Companies that Use a PEO – Tips for Business Appraisers

The use of professional employer organizations ("PEOs") is on the rise. Here are some helpful tips for business appraisers unfamiliar with the PEO model.

What is a PEO?

Professional employer organizations ("PEOs") are human resources ("HR") outsourcing companies that help their clients manage employee-related matters like payroll compliance, benefits administration, and unemployment insurance claims. PEOs provide these services under a "co-employment" structure in which the PEO employs the client's workforce. The client leases back the workforce from the PEO and retains the right to hire, fire, and manage the employees.

PEOs make sense for many different types of businesses across various industries. They help small to midsize companies by reducing the time, money, and risk associated with human resources processes. Typically, they also allow clients to offer more attractive benefits packages than they might otherwise be able to offer. Moreover, as HR experts, PEOs can significantly reduce risk by filing taxes and handling paperwork and compliance issues on behalf of their clients.

There are many options for companies seeking to partner with a PEO, with ADP TotalSource, Paychex, TriNet, and Insperity being some of the more prominent names in the industry. According to the National Association of Professional Employer Organizations, 487 PEOs in the US employ more than 4 million people. As of early 2023, however, only about 135 (or 65 excluding affiliates) have met the IRS' voluntary certification program requirements. (The IRS publishes a list of certified PEOs on its website.)

How do PEOs work?

Different PEOs have specific criteria they want clients to meet; for example, some require a minimum number of employees. They need to ensure that potential clients are legitimate businesses that can meet payroll obligations and that they don't carry an unreasonable risk profile. Once a client has been vetted, they sign a contract with the PEO allowing it to take over employment responsibilities. Clients should be prepared for the substantial amount of information gathering and paperwork involved in the implementation process. In due course, employees must go through the PEO's onboarding process, which includes I-9 verification, benefits election, and technology training.

Payroll processing with a PEO isn't much different from using a standard payroll provider. The client's bank account is drafted to cover salaries, benefits, and PEO fees. However, employees receive their paychecks from the PEO and access their compensation and benefits information on the PEO's employee portal.

So, from an appraiser's standpoint, what's different about companies that use PEOs?

PEO Data Requests

Fundamentally, appraisers should understand that companies using PEOs do not employ their workforce. Therefore, the company may not be able to produce certain documents on the appraiser's data request list. For example, once under a PEO structure, federal tax Forms 941/940 will no longer exist for the organization. (The PEO will file aggregate employment tax returns for all of its customers using the PEO's employer identification number). Also, payroll reports and W-2s will have the PEO's name at the top.

Self-Employment Compensation

Another essential thing to keep in mind is that PEOs cannot classify self-employed individuals as employees. Therefore, a PEO cannot report compensation paid to a partner, sole proprietor, or other non-employee as wages on Form W-2. Instead, payments to self-employed individuals are reported as 1099 income, and payments to partners are reported on Schedule K-1 of Form 1065.

Even though they are not W-2 employees, sole proprietors and partners can buy benefits through a PEO. If benefits are being purchased, an owner draw is processed through the PEO, with the amount of the draw reduced by the cost of benefits purchased by the owner. No payroll taxes are taken out, and the owner will not receive a W-2. Appraisers should confirm that the owner compensation data they receive includes these draws. Although these amounts should appear on the 1040s or K-1s, they may not be identified or broken out in the company's financial statements.

Understanding PEO Fees

Finally, appraisers should be aware that the fee charged by the PEO for its services will be a significant expense to the company, and it may take some work to ascertain exactly how much the PEO is charging. Generally, PEOs price their services on a fixed fee per employee basis or as a percentage of payroll. In our experience, the fixed fee method (reportedly varying from $40 to $160 per month per employee) generally lends itself to straightforward invoicing. Conversely, PEOs that price as a percentage of payroll (expect anything from 2% to 12%, according to one source) tend to have more ambiguous invoicing, with administrative fees sometimes lumped in with payroll taxes, benefits, and other costs.

Regardless of a PEO’s pricing methodology, appraisers should be aware that the company being appraised will have access through the PEO portal to invoice reconciliation reports showing how service fees are allocated among various categories and on a per-employee basis.

Summary

All in all, PEOs should not significantly complicate a business valuation. In fact, appraisers who take the time to understand the PEO model and ask the right questions will likely benefit from the wealth of data available from the PEO. BFMV has significant experience working with the PEO model. Reach out to us with questions about healthcare business valuations involving PEOs.