later in the year, and the buyer wants to move away from using a PEO, the parties may want to consider how to credit any deductibles and co-payments, and they may want to consider waiting until a new plan year to transition employees to a new group health plan.

In addition, if the target employer offers health flexible spending accounts, the PEO may not be willing or able to accommodate a rollover of flexible spending account funds mid-year into the buyer’s plan. This could result in an unexpected cost to the buyer or loss of benefits for participants.

Payroll transitions

For companies that rely on a PEO for payroll services, they will need to make sure that these functions are transitioned smoothly to the new payroll provider if the PEO relationship is terminated at closing.

Related: Why partnering with a PEO is a smart growth strategy for small businesses

Generally, the employer, and not the PEO, is responsible for collecting and depositing federal and state withholding and payroll taxes and filing returns, but there are provisions in the Internal Revenue Code that can shift the responsibility to the PEO. For example, if the PEO has exclusive control of the payment of wages, then it may be considered a “statutory employer,” and in that case it is responsible for the employment taxes on the wages. Therefore, the buyer should understand what the PEO does and who is responsible regarding payroll and tax withholding.

Purchase agreement

The parties will also need to pay close attention to the terms of the purchase agreement that may be impacted by the existence of a PEO. They should review the representations and warranties to make sure that the benefits being offered are described accurately. The representations should be drafted in a way that contemplates the structure of a PEO’s benefit plans and the unique risks and issues raised by those plans (or else schedule any exceptions on the disclosure schedules). The target often does not have significant insight into the compliance of any PEO benefit plans, which may make certain representations difficult.  In addition, the presence of a PEO may need to be recognized in the pre- and post-closing covenants. For example, if the 401(k) plan is to be terminated, the provision should reflect the spin-off process noted above.  As another example, benefits continuation covenants should take into account that PEO benefit plans may not be continued post-closing.

Laura Taylor, a Tax Partner at Eversheds Sutherland with a focus on employee benefits and executive compensation matters and Catherine (Katie) Beaver, a Tax Associate at Eversheds Sutherland, would like to thank summer associate Eric Sadler for his contributions to the article.