Co‑Employment vs Employee Leasing: Legal Distinctions

Co-employment and employee leasing sound similar, but they work differently under the law. Co-employment is a shared employer relationship where a PEO (Professional Employer Organization), a company that teams up with your business to handle HR, payroll, and benefits, and your business split legal responsibilities. Employee leasing is a staffing arrangement where a third-party company supplies workers to your business as the sole employer. This guide covers the legal distinctions between co-employment and employee leasing, including IRS treatment, tax liability, and how state laws handle each one.

What Co‑Employment Means Under the Law

Co-employment is a legal arrangement where two companies share employer responsibilities for the same group of workers. In practice, this means a PEO and your business are both "an employer" at the same time.

Your business keeps control of the work. You hire, fire, set wages, assign tasks, and manage day-to-day operations. The PEO takes over administrative duties: payroll processing, tax filing, benefits enrollment, workers' compensation (insurance that covers your employees if they get hurt on the job), and compliance monitoring.

This split is defined in a Client Service Agreement (CSA), a contract that spells out which employer responsibilities belong to you and which belong to the PEO. The relationship is ongoing and has no set end date. If you end the PEO contract, your employees stay with you. They were always your employees.

NAPEO reports that more than 500 PEOs in the U.S. serve roughly 230,000 small and mid-size businesses, covering 4.5 million worksite employees (NAPEO, 2025).

What Employee Leasing Means Under the Law

Employee leasing is a different arrangement. A leasing company supplies workers to your business for a specific project or time period. The leasing company is the sole legal employer. It holds the employment contracts, handles all payroll and tax duties, and the workers stay on the leasing company's roster.

The key difference: you did not hire these workers. The leasing company recruited them, screened them, and assigned them to you. When the assignment ends, the workers go back to the leasing company, not to you.

This is closer to how a staffing agency works than how a PEO works. You direct the day-to-day tasks, but the leasing company carries full legal employer status.

In the 1980s and early 1990s, "employee leasing" was the industry term for what PEOs do today. The National Staff Leasing Association renamed itself NAPEO in 1994 to signal the shift from temporary staffing to ongoing co-employment. But the legal definition of "leased employee" still exists in federal tax law, which is where the confusion often starts. For a broader look at the practical differences, see our guide to PEO vs employee leasing.

How the IRS Treats Each Arrangement

The IRS draws a clear line between co-employment and employee leasing. The tax consequences are different for each.

Leased Employees: Section 414(n)

The IRS defines a "leased employee" under Internal Revenue Code Section 414(n). A worker counts as a leased employee if they:

• Are not your common-law employee (meaning you did not hire them directly)
• Work for you on a substantially full-time basis
• Have done so for at least one year
• Perform services under your primary direction and control

Why does this matter? Because the IRS requires you to count leased employees as your own employees when you run nondiscrimination tests for retirement plans like 401(k)s (employer-sponsored retirement savings plans where employees can contribute pre-tax income). If you exclude them, your plan could lose its tax-qualified status.

Congress added these rules in 1982 through the Tax Equity and Fiscal Responsibility Act (TEFRA) because some companies were firing rank-and-file workers, leasing them back through a third party, and then excluding those workers from company pension plans. The Tax Reform Act of 1986 tightened the rules further.

Co‑Employment (PEO Clients): Section 3511

The IRS treats PEO relationships differently. In 2014, Congress passed the Small Business Efficiency Act, which created a voluntary certification program for PEOs.

A Certified PEO (CPEO) that passes IRS vetting gets a specific legal benefit: under Section 3511 of the Internal Revenue Code, the CPEO is treated as the sole employer for federal employment tax purposes on the wages it pays. If the CPEO fails to send your payroll taxes to the IRS, the IRS pursues the CPEO, not your business.

For non-certified PEOs, the common-law employer (your business) remains liable for federal employment taxes, regardless of what the PEO contract says. This is a critical distinction.

Who Controls the Employees

Control is the legal test that separates co-employment from employee leasing. It affects liability, workers' compensation, and employment law compliance.

In co-employment (the PEO model):

• You control hiring, firing, work assignments, performance reviews, promotions, and salary decisions
• The PEO handles payroll, tax filing, benefits, workers' comp, and HR compliance
• The Department of Labor considers whether the PEO exercises "substantive control" over workers. If the PEO only performs administrative functions, it is not a joint employer (29 CFR 825.106)

In employee leasing:

• The leasing company is the sole legal employer and holds full employer status
• You direct day-to-day tasks at the work site, but you do not share the legal employer role
• The workers are not "your" employees. They belong to the leasing company

This distinction matters for liability. Under co-employment, the PEO's workers' comp policy typically covers claims. Under employee leasing, the leasing company carries the policy because it is the employer. For a closer look at how the split works in practice, see our guide to how a PEO works.

Tax Liability: Who Owes What

The tax liability question is where the legal differences have the most direct financial impact.

Federal unemployment tax (FUTA): The standard FUTA rate is 6.0% on the first $7,000 per employee per year. Most employers pay an effective rate of 0.6% thanks to the 5.4% credit for timely state unemployment tax (SUTA) payments. With a CPEO, the CPEO takes sole federal employment tax liability and handles FUTA. If you switch CPEOs mid-year, the IRS treats it as a "successor employer" event, so you do not get hit with double taxation on wage bases. With a non-certified PEO or a leasing arrangement, your business remains liable for employment taxes.

State unemployment tax (SUTA): State rules vary. Some states let PEOs report under the PEO's account. Others require each client business to keep its own unemployment tax account. Under employee leasing, the leasing company reports as the employer. If the leasing company loses its license or goes under, each client has to set up its own account.

401(k) and retirement plans: Under co-employment, many PEOs sponsor a multiple-employer 401(k) plan. Your employees join the PEO's plan, and the PEO takes on fiduciary liability (the legal duty to manage the plan in employees' best interest). Under the Section 414(n) rules, leased employees must be counted in your company's retirement plan for nondiscrimination testing. If you skip them, your plan could lose its tax-qualified status and trigger IRS penalties.

To estimate what working with a PEO might cost, try our PEO cost calculator.

How Employee Leasing Became the Modern PEO

The history explains why these two terms still get mixed up today.

The first employee leasing firm opened in California in 1972. The concept was simple: a company would "lease" workers from a third party to avoid the administrative burden of being an employer. But the arrangement quickly attracted businesses looking for a tax advantage.

The pension arbitrage era (1974-1986). After Congress passed ERISA (the Employee Retirement Income Security Act, the federal law that sets minimum standards for retirement and health plans) in 1974, companies with retirement plans had to follow strict nondiscrimination rules. Some owners found a loophole: fire your rank-and-file workers, lease them back through a staffing company, and exclude them from the company pension plan. That left the company's retirement plan covering only executives and highly paid employees. When Congress caught on, it passed Section 414(n) in 1982 to close the gap.

Fraud and the push for licensing. In the late 1980s, regulators found a "troubling number" of leasing companies stealing client funds and stripping workers of benefits (DOL, Employee Leasing Report). Florida responded in 1991 with the first comprehensive employee leasing licensing law. Other states followed.

The rename. In 1994, the National Staff Leasing Association renamed itself NAPEO. The industry formally adopted the term "PEO" to signal it had moved beyond temporary staffing toward an ongoing, shared-employment model.

The numbers tell the story. In 1992, the Census Bureau counted 2,241 employee leasing establishments with 341,884 employees and $7.2 billion in revenue. By the most recent count, PEOs serve 4.5 million employees with $414 billion in industry revenue (U.S. Census Bureau, 2021; NAPEO, 2025). That is a 686% increase in employees.

State Licensing and Why the Terms Still Overlap

About 35 states require PEOs to register or hold a license. But state laws use different terms, which adds to the confusion.

Some states define "PEO" in their statutes. Others still use "employee leasing company" as the legal term. Florida, for example, licenses PEOs under its Board of Employee Leasing Companies. Texas requires PEOs to register with the Department of Licensing and Regulation. The language differs, but the regulated entity is the same: a company that enters a co-employment relationship with clients.

State licensing requirements typically include:

• Registration with the secretary of state
• Proof of workers' compensation insurance
• A surety bond or minimum working capital (commonly $100,000)
• Audited financial statements
• Quarterly reporting for unemployment tax

The National Association of Insurance Commissioners (NAIC) adopted an Employee Leasing Model Regulation in 1991. NAPEO later developed its own model legislation with updated PEO terminology. Where states have adopted PEO-specific language, the legal framework is clearer. Where states still use "employee leasing" language, business owners sometimes assume a PEO is a staffing company.

For a directory of providers with current licensing and accreditation status, browse our PEO directory.

The Bottom Line

Co-employment and employee leasing are legally distinct arrangements. In co-employment, you and a PEO share employer responsibilities. Your employees stay on your team. In employee leasing, a third party supplies workers and carries the full employer role. The IRS treats them differently for tax purposes, and the liability rules are not the same.

If you are evaluating PEOs, you are looking at co-employment, not employee leasing. The industry moved past the leasing model decades ago. What matters now is whether the PEO you choose is certified (CPEO), how it handles your tax liability, and whether its services fit your business. For an overview of how PEO benefits work under co-employment, see our guide to how PEO benefits work.

Request a free consultation through our brokerage team to compare PEO options based on your company size, industry, and needs. The process takes several business days and costs you nothing. PEO providers compensate our brokerage team directly.

Sources

• NAPEO, "What Is Co-Employment?" (2025).
• NAPEO, "Industry Overview" (2025).
• Internal Revenue Code Section 414(n), "Leased Employees."
• Internal Revenue Code Section 3511, "Certified Professional Employer Organizations."
• IRS, "Certified Professional Employer Organizations."
• U.S. Census Bureau, "Workers of Employee Leasing Firms Soared 686%" (2021).
• U.S. Department of Labor, "Employee Leasing: Implications for State Unemployment Insurance Programs, Chapter 2."
• 29 CFR 825.106, "Joint employer coverage under the FMLA."