Whose employees are they when a professional employer organization runs payroll?

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 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 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 the regulation adds that its presumption creates no inference about who is the employer for other federal tax purposes or for purposes of any other provision of law (26 C.F.R. 31.3511-1). 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 (Cal. Code Regs. tit. 18, section 25132, following the model regulation). 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, now largely of historical interest because the city has moved to a single receipts factor, stated the same control test almost word for word, and added that the designation given to the relationship and the method of paying compensation are immaterial to the analysis. The question arises only in states that still use a payroll factor; in the many states that now apportion by receipts alone, leased personnel affect apportionment only indirectly, through nexus and the location of the activity.

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. Under that test, the individuals stay in the client's payroll factor, sourced to wherever they 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 at all. That version does not survive either reading of the regulation: the compensation is somewhere, and the only question is whose factor it lands in.

The harder version of the argument is the one that says it lands in the organization's factor rather than the client's, because the client did not pay it directly, and it has real support in the same instrument that supplies the control test. The model apportionment regulation providing the employee definition also provides, in the payroll factor provision itself, that payments made to an independent contractor or to any other person not properly classifiable as an employee are excluded, and that only amounts paid directly to employees are included in the payroll factor. That direct-payment sentence is the principal authority states rely on to exclude compensation paid through a professional employer organization from the client's factor, on the reasoning that the organization, not the client, is what pays the workers directly. So the regulation points in two directions on one set of facts: the employee definition asks who controls the work and answers the client, while the payroll factor provision asks who paid the worker and answers the organization. Neither sentence has been subordinated to the other in authority binding on the states generally, and the honest description is that the point is contested rather than settled. The practical consequence is that the answer varies by state, according to which sentence that state's administration emphasizes, and by how the arrangement is papered, since an agreement under which the client reimburses identified payroll costs and retains the terms of employment reads differently from one under which the client buys a bundled service at a single fee and the organization stands behind the workforce as its own.

A business that excluded leased personnel from its payroll factor in a state where they worked may well have understated that factor, and the exposure is worth quantifying, but the exclusion is a defensible position in a state that reads the direct-payment sentence as controlling rather than an obvious error everywhere. What is not defensible is not knowing which reading the return took. The consequences 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, and a position taken by accident lands wherever it lands.

Withholding follows each state's employer rules, 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 answers this. Its statute (Cal. Unemp. Ins. Code section 606.5) distinguishes a 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 the worksite state's rules, which may follow a leasing-employer test, the entity that controls payment of the wages, or a PEO statute that assigns withholding to the organization, 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. One scope note belongs in the record: most states now have professional employer organization registration or licensing statutes of their own, some of which restate who the employer is for unemployment insurance and wage reporting purposes, and the analysis here should be checked against the worksite state's PEO statute before it is relied on.

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 performed, not the state where the organization is based or where its payroll system is administered. Second, resolve the payroll factor question state by state rather than once for the whole footprint, since the same model regulation supports the control reading that puts leased workers in the client's factor and the direct-payment reading that keeps them out, and record which reading each return took and why; a prior return that excluded those workers with no stated basis at all is the version that does not survive examination, whichever way the state comes out. 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 worksite state's own employer rules, since some states assign withholding to the organization by statute or because it controls payment of the wages, while California leaves the client as employer for unemployment insurance unless the organization performs every listed leasing-employer function. G&G State Tax Group provides payroll factor and withholding analysis for businesses using professional employer organizations alongside its state and local tax practice.