Whose employees are they when a professional employer organization runs payroll?
Edvin Givargis Published 6 minute read
The short answer
For state apportionment and withholding purposes, the business that directs the day-to-day work is treated as the employer of the individuals doing it, regardless of which entity issues the paycheck, withholds federal tax, or is named as the statutory employer on a payroll registration. A professional employer organization that administers pay, benefits, and federal payroll tax compliance for a client's workforce does not, by that arrangement alone, move those workers out of the client's payroll factor or off the client's withholding rolls. States that source the payroll factor use a common-law control test to define "employee," and a federal statute that names the professional employer organization as the employer for federal employment tax purposes says so only for that purpose. The result is a workforce that can be leased administratively while remaining, for state tax purposes, exactly where it has always been: with the business that assigns, supervises, and directs it.
The arrangement: administrative employer, not the employer that matters here
A professional employer organization enters a co-employment relationship with a client business. The organization typically becomes the employer of record for federal payroll tax administration, issues the workers' pay, handles benefits enrollment, and reports wages under its own federal employer identification number. The client keeps the part of the relationship that state tax law actually cares about: it decides what work gets done, assigns it to specific people, supervises how it is performed, and can end the arrangement for any individual worker regardless of what the administrative paperwork says. That division is the entire mechanism. It exists so that a business, often one too small to run its own benefits program efficiently, can outsource payroll administration without giving up management of its people, and it works precisely because the outsourcing is administrative rather than operational.
The federal tax law that makes certified arrangements attractive says this directly. A certified professional employer organization is treated as the employer of covered workers for federal employment taxes, but the governing regulation limits that treatment to remuneration the organization itself remits and states expressly that the rule creates no inference about who is the employer for any other purpose of law. The federal statute solves a federal administrative problem: it lets one entity file and pay employment taxes on behalf of workers who work for someone else. It was never written to, and does not, answer the state apportionment question.
Why the payroll factor looks past the arrangement
The payroll factor in an apportioning state is built to source compensation to where the work is performed, and the states implementing the model apportionment framework define "employee" the same way: any officer of the taxpayer, or any individual who, under the usual common-law rules applied to determine an employer-employee relationship, has the status of an employee of the taxpayer. That is a facts-and-circumstances test turning on the right to direct and control both the result of the work and the means of accomplishing it, not on which entity's name appears on the pay stub. A city-level payroll factor regulation aimed at general corporation and unincorporated business taxes states the same control test almost word for word, and adds that the designation given to the relationship and the method of paying compensation are immaterial to the analysis.
Applied to a leased workforce, the test does not ask who cuts the check. It asks who tells the worker what to do and how to do it. A business that assigns tasks, sets schedules, supervises output, and can request removal of a specific individual is exercising the control that defines an employer relationship under this test, whatever the co-employment agreement calls the arrangement. The individuals stay in the client's payroll factor, sourced to wherever they actually work, and a state where those individuals are physically present continues to be a state where the client has payroll-factor presence and the physical-presence contacts that inform an income tax nexus analysis. Nothing about routing their pay through an outside organization changes where the work happens or who controls it.
This matters most where a business assumed the opposite. A common but mistaken shortcut treats workers paid through a professional employer organization as belonging to no one's payroll factor, or as belonging only to the organization's. Neither view survives the control test. The organization does not direct the work, so it is not the common-law employer; the client does, so the client is. A business that excluded leased personnel from its payroll factor in a state where they actually worked has likely understated that factor, with consequences that run in both directions: understated payroll can understate apportionment to a state where the business would rather show more activity, or overstate apportionment to its home state when the leased workers are concentrated elsewhere.
Withholding follows the same control test, not the co-employment label
The same question, framed for employment tax rather than income tax apportionment, recurs at the withholding and contribution level. A state that wants to know who is responsible for unemployment insurance contributions, disability insurance, and personal income tax withholding on a given worker's wages has to decide, for state-law purposes, who the employer is when a staffing or leasing arrangement is in place. California's approach is illustrative of how a state actually answers this. Its statute distinguishes a genuine leasing or temporary-services employer, one that negotiates terms with the client, controls assignment of workers, retains the authority to hire and terminate, sets pay rates, pays the workers directly, and retains the right to reassign them, from an arrangement that lacks those features. If the organization administering pay meets that fuller definition, it is treated as the employer. If it does not, the client is the employer, and an entity that merely disburses wages without that bundle of control functions is treated as the client's paying agent rather than as an employer in its own right.
The practical effect is that a professional employer organization relationship does not automatically shift withholding responsibility away from the client. Whether it does turns on how much genuine employer control the organization actually exercises, not on the label in the service agreement. A business that assumed its withholding obligations disappeared when it began using a professional employer organization should confirm that the organization's role meets the state's leasing-employer test before relying on that assumption, because the liability for underwithholding, unlike the convenience of outsourced payroll administration, does not follow the paperwork.
Practice notes
Four disciplines keep this analysis from becoming an annual surprise. First, inventory every worksite worker supplied through a professional employer organization and map each one to the state where the work is actually performed, not the state where the organization is based or where its payroll system is administered. Second, include those workers in the payroll factor of every apportioning state where they work, and revisit any prior return that excluded them on the theory that they were not the taxpayer's employees; the common-law control test, not the service agreement, decides that question. Third, treat the co-employment agreement's internal allocation of compliance duties as a business arrangement between the two organizations, not as an answer to whose employees they are for state tax purposes; a contract cannot assign away a control-based statutory test. Fourth, before assuming withholding responsibility has shifted, test the arrangement against the state's actual employer-determination statute, since a professional employer organization that administers pay without retaining assignment, hiring, and termination authority typically leaves the client as the employer of record for withholding purposes regardless of what the certification or service agreement recites.
This article states the law as of September 17, 2026
Statutes, rates, thresholds, and agency practice change, and a different set of facts can change the answer. Before acting on anything discussed above, contact G&G State Tax Group to confirm what has changed since this was written and how the rules apply to a specific situation.
G&G State Tax Group, LLC is a state and local tax advisory firm. The firm provides state and local tax consulting and representation in state and local tax controversies. G&G does not prepare or file tax returns, perform attest services, or provide bookkeeping, and is not a CPA firm.